The following is an edited excerpt from the World Gold Council’s latest Investment Update. To read the full report, visit www.gold.org.
In August gold fell to a 20-month low amid sharp emerging market currency depreciation. At these levels, we believe the gold price may bounce back. Consumer demand is likely to be supportive in the second half. And short positioning may quickly reverse should one of the many current macroeconomic risks materialize, increasing investment demand.
The gold price lost 3% during the first half of August, a downturn that was exacerbated by gold’s fall below US$1,200 per oz. — an important technical support level — for the first time since early 2017.
Gold was propelled down by the strength of the U.S. dollar against both developed and emerging market currencies, particularly, a weakening of the Chinese yuan first and Turkish lira later. In fact, the dollar’s strength has helped drive gold’s performance this year, as confrontational trade rhetoric and sanctions have so far favoured the United States.
In addition, both the European Central Bank and Bank of Japan have delayed policy rate hikes, increasing differentials between interest rates in the United States.
But gold may rebound due to both technical and fundamental reasons.
Unusually ‘short’ market
Gold speculative positioning in futures markets is increasingly short. CME managed money net long positions stand at a record low since 2006 — when data was first broken down by investor type. Net combined speculative positions, which go back further, are negative for the first time since December 2001.
In recent years, a large increase in short positions has been followed by a sharp rally in gold. And while net shorts were more prevalent in previous decades, there have been structural changes that make these positioning levels different and likely short-lived. Among them are:
• Economic development in emerging markets, especially China and India, has increased and diversified gold’s consumer and investor base, as the combined share of annual demand of those two markets has doubled over the past 20 years from 25% to 50%.
• For almost a decade, the expansion of emerging market foreign reserves has resulted in net gold demand by central banks — about 500 tonnes per year — as a source of return, liquidity and diversification.
• Gold production hedging has also changed dramatically, as miners have not only reduced forward sales, but also consistently de-hedged their cumulative positions since 2000.
• The opportunity cost of holding gold is considerably lower, as nominal and real interest rates are 3% below their average level during the 1990s.
But a bounce back in the gold price can only be sustained if there are fundamental reasons to encourage consumers and long-term investors to seek exposure to gold.
Financial market risks remain
Many market participants have questioned why gold has failed to benefit from recent market turmoil. In reality, gold has indeed allowed non-U.S. investors to hedge risks associated with a depreciating currency — for example, the euro, Chinese yuan or Turkish lira, to name a few.
Historically, risks that have been contained within an industry or region — even with an accompanying surge in local gold demand — have not been enough to push the gold price higher in U.S. dollar terms. Yet when these risks become widespread, flight-to-quality flows have resulted in higher dollar-gold prices and lower portfolio losses.
So far market volatility has been relatively low, yet investors remain wary. An example of this can be seen by the increase in flows from equity to bond funds over recent months, as well as the consistent flattening of the bond yield curve in the United States. And there are good reasons:
• The current U.S. expansion is the second longest in history. It has delivered the longest stock bull market in modern times, pushing valuations to multi-year highs, while real rates remain subdued.
• So far, effects of trade sanctions have affected emerging markets — such as China or Turkey — but expanding or maintaining sanctions for a longer period will likely damage global growth.
• Developed market economies are heating up. Increasingly nationalistic economic policies in many countries, combined with a desire by some governments, if not central banks, to maintain competitive currencies by means of low interest rates, may result in higher inflation.
• Although European economies are expanding, risks — ranging from Brexit negotiations to financial institutions’ exposure to emerging market debt — may create a spillover effect that, to date, has been averted.
The past has shown that any of these risks can be the catalyst that elicits strong investment demand.
Consumers and long-term investors can provide more support for gold going forward.
Gold’s recent price pullback will likely support consumer demand, as, historically, lower prices have increased jewellery buying. For investors, gold’s current price range may offer an attractive entry level.
Chinese demand has proven resilient so far in 2018. The rise in investment demand in the second quarter has been linked in part to the depreciation of the yuan, as gold is often used as a currency hedge. This trend has continued into the third quarter, with increasing volumes in Shanghai and robust inflows in Chinese-listed, exchange-traded funds over recent weeks.
In India, gold premiums are now positive again, showing a tilt towards buying. And while the monsoon has brought devastating floods to parts of south India, expectations remain positive for the second half, as consumers prepare for their traditional buying.