July’s Market Voice analyzes the impact on the gold price of the emergency stimulus by central banks and governments to cushion the economic volatility caused by COVID-19.
- Central banks and governments have flooded the markets with liquidity to counteract the economic turmoil of COVID-19, but what has been the impact on the gold price?
- After initially falling, the gold price recovered. However, this surge in demand was observed mainly in the U.S. and Europe.
- The prospects for gold remain unclear. On the one hand, the worst effects of COVID-19 may blow over and the gold price could lower. However, on the other, should the global economy deteriorate, investors may turn increasingly towards gold in the search for yield.
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The impact of the COVID-19 crisis on the general economic climate has been profound. Volatility increased considerably (the VIX spiked) and markets wobbled, recording considerable losses in the process.
The response from central banks and governments alike was swift, injecting an unprecedented amount of liquidity into the system.
Central banks across the board completely abandoned their prudent monetary policy measures and bloated their balance sheets to boost the economy while governments implemented various measures to keep everyone afloat.
Disconnect between macroeconomics and stock market
Following the response, the S&P returned to just shy of its pre-COVID-19 level. However, never in our history have we seen such a significant disconnect between the stock market performance and the underlying macroeconomic sentiment.
Unemployment levels in the United States, for example, soared towards almost 25 million during the height of the crisis, and have since only moderately retracted. Strong evidence suggests that the real number is probably another 10-15 percent higher because of the vast numbers of people who have not filed for unemployment yet because they are on furlough pay.
Figure 1 — U.S. unemployment and S&P P/E Ratio: Stocks remain expensive in a weak underlying labor market
In addition, the business climate in the world’s largest economy is subdued, indicated by negative industrial production numbers and GDP that is also likely to contract this year.
In any other circumstance — where a proper laissez-faire free market would have run its course, opposed to the draconian Keynesian interventions we have seen to date — the global economy would probably be in a considerably worse state, and heading towards a depression.
Figure 2 — U.S. GDP and industrial production: Contraction in industrial activity will have its ramifications on economic growth
However, given the havoc and socioeconomic ramifications this would have, policymakers have decided otherwise and flooded the markets with cash and low interest rates. With that in mind, it is no surprise stock markets have all but recovered; all that liquidity is looking for yield and despite the prolonged multi-year bull run, investors seem short of investment alternatives.
What’s been the impact on the gold price?
In the current environment, gold has an incredible bull case going for it.
This vast amount of liquidity at some point will point towards inflation, which we in effect are already witnessing by falling and negative bond yields in various European countries, and stock market optimism despite the fragile underlying sentiment.
Therefore, in the face of all this adversity, it was expected the gold price would perform well to-date, which it has, rising by 19 percent on an intra-year basis. Compared with some other asset classes more profoundly anchored to the macroeconomic tides, that is a very decent performance.
Somewhat surprisingly, once the COVID-19-related implications hit the market along with everything else, the gold price also tanked, driven by the need for cash to meet traders’ margin calls.
Figure 3 — Index price performance, gold, S&P and oil: Gold compared with some other assets has done well year-to-date
However, after the dust settled, the gold price started to rise, steadily moving towards its eight-year high at around US$1,800/oz. Its previous high at US$1,920/oz in 2011 was reached based on a similar scenario, where the fall-out of the great financial crisis turned on a massive investor buying spree.
The U.S. dollar and the gold price
That enthusiasm was only detected in parts of the globe this time around.
Due to the persistent strong dollar, emerging market currencies weakened and as a result, gold priced in a whole bunch of other currencies actually recorded record highs, such as in China and India, suppressing new sales and spiking recycling in the process.
In price-sensitive markets, consumer demand plummeted as many were priced out of the market. Not in the United States and Europe, however, where demand surged. Surging so much, that a considerable shortage of coin, bar and grains emerged.
Lockdowns across the board resulted in shutdowns of major mints, refiners and miners alike, choking the global supply chain. Metal was suddenly in short supply when demand spiked and consequently, availability in markets where it was needed quickly dried up.
With few flights to move the metal around and consumers in the U.S. and Europe grappling for investment products, premiums skyrocketed to sometimes even 100 percent over spot and dealers sold out of their inventory quickly.
Figure 4 — COMEX gold warehouse stocks: Stocks surged following increased delivery requirements in an extremely tight U.S. market
Trading on precious metal exchanges
As a measure of last resort, many turned to the CME for metal delivery out of their warehouse stocks, and instead of cash settling future contracts — which occurs 99 percent of the time — traders started to make use of the exchange-for-physical option, demanding physical metal delivery out of the exchange.
The sudden size of physical delivery requests rocked the exchange on its foundations, which quickly had to issue a new contract and restock.
Trading not only increased on COMEX, but across other exchanges, too. Indeed, exchange trading activity across all 13 precious metals exchanges globally, and which was tracked in Eikon, performed well in the first half of the year, rising 12 percent or 17k tonnes to 130k tonnes.
Figure 5 — Gold exchange trading activity: Rise in exchange trading activity reflects underlying appetite for gold in Western markets
This strong sentiment was also seen in exchange-traded products (ETP) demand, which reached the strongest inflow on record of 742 tonnes, pushing total holdings to 3,580 tonnes (representing US$204bn in market value) by end June. Again, North America proved to be one of the main culprits. That added to the total holdings, but Europe and Asia also contributed to the rise.
What are the prospects for gold?
A quarterly Reuters poll available in Eikon provides insight into price forecasts of various commodities, where more than 30 contributors submit their latest expectations.
Although the last updates are from April, the displayed trend tells gold’s story well. A strong bull case remains present, but there is a reasonable chance that the worst will blow over and all will slowly revert back to normal, whatever that might look like.
Yes, pain will be felt but not to an extent that will send significant shockwaves throughout the international markets. After all, not all sectors are equally affected by the current sentiment and an awful lot of support has been provided by governments across the globe.
Figure 6 — Reuters price poll: A host of market experts present their projections on the gold price
The mean came in at US$1,655/oz for 2020, rising towards an average of US$1,704/oz for next year, which does reflect a growing trend, but not anything outrageous given that the current spot price is trading at around US$1,800/oz.
Our somewhat more optimistic scenario for gold is mirrored in a more pessimistic scenario for short- and medium-term global economic progress. Policy makers have done a great job cushioning the first blow and preventing the global economy from screeching to a halt, but once the patient gets off life support, things could quickly turn ugly again.
We could well see a surge in unemployment numbers reemerge, combined with business foreclosures, and government support will not be unlimited. Those with strong capital buffers will be able to weather the storm and maybe even pick up some distressed assets for pennies on the dollar.
However, many businesses will struggle to deal with zero to low revenue streams for quite a few months, while overheads and other (operating) costs continue to be present.
As such, and despite the increase in liquidity, the investment climate is likely to be cautious, and investors will continue to search for yield.
With bond prices inflated and equities expensive at a PE ratio of 24, investors will look elsewhere, and gold might just provide that sort of exposure one feels more comfortable with given the current and uncertain future climate. If that came to fruition, even our more optimistic average gold price forecast of US$1,700/oz this year and US$1,855/oz in 2021 could turn out to be too pessimistic.