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Is now the time to own gold?


Sean Markowicz, CFA

Sean Markowicz, CFA

Strategist, Research and Analytics

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James Luke

James Luke

Fund Manager, Metals

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While most risk assets buckle under the strain of the coronavirus, gold continues to shine brightly. A plunging stock market coupled with declining real yields has propelled the so-called “haven of last resort” to its highest level since 2012.

Two key reasons why investors are turning to gold

1. As a store of wealth. Gold is a rare earth metal that is easily convertible into cash, has no counterparty risk and its supply growth is limited. These features make the precious metal an attractive store of wealth when other financial assets deteriorate in value.   

2. Negative real yields. There is an opportunity cost to investing in gold when your money could be earning a yield elsewhere. Hence, when real yields (i.e. adjusted for inflation) approach zero or go negative (either because inflation expectations go up, or nominal yields go down), the opportunity cost of owning a zero-yielding asset such as gold decreases. This is what has happened recently.

However, gold has not always correlated with real yields. Historically, the level of yield has determined the strength of this relationship. When bonds offer negative or low real returns, gold prices closely track changes in real yields. But when bonds offer high real returns, then the correlation between gold and real yields breaks down.

What could further increase the price of gold?

As central banks pump an unlimited amount of monetary stimulus into the economy, real yields are likely to stay anchored around zero or negative long after the crisis has abated. This backdrop should support gold investment demand.

At the same time, there is the added risk of inflation overshooting once lockdowns are lifted and the economic recovery starts. Unprecedented increases in fiscal spending combined with monetary stimulus raise the possibility of inflation surpassing target levels.

Governments could be prepared to tolerate higher inflation in order to erode their skyrocketing debt burdens. Should this be the case, gold would be expected to strengthen further as investors seek refuge amid fears that their currency is being debased.

Could a strong dollar hurt gold?

As gold is priced in US dollars, there is generally an inverse relationship between gold returns and the strength of the US dollar. When the dollar strengthens, gold becomes more expensive for non-dollar investors, which decreases demand for gold. Despite this, the correlation has recently become quite muted. This should not be too surprising as both gold and the dollar are perceived as safe-haven assets and both have risen this year. Ultimately, a strong dollar alone is not sufficient to hold back gold.

2020 to be viewed as turning point for the sector

On a relative basis, the outlook for gold equities is stronger today than at any point in the last 20 years. Gold producers are generating margins roughly 200% higher than at the peak of the last bull market in 2011. Gold producer equities are reflecting gold prices that are significantly below current spot prices. The macro environment that is driving current gold price strength is particularly favourable to gold producer profitability.

As the macro environment shifts, we think that 2020, even if there is more short-term stress, will come to be viewed as a historic turning point for the sector.

Overall, the case for having a gold allocation split between gold bullion and gold equities (primarily gold producers) is strong. Investors understandably worry about the additional volatility of gold equities, as well as the risk that in deep equity market corrections gold equities dislocate from the gold price. The reality is that this risk exists for both the gold bullion price and gold equity prices.

As long as we take a longer-term view, it can be said with confidence that the dramatic macro shifts being triggered by crisis events, are positive for both gold and the gold producers.

 

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