Investment Commentary

In our paper Gold: the most effective commodity investment, we highlighted:

• gold is not a typical commodity
• it is the most effective commodity investment and
• it is under-represented in commodity indices.

Interestingly, developments in the performance and liquidity of the broad commodities market have led two major commodities indices -The S&P GSCI and Bloomberg Commodity (BCOM) Index - to adjust their composition, partly addressing the third point. Both indices recently announced that for a second year in a row, their weighting of gold will increase.

Specifically (in 2021):

• Gold will have the largest individual commodity weight increase in the S&P GSCI, and
• Gold will have its highest weight ever in the BCOM, which also takes the precious metals weight of the index to all-time levels.

Table 1. Gold weights increased in each of the past two years 

Sources: S&P Global, Bloomberg

While we continue to believe some weighting metrics, like liquidity, remain understated, we are encouraged by the acknowledgement from two leading indices of gold’s increasingly important role in the broader commodities complex.

We also believe it is important to underscore why gold is an asset that stands somewhat apart from other commodities, namely:

• Gold has delivered better long-term, risk-adjusted returns than other commodities
• Gold is a more effective diversifier than other commodities
• Gold outperforms commodities in low inflation periods
• Gold has lower volatility
• Gold is a proven store of value
• Gold is highly liquid.

As we’ve discussed recently, a balanced result of the US election (Democratic President and House of Representative; Republican Senate), gave the markets a sense of “status quo”, which propelled risky assets higher and gold lower. This came as investors took profits and the gold price made a technical pause. While gold held important support levels of around US$1,850/oz for the past four months, it broke that level yesterday and has continued lower today, near US$1,800/oz, as the perception of market risks fall.

There are a few reasons for the recent decline in the gold price. First, there have now been three confirmed successful vaccines, with AstraZeneca the latest company to note favourable results. President-elect Biden began announcing his Cabinet and yesterday named Janet Yellen his Treasury Secretary. As Chairperson of the US Federal Reserve, her accommodative policies were positive for risky markets over a large portion of the past decade. And finally, the General Services Administration declared Biden the winner of the Presidential election, and to some surprise, President Trump agreed to have his team transition to the new administration.

While the aforementioned news is negative for gold in the short term, some potential positive catalysts have emerged. While the Janet Yellen announcement is positive for stocks, it ironically should also be positive for gold as it increases the likelihood of lower rates for a longer period. We continue to highlight lower rates as positive for gold as it improves its opportunity cost. Seasonal improvements in gold demand in India and China are also positive for gold. Jewellery sales in China increased during October as its economy continues to improve, and recent data suggest positive consumer activity surrounding Diwali in India.

Gold remains 17% higher on the year, stronger than most major assets. But there is no denying that recent news has been overwhelmingly positive for broader markets and negative for gold prices. However, it could take some time before the vaccines are approved and even longer before they are deployed, and a substantial proportion of the population is vaccinated. Also, there is continued concern about whether enough of the population will take the vaccine to create herd immunity. Vaccines could end the pandemic, but the economic impact will be realized for years to come. And it will likely take additional fiscal and monetary help to fully “cure” the economy, adding additional credence and support for gold demand.

I recently joined Liz Young on her podcast, “Conversations with Liz Young,” to discuss gold’s performance drivers and its role as a strategic portfolio asset.

Listen below!

Despite returning investors an impressive 25% - making it one of the best performing assets – last year, gold has had a much less sparkling start to 2021. Year-to-date, gold has fallen 4.5% in US dollar terms, its worst start to a year since 2005.¹ And the picture looks no better in other key currencies too.

