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ANALYSIS

WGC recommends keeping gold in portfolio


The gold price fell in 2013 as investors reacted to Fed tapering expectations, and money flowed into equities. The prices now reflect a consensus view to monetary policy normalisation and should be less sensitive to it, the World Gold Council (WGC) said in a report. The council views the direction of the US dollar as well as the strength of Asian demand as key indicators of gold sentiment. Further, potentially reduced mine production at lower prices should limit the downside. Finally, the research shows that gold should not be looked at in isolation but as part of portfolio and that a small strategic allocation can reduce the long-term level of risk.

What should investors expect this year? Beyond gold’s historical performance, the answer, put simply, is that expectations about Fed tapering and rate hikes can still influence gold, but WGC considers that gold prices today largely reflect a path to US monetary policy normalcy. Deviations from that path can exert a certain degree of pressure on gold prices – whether up or down. Further, not all gold demand is linked to investment, and not all investment demand is linked to US policy. Gold prices also respond to demand factors such as emerging market demand and are influenced by costs of mine production or the willingness of consumers to recycle gold.

Longer term, WGC sees growth in the gold market supported by the expansion of developing economies which are expected to be the lion’s share of global GDP before the end of the decade – regardless of any potential slowdown in the near term. With its role as a high quality, liquid diversifier for central bank reserves – as well as investors’ portfolios – and its ability to protect purchasing power by hedging inflation at a global level, WGC expects that gold will continue to play a crucial role in portfolios. But what factors should investors monitor in 2014 for insight into the gold market?

The US dollar, monetary policy and the US labor market

There are seven factors that influence gold’s performance: currencies, inflation, interest rates, systemic and tail risks, consumer spending and income growth, short-term flows and income growth, and supply side drivers. Among these, the performance of the US dollar against a global basket of currencies tends to be one of the most relevant factors. Fluctuations in the US dollar will continue to be a guide for investor positioning in 2014. In turn, the US dollar will respond to market expectations of monetary policy and labor market developments. Currently, consensus estimates anticipate the Fed to slow down its asset purchase program throughout 2014, while holding rates steady at least until early 2015.

Importantly, however, that gold prices already reflect these current market expectations. This has been ratified by the price action since the Fed announced a slowdown of asset purchases in mid-December 2013. Significant upside surprises to the strength in the labor market and an acceleration of tapering would negatively influence gold investor sentiment. As noted earlier, neither increasing rates, nor short term real rates between 0% and 4% have necessarily been negative for gold. Conversely, WGC believes a weaker recovery or an extension of monetary policies would support the price.

Chinese market

While there is wide consensus that developed markets are in recovery mode, there is less certainty about the state of the Chinese economy. Following more than a decade of strong growth, some market participants fear the economy could continue to lose steam and that easy credit may have formed asset bubbles that could burst at any time. However, there is also an alternative view in the market: concerned with growth suitability, the Chinese government will continue a pro-market shift to economic policies, including financial reform and improving the budget management and tax systems, in the hope of structurally improving long term growth.

Further, a recovery in developed markets could strengthen exports and reignite growth in various economic sectors. With respect to gold, Chinese demand was by any measure stellar in 2013 – even with Q4 statistics pending. Thus, topping such a demand figure in 2014 will not be easy, especially since gold demand responded positively to periods of strong gold price pullbacks during 2013. However, China is the only country that has consistently increased its consumption year after year for more than a decade, with only the exception of 2012 that saw similar levels of demand to that in 2011.

Moreover, gold prices, adjusted for income growth, have remained fairly consistent in China, signalling that economic growth even at single digits has produced a strong support for gold. An early indication of 2014 demand will be related to the Chinese New Year, a typical gold-gifting season, at the end of January.

Indian market

India continues to face political and economic headwinds. With a general election approaching, the current account and fiscal deficits, currency weakness (the rupee lost 13% against the US dollar during 2013) and a general slowdown in economic growth will remain front and centre in the political debate. While none of these issues will be fully fixed prior to the election, actions are being taken to try to reduce them, and any controversial policies will likely be postponed until after the general election.

For gold, despite increased taxation, import restrictions and a weaker rupee in 2013, Indian demand during the first three quarters was not only higher than the same periods in 2012, but also above the corresponding 3-, 5-, and 10-year average. Moreover, there has been discussion about the unintended consequences of the current gold restrictions (including an expanding unofficial market and the reduction of jewelry exports, to name a couple). WGC expects that investors will closely follow the general election and, subsequently, any developments in gold-related policies, as many consider the gold restrictions to be unsustainable over the longer term.

