Gold’s ascent fueled by risk and policy jitters

In fact, our Gold Return Attribution Model (GRAM) points to the significant plunge in the US dollar – captured by ‘opportunity cost (FX)’ – as one of the key drivers of gold’s performance in April (Chart 1). Other contributing factors were a spike in market volatility and geopolitical concerns (‘risk and uncertainty’). The model also suggests that there was a degree of mean reversion that created a drag on gold’s performance, as some investors likely took profits following four consecutive months of strong returns (‘momentum’).

Can gold’s run last?

Gold is up by nearly 27% YTD, significantly outperforming major asset classes. Not surprisingly, investors are asking what’s behind the move and how sustainable it might be.

Gold has been supported by a combination of:

• US trade policy uncertainty and, more generally, geoeconomic risk
• A weakening US dollar
• Higher inflation expectations combined with lower bond yields
• Continued central bank demand.

Against this backdrop, investment flows via gold ETFs have significantly ramped up. In Q1, gold ETFs amassed US$21bn of inflows – the strongest quarter in three years – with an additional US$11 billion in April. Collectively, US funds have led the way, but Chinese funds have increased their holdings by a whopping 77% YTD.

Early innings?

Does this mean that the gold investment market is becoming saturated? We don’t believe that’s the case.

Previous gold bull runs have coincided with significant inflows in gold ETFs. But there seems to be room to grow. For example, gold holdings by funds listed in Western markets are 575t (or 15%) below their record high. In addition, Asian gold ETFs, driven by Chinese and Indian investors, have been consistently growing for the past two years, signalling a structural shift in adoption.

Furthermore, COMEX futures net longs, which typically represent the more speculative end of the investment spectrum, do not look overextended. They are currently sitting near 570t – their lowest level in more than a year and well below their 2020 high of over 1,200t.

This, of course, would not rule out further profit taking by some market participants and potential pullbacks in price.

Risk by any other name…is still risk

Investors have grown increasingly concerned over the growth and inflation outlook from the fallout of the ongoing trade war, both in the US and globally (Chart 2). The rise in uncertainty around trade policy and international relations has been supportive of gold as investors typically turn towards safe-haven assets for downside protection in those types of environments.

This has been exacerbated by pressure on US Treasuries and the dollar, which traditionally function as safe havens. This phenomenon is well documented by the media. In addition, conversations with wealth managers suggest that, for the first time in a long time, many investors have been seeking to hedge their overexposure to US dollar assets.

We estimate that trade concerns have accounted for approximately 10% to 15% of gold’s return YTD, stemming from USD devaluation, heightened geopolitical and market risk, and at least partly from some of the investment flows we’ve seen in recent weeks.

However, even if trade negotiations were to progress and conditions to improve, we would not expect gold to completely reverse its risk-induced bump.

For one, gold remains well bid despite some easing of trade tensions and the noteworthy rebound in the US stock market since early April. In addition, investors – especially international ones – appear wary of policies on which the Trump administration may concentrate next…and all other policies that may come over the following three and a half years.

Focusing on the ‘real’ side of real rates

A major concern regarding US trade policies is the potential effect they could have on US and global inflation. Indeed, short-term inflation is expected to rise in the US according to consumers and market measures (Chart 3).

Generally, high inflation is supportive for gold as investors seek out real assets for protection amidst falling purchasing power. Inflation, however, is often accompanied by higher rates that may create a drag on performance.

In this instance, there may be a limit to how much interest rates may rise.

The Fed has become a little more dovish recently. According to the Fedspeak Index, the FOMC is now very much on the fence as it balances the need to control inflation with supporting slowing growth (Chart 4).

At the same time, bond market participants certainly think that the Fed will prioritise economic health in this stagflationary-led dilemma (Chart 5).

Even if the Fed were to turn more hawkish, which we believe would only occur in the event of longer-lasting inflation effects, gold could remain supported.

Using GRAM, we have analysed the effect that changes in inflation and yields can have on gold, holding other variables constant. The main conclusion is that, in this environment, a rise in inflation will likely have a more positive effect on gold’s performance than the potential drag that higher rates may bring (Table 2). 

Looking beyond investors

We have covered multiple reasons why gold investment may remain strong. However, it is important to consider potential headwinds.

While investment flows are the key driver of large gold price movements, consumers are an important contributor to gold’s performance in the medium and long term. And they are key to sustaining gold trends. Higher gold prices have been deterring some jewellery buyers and while consumers can adjust to higher price levels, they still need time to adapt.

At present, recycling has remained surprisingly muted, but deteriorating economic conditions could change this, bringing additional supply and adding pressure to gold.

Central banks have also been an important source of demand for the past three years, significantly contributing to gold’s performance. We still expect central bank demand to remain robust this year, but rapidly rising prices have, in the past, temporarily decelerated purchases.

In summary

Gold’s performance so far this year has been remarkable. But the speed at which it has occurred has raised concerns about its endurance. 

We believe that structural reasons will enable investment demand to continue to thrive: 

• Uncertainty surrounding US policies and their effect on the dollar
• More sensitivity to higher inflation expectations and a higher likelihood of lower interest rate
• Lower gold accumulation levels than in previous cycles.

That, of course, would not prevent potential pullbacks driven by profit taking or signs of advancements in trade negotiations.

Equally, for gold’s bull run to be sustainable for longer, consumers need to be given time to adapt to higher prices.

This is a summary of the World Gold Councils April Gold Market Commentary report. View the full paper from the goldhub site.