Investment Commentary

Celia Dallas, Chief Investment Strategist at Cambridge Associates, is the latest industry expert to join us for our Strategic Edge Video series. In a dynamic discussion with World Gold Council’s Head of Americas, Joe Cavatoni, she shares incisive and timely perspectives on key trends shaping allocation strategy, untapped market opportunities and Cambridge’s comprehensive diversity manager initiatives. 

Watch below and explore more from our Strategic Edge series on Goldhub. 

Gold’s price has dropped by almost 7% since the end of May.¹ Most of the move can be attributed to an increase in interest rates following last week’s US Federal Reserve (Fed) FOMC meeting. As inflation concerns grew, the Fed signaled a more ‘hawkish’² direction with an expected hike in the policy rate by 2023, earlier than the market had thought.³ In turn, US 2-year rates almost doubled from 14bps by the end of May to an intra-day high of 28bps on 18 June.⁴

Gold’s reaction is not surprising given that it has experienced higher sensitivity to interest rates over the past year, as we discussed in our most recent 'Gold Market Commentary', and our recent blog: 'Short-term gold performance model: how it works and why it matters'. In addition, investor positioning prior to last week’s Fed meeting indicated that gold had likely become overbought and could pause its ascent or even retreat in the short run (see 'Investment Update: Time to realise gold’s true volatility'), along with an assessment of market positioning as likely indicating that gold had, at that time, become.

Now that a pullback has materialised, the gold options market shows some interesting dynamics forming. Historically, from a volatility perspective, when gold sells off quickly, we usually see the ‘put skew’^5,6 increase as investors are willing to pay a premium to protect against further downside. In the selloff over the past week, however, we have seen the put skew decrease or ‘cheapen’⁷, suggesting investors may be selling out-of-the-money (OTM) put options to gain long exposure to gold at a price they might consider more attractive. They have also been buying more at-the-money (ATM)⁸ puts, in lieu of downside puts to take advantage of the recent increase in implied volatility,⁹ as the ATM put prices will likely be more sensitive to price and volatility changes (Chart 1).

By the same token, while implied volatility has risen so, it has so far only done so slightly, moving up about one volatility point to a level of 16 (equivalent to a 16% annualised expected volatility). This is still in line with historical average levels. By means of comparison, during previous similarly sharp downward moves, we have often seen gold’s implied volatility reach levels closer to the 20’s. This could suggest that some of the selloff is being buffered by buyers, some of which may see this as a tactical opportunity but also by investors building strategic positions, as we discuss below.

While investors may still be concerned about further downside risk their positioning suggests that many of them believe the selloff could be overdone and could be using this higher implied volatility to gain long exposure to gold at a more attractive level.

Chart 1: Put skew 

Similarly, we have not seen a meaningful shift in COMEX net longs (Chart 2), which can represent sentiment from momentum traders and often correlates with market moves, although the most recent data came from 15 June, the day before the Fed meeting, with this week’s data being released on Friday, 25 June.¹⁰ Occasionally we see net long positions act as a bit of a reverse barometer in terms of where prices could go, particularly as they become exceedingly long or short. In this instance, there was minimal impact on net longs, which could suggest strategic investors are offsetting some of the momentum of short sellers, or that short sellers are closing some of their positions.

Chart 2: COMEX net long positioning

Additionally, while gold fell nearly 7% in June, we have seen positive gold-backed ETF inflows, even as the gold price sold off sharply last week. In particular, North American funds, whose flows often move in the same direction of price and often with larger magnitudes, have actually seen inflows this month - a further indication that investors may be taking advantage of the lower price level to gain long gold exposure.

Finally, we previously discussed the overbought technical indicators prevalent in the gold price in the above-mentioned 'Investment Update: Time to realise gold’s true volatility' which suggested a pending pause or retracement in price, prior to the most recent selloff. Now, the opposite effect has occurred with gold prices now being oversold with the RSI drifting below 30 (Chart 3). Additionally, gold remains in a longer-term bullish trend as long as it holds above the US$1,750 support level.  

Chart 3: Gold Price

Ultimately, the long-term strategic rationale for a gold allocation remains. Inflation expectations remain higher, which has historically been good for gold with average nominal returns exceeding 15% during times when US CPI was above 3%. And while higher rates may be a short-term headwind, the absolute levels of those rates are still extremely low – for example, the 2-year US Treasury rate remains well below historical levels. In addition, longer dated rates such as 10- and 30-year US Treasuries have held steady suggesting investors adjusted their short-term expectations but not their loner-term expectations haven’t changed as much. Finally, gold has very much tracked money supply globally over recent years, and with many countries committed to additional monetary and fiscal stimulus, this could continue (see 'The relevance of gold as a strategic asset').

Our analysis suggests that gold plays a strategic role in portfolios. Understandably, investors may overweight or underweight strategic positions based on market developments. And gold market positioning suggests downward pressures may still remain, some investors are also using the recent pullback as an opportunity to strengthen their core position.

Joining us for this episode in our Strategic Edge video series is Alasdair McKinnon, Manager at The Scottish Investment Trust. In conversation with John Reade, our Chief Market Strategist, Alasdair discusses the key themes for investors post-pandemic, the allocation approach of The Scottish Investment Trust and looking ahead, some key areas of opportunity.

The Shanghai-London gold price spread again turned negative in June after being positive since early 2021,¹ falling to -US$6.7/oz on 2 June and remaining negative most days during the month. We believe this is likely driven by:

• the difference between Chinese and Western investors’ risk appetite
• the expectation of tighter regulations in China’s gold market
• the sharp rise in China’s gold imports.

