IS THE TIDE TURNING IN FAVOUR OF GOLD?

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Gold SPX
Chart 1: Gold and S&P500 Correlation

Gold, one of the top performing assets so far in 2016, has attracted a lot of attention. Turmoil in the equity markets and oil price crash have not only made investors jittery, but also forced many of them to invest in safe haven assets such as gold. As a result, billions of dollars of new money poured into physically backed gold exchange-traded funds (ETFs). In fact, fund inflows in the world’s largest gold ETF, SPDR Gold alone crossed more than $7 billion since December 2015, while gold holdings of ETFs have jumped to their highest level in 27-months.

Gold mining companies have been the biggest beneficiary as gold prices have surged 21.6 percent from December 2015 to a 15-month high. The HUI Gold, the index of gold mining companies, has more than doubled from December 2015 level. However, even after the recent rally, gold is still down by 23 percent from the closing level of 2012.

In the last 10-years, 2007 was the best year for gold. It witnessed a 31.4 percent jump in prices as the US economy witnessed subprime mortgage crisis. Gold has enjoyed bullish run during the period of October 2008 to December 2012 along with equities, helped by near-zero interest rates in the US and the Fed’s quantitative easing. During the same period, price of gold and S&P500 witnessed a strong correlation. Later, price of gold and S&P500 saw inverse correlation as yellow metal lost more than 1/3rd of value from 2013 to 2015, while S&P500 remained buoyant during the same period (See chart 1).

From investors’ perspective, it is essential to understand whether this 4-month rally in the safe haven asset is just the beginning of bullish run or mere short-term bounce back. Gold has been considered a hedge against inflation for years. There are several factors which play a critical role in determining prices of gold such as central bank activities, interest rates, currency, strength of economy, geo-political uncertainties, besides demand and supply. Hence, a closer look at each of these factors is warranted to know where gold is heading from here on.
Table

Central Bank Activities:

Central banks keep gold reserves as a store of value. Since 2010, central banks have been net buyers of gold, driven in part by uncertainty over the future of the international monetary systems and the need to diversify reserves.

China and Russia have been adding gold reserves aggressively in an effort to diversify their foreign reserves (See chart 2). In April, top gold consumer, China launched a yuan-denominated gold price fix to exert more control over pricing of the yellow metal and influence in the global bullion market.

Gold Reserves
(Chart 2)

Interest Rates:

The interest rate plays an important role in determining the attractiveness of the investment alternatives. If interest rate goes down, then the demand for safe haven asset goes up, and vice-versa.

Recent policy meetings showed change in tone of the US Federal Reserve from hawkish to dovish. The market experts believed the US Fed will go easy on rate tightening cycle, which it started in December last year, amid weak economic growth and slowly rising inflation. Moreover, the Bank of Japan became the second central bank after the European Central Bank (ECB) to adopt negative interest rates in January.

From the start of this year, the inflation adjusted yield on the 5-year US treasury fell sharply. Gold has also started rallying around the same time (See chart 3). Later, the real yield slipped below zero level in February. Since then, the real yield has remained in the negative territory, helping the yellow metal to maintain the momentum. It suggests there is a strong inverse correlation between the price of gold and the 5-year US treasury real yield.

Gold Yield
(Chart 3)

Currency:

The value of gold is expressed in the US dollars per ounce. Hence, the dollar plays an important role in determining gold prices. When the dollar weakens, the banks as well as investors buy more gold to protect their money and hedge against depreciation in the dollar. On the contrary, when the dollar appreciates, they invest more in the dollar, lowering the demand and the price for the yellow metal.

The dollar index lost 5.8 percent since December 2015 as the value of oil exporter currencies gained tracking rebound in the price of crude. As a result, decline in the dollar helped gold to add more gains (See chart 4).

However, the impact of recently launched yuan-denominated gold benchmark on gold and the dollar inverse correlation remains to be seen.

Gold DYX
(Chart 4)

Growth and Investment Sentiments:

Interest rates and value of the currency are dependent upon the progress of the economy. Based on the positive or negative perception about the economic prospects, investors positioned themselves in equities and safe haven assets. Gold-to-copper ratio is a very useful indicator to capture the industrial growth as well as investment sentiments in the economy. Copper is used in industries across the board, while gold is used as a hedge against uncertainty in the global economy. The ratio basically measures how many pounds of copper it takes to buy one ounce of gold. The uptrend in gold-to-copper ratio signals positive bias towards gold in a slowing global economy. On the other hand, the downtrend in the ratio suggests increased appetite for riskier assets in a stronger economic environment. Since May 2015, gold-to-copper ratio is in uptrend (See chart 5), suggesting the investors are in favour of yellow metal to protect their wealth in a slowing global economy.

Gold Copper
(Chart 5)

Demand & Supply:

The supply of gold declined 3.5 percent in 2015 to 4,258.3 tonnes, while the demand was almost stable at 4,252.6 tonnes in the last year, as per the World Gold Council. On the other hand, the surplus supply has dropped significantly by 96.4 percent from 156.2 tonnes in 2014 to 5.7 tonnes in 2015.

The mine production of gold has been on the decline. Barrick Gold Corp, the world’s largest gold miner, witnessed a fall of 2.1 percent in the production for 2015 to 6.12 million ounce. Barrick issued 2016 production guidance of 5 to 5.5 million ounce, which is substantially lower than the production in 2015.

On the contrary, the world’s top 2 gold consumers, India and China recorded a surge of 40.6 percent and 22 percent in demand for yellow metal respectively in 2015. The demand for gold from the India and the China stood at 848.9 tonnes and 984.5 tonnes respectively in 2015. At the same time, the central bankers bought 588.4 tonnes of gold in 2015, up 0.8 percent from 583.9 tonnes in 2014.

Bottom-line:

Though the world economy has recovered from subprime financial crisis, it is not out of the woods yet. The IMF has recently revised its global economy growth forecast downward by 20 basis points to 3.2 percent. Moreover, the world is facing challenge of negative interest rates. Hence, outlook for price of gold depends largely on the progress of global economy as well as demand from the central bankers and top two yellow metal consumers.

Note: This article was first published in June – 2016 edition of BSE Brokers Forum Magazine.

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