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Going for gold: why is the ultimate “safe haven” so volatile?


James Luke

James Luke

Fund Manager, Metals

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As fears over coronavirus have intensified and been exacerbated by collapsing oil prices, we have witnessed a rush for liquidity across all asset classes. Gold and gold equities have been caught up in this stress. Gold prices have fallen (and are now flat for the year to date), while gold equities are now down on the year.

There are a number of reasons for this. Short-term liquidation of speculative futures positions has had an impact. Hedging (selling forward) by producers, particularly in countries where gold prices are at record highs in local currency terms, such as Australia, has increased. This is when a producer agrees to sell gold at a specific price in the future.

Gold had also been bought as a hedging instrument for index equity positions. It is possible that the scale of equity market falls forced the liquidation of hedge positions into an environment where liquidity is reduced. Interestingly, physical gold retailers are reporting all-time record sales.

Gold equities have also been caught in equity market falls. Ultimately, gold equities are still classified as “commodity producers” and sit in broad equity indexes. This means disorderly liquidation events (for example, forced selling) can push gold equities down in the short term.

Why would a collapse in oil prices affect the price of gold?

The largest impact has been a sharp fall in inflation expectations. For example, two-year forward inflation break-evens (effectively a measure of inflation expectations) in the US have fallen from more than 1.5% a month ago to close to zero today. This has also increased gold volatility because it has started to put upward pressure on real interest rates (because inflation expectation has fallen faster than nominal yields). Gold is sensitive to this in the short term.

Will the gold price become less volatile?

In a world of already high debt and low interest rates, the policies which we expect to emerge in response to the current crisis will represent a new paradigm. We expect that interest rates will be kept at close to zero (via massive quantitative easing and central bank balance sheet expansions, if necessary) and that fiscal policy will be used to drive inflation back towards targets.

Fiscal policy can take various forms and we do not rule out direct “helicopter money” type interventions at all. As such, we could not imagine a more bullish environment for gold prices.

Structural drivers are behind gold prices and it is not just a short-term hedge

There are clear structural drivers behind gold prices. Even before the current crisis, we have been arguing that we are in the early stages of a structural surge into monetary gold investments by both private investors and central banks driven by two main factors.

Firstly, there is a high probability that very high global debt will suppress global growth, making the normalisation of monetary policy impossible and pushing policy makers towards more extreme “un-conventional policy solutions” through the next downturn (a classic debt trap). These will drive deeply negative real interest rates and increased focus on sovereign debt risks, both of which should be very positive for gold prices.  

Secondly, a historically overvalued dollar and increased focus in the future on US deficits and fiscal sustainability. This focus could become far sharper after the November 2020 election, regardless of who wins.

Depending on how quickly the macro environment evolves, we would be surprised if gold does not reach new all-time record highs of more than $2,000 an ounce in the next couple of years.

Why do gold equities have a role to play in gold allocations and do they offer long-term value?

We think gold equities remain a little misunderstood. Essentially, we believe that gold miners produce a monetary asset for which the long-term outlook is very strong. However, they are currently valued at very depressed commodity producer valuations. This is partly due to the inability of the sector to generate strong returns in the recent past, particularly between 2005 and 2015.

However, gold producers today are in a very different position to previous years both in terms of returns generation and management discipline. As an example, even after the recent correction in gold prices, gold producers are earning all-in-cost (AIC) margins which are close to double those seen in 2011 at the top of the previous gold bull market. By contrast, valuations are far lower. As the macro environment shifts, we think 2020, even if there is more short-term stress, will come to be viewed as a historic turning point for the sector.

 

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