We believe that gold’s performance so far this year can be explained by:

• Rising Treasury yields and a stronger US dollar
• Negative gold price momentum
• Investor concerns on inflationary pressures

Gold started the year on a positive note, breaking above US$1,900/oz and up to US$1,959/oz, likely helped by rebalancing to a record weights in both the Bloomberg Commodity Index¹ and S&P GSCI indices, expectations of a potential commodity-led reflation which sent Brent Crude surging on 5 January, and political wrangling in the US. But gold pulled back sharply as ebullient US treasury yields snuffed out gold’s rally. The 10-year Treasury yield pushed above 1% for the first time since March 2020. This was likely in response to the news that the Democratic Party had wrestled control of the US Senate, improving the prospects for increased government spending and, in turn, expectations of economic recovery but also of potential inflation. For the rest of the month, gold remained within a narrow US$40/oz range, finding resistance at US$1,860/oz and support at US$1,820/oz, before dropping below the US$1,800/oz level in early February.

But the rise in US Treasury yields is unlikely to explain all gold’s price performance. Our short-term model provides a useful guide about what drove gold during the month:³

• We can see that the Opportunity cost category did indeed create a headwind for gold in January. While slightly higher interest rates will have contributed to this, it is likely that the US dollar also had an effect. It has steadily strengthened since the start of the year as optimism has grown over further government spending

• Negative momentum has also been a big factor in keeping gold’s performance subdued at the start of 2021. Gold has been on a downward trend since hitting its new nominal all-time high of over US$2,000/oz in early August, with investors increasing their risk-asset exposure as sentiment has improved in the wake of the US election and the successful development of several COVID-19 vaccines
• The short-term model indicates that there has been support coming from the “risk and uncertainty” category. As we noted in our Gold Outlook 2021: “…many investors are concerned about the potential risks resulting from expanding budget deficits, which, combined with the low interest rate environment and growing money supply, may result in inflationary pressures. This concern is underscored by the fact that central banks, including the US Federal Reserve and European Central Bank, have signalled greater tolerance for inflation to be temporarily above their traditional target bands.”⁴

We believe that the 13.8t of inflows into gold ETFs in January, after two consecutive months of outflows, provides evidence for the view that gold investment will remain well supported. COMEX net positioning, via the recent Commitment of Traders (COT) report for gold COMEX futures, also shows that despite the recent price performance in gold, it remains elevated signalling that investors remain bullish on gold’s longer-term prospects.

While gold has struggled for upward momentum so far this year, we continue to believe that the outlook for gold investment demand remains positive. Investors still face an environment of uncertainty, with the need to navigate several potential portfolio risks such as ballooning budget deficits, inflationary pressures, and possible equity market corrections. In our view, gold is well-positioned to help investors manage these risks going forward.

Footnotes

¹ Year-to-date performance to 5 February, calculated using the LBMA Gold Price PM (USD).

² Bloomberg Commodity Index 2021 Target Weights Announced

³ While the short-term model provides an interesting perspective on recent gold price performance, this top-level analysis may mask important changes to the factors within each category.

⁴ FT: Fed to tolerate higher inflation in policy shift (August 2020) and The ECB begins its shift to a new inflation goal (October 2020).

Last week we hosted a webinar for PLSA members in which we demystified common misconceptions about gold and highlighted the overall benefits an allocation can bring to a pension fund portfolio.

It was a pleasure to speak alongside John Reade, our Chief Market Strategist and webinar moderator Helen Lamb, PLSA Membership Engagement Manager. We discussed a range of topics including...

• Why gold? Long-term returns, liquidity, and diversification
• The drivers behind global gold demand
• Where can gold fit within a pension fund portfolio?  
• How an allocation to gold can help improve a portfolio’s risk adjusted returns
• The World Gold Council’s gold valuation framework

Watch the webinar below! 

Last week I had the pleasure of speaking to Helen Hayes, Managing Director and Head International Equity Sales and Trading at CIBC Capital Markets on CIBC's The Holler podcast. We discussed the outlook for gold, touching on the Robinhood phenomenon, cryptocurrency, inflation and global supply and demand dynamics.

Listen below!

It was great to return to the virtual stage at another SPS conference in mid-February. In this short video I introduce gold’s key attributes, sources of demand, and touch on the key takeaways from our Gold Market Outlook 2021.

