The middle of December is the traditional time to dust off the crystal ball and make annual predictions.
The annual predictions I started making here in 2014 have had a success rate of 75% (three out of four), where only last year’s prediction that gold would decline below $1,000 an ounce in 2017 did not work out (with two weeks to go).
For 2018, I think the U.S. dollar will rally big time.
In 2017, the dollar reached its highest level on the first trading day of the year and it went pretty much straight down until September. During the fourth quarter, we have seen some bottoming action. I think the chances are better than 50-50 that the dollar recovers all the losses it saw in 2017 and makes a fresh multi-year high in 2018 (see chart).
Why did the dollar decline in 2017? Primarily because the euro — the largest component of the U.S. Dollar Index DXY, -0.20% at 56.7% — had a massive unwinding of what I call “the eurozone disintegration trade.”
Instead, the eurozone delivered a wave of political victories for pro-EU parties in the Netherlands, France and, to a lesser degree, Germany. Nonetheless, Angela Merkel’s party must yet again start negotiations with the Social Democrats (SPD), which originally wanted to stay in opposition. But the SPD realized that if no government is formed, they might be worse off with a new federal election, so they changed course.
Meanwhile, the European Central Bank is in quantitative easing (QE) mode, while the Federal Reserve is in quantitative tightening (QT) mode. The seeds have been sown for the dollar to rebound, particularly if the tax plan goes ahead and if Congress helps President Trump execute on his infrastructure program.
China is another dollar factor
Another reason for the dollar to rally in 2018 is what I expect to be an unwinding of China’s credit bubble, which I think is at an early stage. Chinese gross domestic product (GDP) is forecasted to end 2017 at $11.8 trillion, while at the turn of the century it stood at only $1.094 trillion. The trouble is that at the turn of the century, China’s total-debt-to-GDP ratio was about 100%, while now it stands at 400%, if one counts the shadow banking system, which is conveniently omitted from many official statistics. The reason it should not be omitted is its size. Some credible sources, not the least of which is the Brookings Institution, estimate that China’s unregulated lending is larger than the size of the country’s GDP.
In other words, as the Chinese economy grew more than 10-fold since the turn of the century, total credit in the Chinese financial system grew more than 40-fold. I believe we have reached a tipping point in this massive credit cycle, and now we are “over the hill” in the sense that GDP growth has begun to slow while credit growth is still surging. Bigger mountains of debt cannot produce an accelerating economy in China, which is a sign of a busted credit bubble (see chart).
The better than 50% decline in major commodity indexes in the 2014-2016 period is a direct result of this Chinese economic slowdown. One indicator of Chinese deterioration to watch for is renewed weakness in commodity prices. China is the No. 1 consumer in most commodities, so their prices should act like canaries in a coal mine. Typically, busted credit bubble situations result in a hard landing, which I think will be like what we saw in the Asian crisis of 1997-1998, which had similar debt-to-GDP dynamics. The trouble is that the Chinese economy today is several times bigger than the total GDP of the local economies affected by the Asian crisis 20 years ago (see chart).
I think China’s credit bubble will ultimately result in a devaluation of the yuan similar to the devaluation that was engineered in December 1993 to the tune of 34%. One way to see the hard landing coming is to see a sharp acceleration of foreign exchange outflows. A Chinese yuan devaluation, if it comes in 2018, will be highly deflationary for the global economy and will be decidedly a dollar-bullish event (see chart).
Gold may finally decline below $1,000
With two weeks to go in 2017, it looks like I will lose the bet I made with Gary Alexander, who edits my Navellier market commentaries, in early 2017. He has agreed to enter into another bet for 2018 on the same terms — that goldGCG8, +0.16% will decline below $1,000 an ounce at any point in 2018. That’s like a binary put option on gold with an expiration date of Dec. 31, 2018.
While some may see my entering into a second binary put options contract on gold after the 2017 one is getting ready to expire worthless is an attempt to hope that a broken clock will be right twice a day, I don’t think this is the case. Thinking that gold will decline in 2018 is derived directly from the expectation that I think the dollar is likely to rally in 2018, which I believe is a better-than-even-probability event.
There are already signs that the precious metals markets are weakening again, with silver leading to the downside and trading at levels not seen since December 2016, when gold bullion was near $1,120 an ounce (see chart). I think a decline in gold to below $1,000 is likely to happen if my dollar forecast for 2018 works out.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own.