After the gold price traded above $1,190 yesterday, news of Dubai’s debt default sent the price of gold plunging $52 to a low of $1,138. While gold is currently stabilizing near $1,157, down $31.50, the gold mining stocks are under severe pressure heading into the open as the U.S. dollar rallies and risk aversion rises. The Market Vectors Gold Mining ETF (GDX) is down 3.5% in pre-market trading. The streak of nine consecutive record closes in the COMEX gold futures contract looks to be over - as all weak dollar trades are being liquidated. The U.S. dollar is stronger by 0.8% versus the euro and 1.4% and 1.2%, respectively versus the Canadian and Australian dollars.
News that Dubai World, the government’s investment arm, would seek a “standstill” agreement to delay payments on its $59 billion of debt sent global stock and commodity markets lower. According to Bloomberg, Dubai World, controlled by the emirate’s ruler, borrowed funds from in excess of 70 entities in order to purchase a wide range of assets, including a stake in MGM Mirage. Dubai aggressively borrowed to build a 21st century tourist attraction and business center in the Middle East. The news that Dubai was defaulting on its debt caused many investors to question how many other aftershocks of credit crisis were still to come. It is unknown exactly which institutions hold exposure to Dubai, and this fact caused investors to sell European banking shares when the markets opened. Emerging market equities sold off, dropping 2.5% as measured by the MSCI Emerging Markets Index.
Global financial markets stabilized over the past two quarters as the central banks worldwide aggressively flooded the markets with liquidity. This liquidity, primarily funneled to large banking institutions, stabilized the system and prevented banks from being forced into a mass liquidation of toxic assets. With a zero cost of capital and a steep yield spread, banks have been able to bolster their balance sheets. The gold price has benefitted from this zero cost of capital world and the reemergence of negative real interest rates.
The unintended consequence of a higher gold price, in addition to the potential creation of other asset bubbles, has not yet forced a policy change. Central bankers have not given the all-clear signal and are still in deflation-fighting mode. The Dubai default, in some ways, illustrates that the global economy is not yet strong enough to stand on its own. Longer-term this fact is bullish for the gold price, but over the short- to intermediate-term, as the events of last fall demonstrated, uncertainty and liquidation leads to indiscriminate selling of any and all asset classes - including counter-cyclical gold and gold mining stocks.
Uncertainty equals volatility and if the perception grows that the banking system is not on stable ground then the possibility exists of a deeper correction in risk assets such as equities and commodities. Equity volatility has been contracting, hitting a 15-month low as measured by the CBOE Volatility Index (VIX) earlier this week. Also demonstrating the current complacency is the percentage of bears on the stock market, which as measured by Investors Intelligence, is at levels not seen since mid-2004. Whether Dubai’s default is a isolated event or whether there are more systemically important entities in trouble will only be known months from now and with the benefit of hindsight.
Markets do not like uncertainty and the Dubai default injects a new element of uncertainty in the global marketplace. As penned on a number of occasions in these pages, the gold price and gold mining equities have benefitted from the tailwind of a weak dollar and healthier risk appetites. If either or both of these become headwinds, the prospect of a pause in gold’s bull market becomes a distinct possibility.