For further details on the role gold can play in a portfolio take a look at our strategic case for gold 2021 edition.

• Interest rates have been a key driver for gold in both 2020 and 2021
• As interest rates have moved higher, the gold price has decreased…
• …but higher inflation expectations may provide some support for gold.

Interest rates as a key driver

One of the four key drivers of gold is the opportunity cost of holding it.¹ In particular, the level and direction of interest rates are good indicators of gold’s performance, especially in the short and medium term.

The recent movement in US rates, on the back of the testimony of the Federal Reserve’s (Fed) Chair Jerome Powell to the US Congress, is a good example. The intra-day movement in the gold price on 24 February mirrored the behaviour of the US 10-year yield (Chart 1). As the 10-year yield topped 1.42%, the gold price dropped below US$1,785/oz, but as rates settled back to around 1.37%, the gold price climbed up again to above US$1,800/oz…

…But the influence of interest rates on gold goes beyond the past 24 hours.

Rates have risen sharply in 2021

During 2020, gold benefited from the significant fall in interest rates worldwide. As rates reached historic lows and real rates across developed markets turned negative, the opportunity cost - relative to rates - of holding gold all but disappeared.

But as rates have moved higher in 2021 - particularly in February - this trend has reversed. For example, the US 10-year yield has risen from 1% in late January to over close to 1.4% at the time of writing.² The recent move has been relatively sharp: it took almost five months for the US 10-year yield to move 40bps from 0.6% to 1%, but only a little more than one month to reach 1.4%.

In this context, gold’s 5% decline in the year-to-date³ can be explained in good part by the movement in rates (Chart 2).

A reflationary environment

Much of the recent movement in rates can be linked to the so-called reflation trade. Real assets like homes, lumber, copper and oil have all moved sharply higher partly due to expectations of economic recovery, but also in anticipation of potentially higher inflation – especially given the large amounts of money that have been pumped into the economy.

Inflation expectations are also ticking higher. It is likely that investors are positioning for a higher (non-seasonally adjusted) US Consumer Price Index (CPI) print during Q1. This could be partly due to the significant increase in oil prices which, in turn, make up a sizable component of the US CPI. If history serves as a guide, and given that the year-on-year increase in the price will be measured against its near-zero level in late Q1 2020, we could see the US CPI in March shoot up to levels not seen in over a decade (Chart 3). This ‘base effect’ will likely be temporary, but it may nonetheless rattle markets. Looking forward, however, an increase in money supply and the effect of fiscal stimulus could materialise in a more consistent higher inflation level.

Fed expectations

During his testimony to the US Congress, Fed Chair Jerome Powell highlighted that the recovery in housing, business investment and manufacturing has likely been driven by fiscal and monetary stimulus.

He also highlighted that monetary policy tightening – when it occurs – will not be solely linked to a strong labour market. Most importantly, he emphasised that inflation should exceed 2% for some time before the Fed will consider tightening.

For the time being, they expect to keep increasing their holdings of Treasuries and Agency mortgage-backed securities at the current pace through their asset purchase program.

What this means for gold

While higher interest rates may continue to pose headwinds for gold in the short and medium term, inflation expectations are also likely to move higher. Historically, gold has performed well in high inflationary environments globally. In addition, despite their recent increase, interest rates remain structurally low. This is reshaping asset allocation partly as investors search for yield and partly because, at such low levels, bonds may be less effective at providing the diversification investors may need in the event of equity market pullbacks. This concern has prompted some investors to increase strategic allocations to gold, which continue to be seen through inflows in low-cost gold ETFs despite overall outflows in the gold ETF space during the month.

For more on our 2021 Gold Outlook, visit Goldhub.com.

Footnotes

¹ See Gold Outlook 2021, January 2021, p.4.

² As of 24 February 2021. Based on Bloomberg’s US Government Generic 10-year Yield Index.

³ Based on the LBMA Gold Price PM as of 24 February 2021.