Supply side dynamics

With estimated average all-in costs of production by Thomson Reuters GFMS surpassing US$1,200/oz, WGC expects that any sustained price reduction in gold may impede the ability of gold miners to maintain profitable levels of production. Further, the significant level of capital write-downs reported in 2013 could impair future production for some miners.

Taking this into consideration, while gold prices can be under pressure for various reasons, considerably lower levels are not sustainable for an extended period of time unless mine production experiences an unlikely structural shift, such as a general reduction in costs of production or readily available new deposits, both of which we view as unlikely. In addition, total recycled gold has been decreasing since 2009 further constraining total gold supply available.

US and global inflation

Inflation expectations in the US appear well anchored, and a large number of investors do not expect inflation to be much of an issue in 2014. Whether inflation materializes could depend on how the Fed times the end of quantitative easing measures. As we see it, the effects of an extended period of low interest rates and aggressive policies will likely not be fully understood until much later. Consequently, in our view, some degree of inflation hedging would be appropriate for most investors. In the US, Treasury Inflation Protected Securities (TIPS) tend to be a common alternative. However, under an environment of raising rates and unless held to maturity, part of TIPS’ inflation protection is undermined by a price drop in the underlying bond. Complementing TIPS with gold has been shown to benefit investors.

Overall, inflation is expected to take a back seat to other factors such as the US dollar and emerging market demand, at least until there is a clear indication of whether the aggressive monetary policies around the globe will be linked to higher inflation or whether central banks will time their exit from such policies appropriately.

European recovery

Europe is still grappling with the spill-over effects of its sovereign debt crisis, and the general consensus is that it still has a long way to go before normalcy. However, conditions have improved considerably, and even peripheral countries are showing encouraging signs. As a consequence, risk premia have declined across the board and investors seem to be putting more money to work.

Europe is not expected to be a major force in determining gold’s performance unless one of two things happens. Negative economic developments and instability in the Union would create a flight-to-quality environment that could prompt gold purchases. Alternatively, a very strong recovery and a strong euro appreciation against the US dollar could lead investors to turn more bullish on gold, as many rely on the euro/US dollar exchange rate for position guidance. Notably, the first event would be structural in nature, and therefore more persistent, while the latter more tactical and possibly shorter lived.

Japanese policy

After a record equity market performance (+57%) – its largest annual gain in 40 years – and Japanese yen weakness on the back of Abe’s expansionary policies, the market expects Japan to continue to grow. However, financial markets may be less responsive than in 2013 because Japan’s current (inflationary) policies have largely been priced in. Consequently, surprises to market consensus will likely be linked to the effectiveness of government policies in achieving their growth and inflation targets.

For Japan, a continuation of Abe’s policies will be supportive of gold. Additionally, the pension funds will likely continue to look for alternative high-quality liquid assets to Japanese government bonds, with gold being a natural alternative, as it was in 2013. While potentially significant in marking a trend that could eventually be followed by other institutional investors globally, the Japanese gold market is relatively small and its effect may not be as widely felt.

The role of gold in 2014

The most relevant way to think about gold is not in isolation but as part of a well diversified portfolio. As such, while it is undeniably important for investors to understand what to expect from gold and its most relevant drivers during 2014, it is paramount to understand the rationale behind holding gold in the first place.

Conclusion

After a significant price pullback, the gold market appears in our view to be better balanced than a year ago. Many Western investors have sold their positions, which we consider means that a good portion of non-core investors have substantially reduced their position or even turned short.

At the same time, we see that many of the factors that helped support the gold market before the financial crisis are still present: demand in Asia has shown resilience and, in many cases, even surprised the market. This occurred during periods of rising rates, which are not incompatible with higher gold prices based on our research.

Further, our sense is that gold prices already reflect a consensus view on Fed tapering. We expect that only significant deviations from this view would affect the gold market in the same way they did during 2013. Considering that the structural effect of money supply growth and global quantitative easing on financial markets is not likely to go away, we consider that investors would not likely expect gold to return to pre-2008 levels.

In addition, with estimated all-in production costs by Thomson Reuters GFMS above US$1,200/oz, our view is that considerably lower gold prices over an extended period of time would not be sustainable unless a structural increase in mine production occurs or unforeseen discoveries reach the market, both of which we view as unlikely. Therefore, while the gold market may encounter challenges in 2014, we expect it will also open opportunities for many investors who are waiting on the sidelines while the gold price stabilises.

Especially in a period where investors add risk to their portfolios, our research shows that gold should make up 2% to 10% of a portfolio – 5%-6% for a 60/40 equity/bond composition – to help them manage portfolio risk more effectively.17 This optimal allocation is well above the 1% currently allocated among global investors.

End

15.07.2014 20:17


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