The Shanghai-London gold price spread turned negative in June*

Chinese investors are less risk-averse than Western investors

The attitudes and perspective of Chinese and Western investors can differ. And this has been true for gold in recent months. For example, while there were inflows into Chinese-listed gold ETFs during Q1, Western-listed ETFs saw outflows. Conversely, Chinese gold ETF holdings saw a 3.7t outflow in May and a 1.7t decline during the first half of June, while US-listed funds generally saw inflows.²

Chinese gold ETFs: outflows, Western gold ETFs: inflows*

Such divergence could be a result of a higher risk appetite among Chinese investors than their Western counterparts. First, the Chinese renminbi index – an index developed by the China Foreign Exchange Trade System to reflect the RMB’s strength against a basket of currencies – has climbed rapidly recently. A strong local currency usually results in a higher risk tolerance from local investors as it often indicates a strengthening in the local economy. This has, in turn, pushed up trading volumes on the local stock market and lowered Chinese investors’ interest in safe-haven assets such as gold.

The strengthening RMB has lifted local investors' risk appetite

Also, Chinese investors have had less rising inflationary concerns so far in 2021 than investors in the West. With commodity prices rocketing, China’s Producers Price Index (PPI) rose rapidly in 2021. But the country’s Consumer Price Index (CPI) has remained subdued, chiefly due to lower food prices and a relatively gradual recovery in the demand side of the economy so far in 2021. As a result, the demand for gold as a hedge against inflation has reduced.³

Inflation in China has been subdued so far in 2021

y-o-y changes in Chinese CPI

The expectation for tighter regulation in the local gold market

On 1 June an announcement was made by the People’s Bank of China’s (PBoC) that the scope of the anti-money laundering law has extended to gold spot exchanges and dealers – leading to the expectation of tighter regulation in physical gold trading. This further weighed on the mood of Chinese gold traders and drove the Shanghai-London spread down sharply. And traders betting on the Shanghai-London gold price spread widening had to close their positions by selling RMB gold contracts and buying USD gold contracts to limit their losses, accelerating the spread’s plunge.

A significant rise in China’s recent gold imports

Recent jumps in China’s gold imports have also lowered the local gold price spread. The authorities’ restrictive controls on gold import quotas have, on most days, contributed to a premium in the Chinese local gold price (except during 2020 when local gold demand was severely hampered).⁴ After remaining subdued in 2020 and early 2021 amid the COVID-19 pandemic, China’s gold imports rose rapidly – 54t in Q1 2021 and a total of 178t in April and May – primarily driven by rising gold consumption and an easing of restrictions on gold inflows. This increase in gold import quotas has also played a role in driving down the local gold price spread in recent months as there is an expectation that China’s gold imports will increase further in the coming months, thus reducing the “scarcity” of gold in China – a factor that may have been exacerbated by lower than expected investor demand for the reasons explained above.⁵

Recent uptick in China's gold imports further weighed on local gold price spread

Outlook

In summary, the higher risk appetite among Chinese gold investors than those in the West – where inflationary concerns continue to intensify – combined with the expectation of tighter regulatory controls in China’s physical gold market and a significant jump in its gold imports, have led to a weaker performance in the RMB gold price than in the USD gold price over recent months and a negative Shanghai-London gold price spread.

But the outlook for gold demand – the fundamental driver of the local gold price spread – suggests that the negative spread will not last. With commodity prices remaining stubbornly high and a continuous recovery in the demand side of the economy, China’s inflationary pressures could start to rise, potentially increasing Chinese investors’ demand for gold as an inflation hedge. And as we enter Q3, gold jewellery consumption is likely to pick up due to the seasonal pattern, a stable economic growth and the holiday-related gold consumption boom.

I was pleased to speak at Fund Selector Asia's recent Spotlight on Alternatives virtual event. Watch the replay below to hear my perspective on topics including... 

• Gold's characteristics, and why they may be attractive to investors in alternative assets 
• What makes gold a strategic asset
• The drivers of gold performance 

Bob Haber, Founder, Partner and CIO at Proficio Capital Partners joins us for this edition of our Strategic Edge video series. In this dynamic two-part conversation with Joe Cavatoni, our Head of Americas, Bob shares his insights on topics including...

• The balanced investing approach: equities, bonds, and cash, and gold
• Diversification strategy
• Asset classes to watch in the next decade
• Cryptocurrency landscape

Part 1

Part 2

In a move which brings it closer in line with the US approach, the European Central Bank (ECB) has decided to adopt the tolerance for inflation overshooting its target. But the ECB has also gone a step further; it has also raised its inflation target from “below, but close to, 2%,” to simply 2%. This move may give the ECB more room to keep accommodative monetary policy in place for longer to help support the region’s nascent economic recovery.

Euro area harmonised index of consumer prices*

What does this mean for European investors, who have been watching the wrangling within the ECB over the direction of monetary policy for months now? Well, it seems further indication of the central bank commitment to an ultra-loose monetary environment – i.e. more asset purchases and ultra-low interest rates – until it is comfortable that the economic recovery is well-established.

This, in our view, maintains a supportive environment for gold for three key reasons:

• Persistently low interest rates reduce the opportunity cost of holding gold
• It highlights the increasing difficulty for investors to achieve yield, with many moving into higher yielding assets which carry greater levels of risk
• keeps the spotlight on inflation as a potential threat, which investors have sought to hedge to protect capital.

Despite concerns that central banks may be wavering in their commitment to loose monetary policy following recent jumps in inflation, it seems the ECB are doubling-down. Given what this might mean for monetary policy going forward, we believe that gold investment among European investors will remain well supported.

I recently had the pleasure of joining Alex Proimos for an episode of Investment Magazine's Market Narratives podcast. Listen below to our conversation on the impact of the Basel III changes on gold, global investment trends, the role of gold as a strategic asset and gold's journey from mine to market.