Gold’s allure boosted by rate, inflation outlook

If inflation remains elevated for several years, the financial system will not return to normal for an extended period, creating an environment where gold and gold stocks may shine.
If inflation remains elevated for several years, the financial system will not return to normal for an extended period, creating an environment where gold and gold stocks may shine.

Markets react to rising rates expectations

Gold continued its year-long consolidation in a range around US$1,800 per ounce. US interest rates, the US dollar, and the US Federal Reserve (the “Fed”) remain gold’s dominant drivers. Based on U.S. interest rate futures prices, on January 3 the market anticipated the first Fed rate increase to be in May, with 77 basis points (bps) of tightening expected by year-end. Over the course of the month, markets priced in an increasingly hawkish Fed, following the release of the minutes from the December Federal Open Market Committee (FOMC) meeting, Fed Chairman Jerome Powell’s congressional confirmation hearing, and the January FOMC policy meeting. As a result, markets are now anticipating a March lift-off in US rates and increases that would total at least 100 bps of tightening this year. This caused both interest rates and the U.S. dollar to trend higher, with 10-year US treasuries hitting two-year highs.

Gold price’s counter moves relatively short-lived

All of this might appear negative for gold prices. However, the gold market trended to its high for the month of US$1,853 on January 25 in choppy trading. Gold’s resilience did not last, when Chairman Powell’s comments on January 26 following the FOMC meeting caused the US dollar index to break out to near-term highs and gold took a tumble—ending the month at US$1,797.17 for a US$32.03 (1.8%) loss. Gold stocks mimicked gold’s trend higher, then fell to end the month with losses of 2.65% for the NYSE Arca Gold Miners Index.

Gold market tides may be shifting

One of the defining characteristics of the lackluster gold market in the past year has been redemptions from gold bullion exchange traded products. The outflows indicate a lack of investment demand, particularly from institutional investors. However, on January 21, the world’s largest physical gold ETF, recorded its biggest inflow ever in dollar terms, worth US$1.63 billion. In tonnage terms, it was the largest inflow since September 21, 2020. The deceleration in outflows shown on the chart suggests most of the selling pressure has passed, while the recent large inflow might indicate that investment demand is picking up.

Inflation finally luring investors back to gold?

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Source: Bloomberg. Data as of February 2, 2022. Not a recommendation to buy or sell any security. Past performance is not indicative of future results.

More to watch beyond gold investment demand

While bullion ETF investment demand has been lackluster, the World Gold Council’s (WGC) Gold Demand Trends report for 2021 shows every other source of gold demand has been gaining.

  • Jewelry – Jewelry consumption grew 52% over 2020 to match the 2019 total. Demand in India nearly doubled in 2021 to a six-year high with a strong fourth quarter driven by pent-up demand during the festive season. Jewelry demand in the US gained 26%, the strongest in 12 years. The WGC attributes this to a lack of competition for discretionary spending, given the ongoing lull in spending on travel and entertainment.
  • Bars and coins – Bar and coin demand had a 31% annual advance to an eight-year high. This was driven by China, the U.S., and Germany. China’s bar and coin demand increased 44% to a three year high. The U.S. and Germany both set new records. Bar and coin demand stands in stark contrast to the outflows in the bullion ETFs. Each is driven by different types of investors. Coin demand mainly comes from retail investors, while bar demand from high-net worth investors. These investors are usually small to mid-sized local players, who are concerned about inflation and pandemic-related risks. Bullion ETFs are dominated by institutional investors, where gold is weighed against a myriad of investment choices that have gained prominence.
  • Industrial manufacturing – Gold used in technology grew 9% to reach a three-year high. Electronics applications include LEDs, printed circuit boards, dynamic random-access memory (DRAM) chips, and wireless technology that includes automotive, satellites, 3D imaging sensors and smartphones.
  • Central banks – Central bank demand increased 82%, lifting global reserves near a 30-year high. The largest buyers in 2021 were Thailand, India, Hungary, Brazil, Uzbekistan and Singapore. The trend to increase gold in foreign currency reserves is global.

Fed easing is over…

Soon quantitative easing (QE) will be over and the Fed will begin raising rates. The multi-billion dollar stimulus packages will also be over. Through QE, the Fed has crowded out the private sector, funding over 50% of the entire government borrowing requirements since 2010. The Fed also holds over 30% of all federally insured mortgage-backed securities. All of this stimulus has distorted markets and the pricing signals that follow. For example, the yield curve has flattened at a time of increasing inflation expectations, which is the opposite of past inflationary cycles. The last time real rates were as deeply negative as in 2021 was in 1974, a year when the S&P 500 Index fell 37%. However, in 2021, the same stimulus-fueled index gained 29%.

Markets might need a shoulder to lean on

The realisation of an economy without stimulus has caused many major stock indices to decline in January.

The volatility since the start of 2022 looks like a precursor to a year of extraordinary uncertainty, as the financial system attempts to transition back to normal. The transition, if successful, will take years of 25 basis point rate changes and disposal of trillions in treasuries and mortgage-backed securities. We doubt the system can get back to normal without more market volatility, along with some unintended consequences.

So far, gold has sidestepped the market’s volatility. Its January performance hovered around US$1,800, as it has done for over a year. However, we expect more room to grow for gold in 2022. We expect it to outperform, as the risks around a tightening Fed play out and as other inflation drivers continue to mount.

No shortage of supply shortages

Supply shortage and disruption is expected to continue. US firms’ semiconductor chip inventory has declined further to less than five days. Fast food company McDonald’s Corp. expects the rate of cost increases for food, paper and other materials in the US to roughly double this year. Also, most foreign business investments are not going to increase production. The United Nations Conference on Trade and Development showed the number of new projects to expand capacity fell in 2021 and remained far below their 2019 level. Foreign investment is being used to purchase existing businesses, instead of new projects that expand manufacturing.

Pandemic’s history lesson: inflation

The last pandemic that was comparable in terms of lethality broke out over a century ago and was accompanied by World War I. The spending on the war can be equated to the spending to fight the coronavirus pandemic. Inflation surged to 18% in 1918, 14.6% in 1919, and 15.6% in 1920. While we do not expect double digit inflation in this post-pandemic cycle, if inflation remains elevated for several years, the financial system will not be able to return to normal for an extended period. This could create a favourable environment for gold and gold stocks to shine.

Published: 09 February 2022

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