Will the Sequestration Deal Hammer Gold?

Last week, the Senate passed a sequestration deal that will lock in the $85 billion of government spending cuts slated for this fiscal year. While many of the measures are hugely unpopular, when President Obama signs the resolution into law this week – as he is expected to do – it will keep the government from completely shutting down. It is difficult to predict whether Congress will continue to work towards further compromise that might address some of the cuts, but given the blunt instrument that sequestration represents, addressing blossoming issues would be appropriate.

Meanwhile, gold, as represented by the SPDR Gold Trust (NYSEMKT: GLD  ) , is already down roughly 4.5% this year. In certain respects, the cuts have the potential to bring a further measure of stability to the economy by forcing discipline. On the other hand, various projections from the Congressional Budget Office, or CBO, suggest that the cuts may be costly for the economy, making gold a reasonable place to protect your wealth. Ultimately, gold looks attractive at current levels and deserves an allocation.

The sequestration deal
While the current version of the legislation provides flexibility to specific departments, the overall level of the cuts remains at $85 billion and flexibility is limited. Those departments that have been given wiggle room include:

  • The Food & Drug Administration
  • The Department of Homeland Security
  • The Department of Defense
  • The Justice Department
  • The State Department
  • The Department of Veterans Affairs
  • The Commerce Department

Congressional Democrats pushed for greater flexibility, but Republicans held firm, insisting that without further negotiation on reductions, the widespread cuts were needed. Other smaller measures passed with bipartisan support that did not require a vote. For example $55 million was transferred to the Agriculture Department’s Food Safety and Inspection Service from other internal accounts. 

Sen. Roy Blunt of Missouri explained the importance of the measure: “Without this funding, every meat, poultry, and egg processing facility in the country would be forced to shut down for up to two weeks. That means high food prices and less work for the hardworking Americans who work in these facilities nationwide." Rhetoric aside, meat inspection is a vital party of the America infrastructure the lack of which would be felt immediately and profoundly across many industries including retail, restaurants, and discounters.

Macroeconomic impacts
In a recent study by the CBO, the imposition of the sequestration cuts is expected to cost the U.S. as much as 1.5% GDP growth. This reduction was acknowledged in Federal Reserve Chairman Ben Bernanke’s remarks after last week’s FOMC meeting. While Bernanke massively downplayed the projection – talking out of both sides of his mouth with typical Fedspeak – he did ultimately admit that the cuts will “slow job creation.” Assuming that the Fed sticks to its stated policy initiative, this means that the central bank will continue to pump capital into the market at the rate of $85 billion per month as a part of the current course of quantitative easing. While there are other factors that have given Bernanke a breather in terms of inflation, if he keeps printing money, at some point inflation must be a concern.

The net result, then, is that while the cuts will impose some highly overdue discipline, they will hurt growth, destroy jobs, push quantitative easing, and fuel inflation and economic instability. These elements combine to make a recipe for another run in gold. One issue to remember, however, is that these factors may take time to develop and are not universally accepted. I believe it is premature to pile into gold, but particularly at currently depressed levels, I would keep an allocation.

How to play gold
While the GLD is an effective way to get commodity-like gold exposure, it is worth exploring the relative attractiveness of the miners before making a decision. Companies like Barrick Gold (NYSE: ABX  ) and Goldcorp (NYSE: GG  ) have significantly underperformed the commodity over the past six months. This can be largely explained by the recessionary pressures that have hit the miners. When Barrick released its most recent earnings, CEO Jamie Sokalsky explained some of the pressures faced by the industry: "Rising costs, poor capital allocation and the pursuit of production growth at any cost in the industry have led to declining equity valuations across the sector. The message is clear: the industry must chart a new path forward.” Goldcorp faced these same pressures and has seen similar results.

GLD Chart

GLD data by YCharts

If, however, you consider the long-term behavior of the commodity relative to miners in the chart, what you notice is that over time (using Goldcorp for this example), the relative performance winner shifts. Miners have significantly underperformed, meaning that if the tide turns, gold miners may catch up in a hurry. GLD is the more conservative option, and, given the economic uncertainty in the market, likely the better choice, but it is always important to put these decisions into context. 

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