In 2016, investors around the world returned in large numbers to the gold market, as a combination of macroeconomic drivers and pent up demand kept interest in gold high.
As we start the new year, there are some concerns that US dollar strength may limit gold’s appeal.
We believe that, on the contrary, not only will gold remain highly relevant as a strategic portfolio component, but also six major trends will support demand for gold throughout 2017.
Major trends in 2017
The gold price had a strong performance in 2016, rising close to 10% in US dollar terms (higher in most other currencies) and amassing multi-year record inflows through physically-backed gold ETFs – making it one of the best performing assets last year, despite a post-US election pullback. And the price has gained more than 5% since the Federal Reserve (Fed) increased rates in mid-December.
But, what does 2017 hold for the gold market?
Using the economic perspective from our guest economists as a backdrop, we believe there are six major trends in the global economy that will support gold demand and influence its performance this year:
1. Heightened political and geopolitical risks
2. Currency depreciation
3. Rising inflation expectations
4. Inflated stock market valuations
5. Long-term Asian growth
6. Opening of new markets.
Heightened political and geopolitical risks
Political risk is rising. Europe will hold key elections in the Netherlands, France and Germany in 2017. As John Nugée says, the election cycle will happen “against a backdrop of continued citizen unrest, fuelled by the ongoing uneven distribution of economic welfare.” In addition, Britain must negotiate its exit from the European Union.
While the UK economy is still expanding, the pound fell sharply following the referendum decision and continues to weaken every time the markets sense that there is an increased chance of a ‘hard’ Brexit.
In the US, there are positive expectations about some of the economic proposals of President-elect Donald Trump and his team, but there are also concerns. The US dollar has gained ground since Trump swept to victory last November, but uncertainty is rife. Jim O’Sullivan sees “a meaningful risk that negotiations on trade will turn belligerent” and suggests that “confidence in markets could be affected by geopolitical tensions triggered by the new administration”.
As a high-quality, liquid asset, gold benefits from safehaven inflows.
Gold is especially effective as a safe have during times of systemic crisis, when investors tend to withdraw from risk assets. As they pull back, gold’s correlation to stocks becomes progressively more negative and its price tends to increase. Gold historically performs better than other high-quality liquid assets during periods of crisis and that makes it an excellent liquidity provider of last resort.
In 2016, gold-backed ETFs increased their collective holdings by 536 tonnes (US$21.7bn), the highest since 2009. And while US-listed gold backed ETFs saw a 40% plus reduction in their gold holdings in Q4 2016 – relative to the three previous quarters – UK, Asian, and Continental Europe-listed ETFs fell by just 14%, 9% and 1%, respectively. In all, Europe and Asia accounted for 57% of total ETF flows last year. And we expect that gold investment demand is likely to remain firm.
Monetary policy is likely to diverge between the US and other parts of the world. The Fed is widely expected to tighten monetary policy, but it is far from certain that other central banks may be willing and/or able to do so.
The situation in Europe is a case in point. As John Nugée states: “Europe’s economies are likely to face a continuation of the current tight fiscal, expansionary monetary policy as they have for at least the last five years.” Since the European Central Bank announced further quantitative easing measures in January 2015, its balance sheet has increased by approximately €1.5 trillion, resulting in an increase of 70% and bringing the current balance sheet total to more than €3.6 trillion.
This will inevitably lead to fears of currency depreciation.
In fact, over the past century, gold has vastly outperformed all major currencies as a means of exchange. One of the reasons for this is that the available supply of gold changes little over time – growing only 2% per year through mine production. In contrast, fiat money can be printed in unlimited quantities to support monetary policies.
This difference between gold and fiat currencies can drive gold investment demand as investors seek to preserve capital from depreciating currencies, exemplified by European investors last year, when they turned to gold through bars, coins and ETFs. German investors added 76.8 tonnes of gold (+76%) to ETFs in 2016. They also bought 72.3 tonnes through bars and coins between Q1 and Q3 2016 (based on the available data).
But gold’s relative steadfastness can also support central bank demand. To that end, central banks continue to acquire gold as a means of diversifying their foreign reserves and we expect them to continue to do so in 2017.
Rising inflation expectations
Nominal interest rates are widely expected to increase in the US this year, but all the economists we spoke to forecast that inflation will rise as well.
An upward inflationary trend is likely to support demand for gold for three reasons. First, gold is historically seen as an inflation hedge. Second, higher inflation will keep real interest rates low, which in turn makes gold more attractive. And third, inflation makes bonds and other fixed income assets less appealing to long-term investors.
Jim O’Sullivan expects US CPI to rise by 2.6% in 2017. And “while those inflation numbers are not high by historic standards, they would signal that momentum remains upward.” He is also concerned about the tightness of the US labour market and consequent wage growth. In Asia, David Mann expects “exports prices to rise,” which may eventually make their way down to Western consumers.
In all, the massive amount of stimulus that has been pumped into the global economy for years may eventually create an upward spiral of price inflation that could surprise investors.
Inflated stock market valuations
Stock markets had a significant rebound in the last stretch of 2016. And while some stock markets are just recovering from lacklustre multi-year performance, stocks in the US have reached historical highs.
In many cases, valuations have been elevated, as investors increase their risk exposure in search of returns in a very low yield environment.
Until now, investors have used bonds to protect their capital in the event of a stock market correction. As rates rise, this is a less viable option – and in the meantime, the risk of a correction may be increasing. The interconnectedness of global financial markets has resulted in a higher frequency and larger magnitude of systemic risks. And as Jim O’Sullivan puts it: “The [US economic] expansion will not last forever.”
In such an environment, gold’s role as a portfolio diversifier and tail risk hedge is particularly relevant.
Long-term Asian growth
Macroeconomic trends in Asia will support economic growth over the coming years and, in our view, this will drive gold demand. In Asian economies, gold demand is generally closely correlated to increasing wealth. And as Asian countries have become richer, their demand for gold has increased. The combined share of world gold demand for India and China grew from 25% in the early 1990s to more than 50% by 2016. And other markets such as Vietnam, Thailand and South Korea have vibrant gold markets too.
As David Mann notes. “Asia has reduced its economic exposure to the West. […] The region has achieved relatively strong growth since the global financial crisis, despite persistently weak growth in the West. Domestic demand – from both consumers and investment – is behind this resilience, and has cushioned the region against its high degree of openness to external trade. Asia will account for approximately 60% of global growth in 2017.”
While jewellery demand in China has suffered from changing consumer tastes, the investment market has undergone a remarkable period of development. In little more than 10 years its bar and coin market has become one of the world’s largest. China’s gold-backed ETFs continue to grow as well. Investors bought 30.3 tonnes of gold in 2016 through ETFs – an almost six-fold increase in assets under management. Trading volumes on the Shanghai Gold Exchange are increasing. And interest in new products continues to increase; we believe innovation should continue to support China’s gold market in years to come.
In India, the government’s decision to remove large denomination rupee notes (Rs. 500 and Rs. 1,000) took around 86% of India’s circulating cash out of its economy. While the purpose is to replace them with newly printed notes, we believe that the liquidity squeeze could have a temporary negative effect on economic growth, and may also affect gold demand in the short term. But more importantly, we believe that the transition to transparency and formalisation of the economy will lead to stronger Indian growth in the longer term, thus benefitting gold.
Opening of new markets
Gold is becoming more mainstream. Gold-backed ETFs made gold accessible to millions of investors, primarily in the West, over the past decade, but other markets continue to expand too. China has seen dramatic growth in recent years through Gold Accumulation Plans, physicallysettled gold contracts in the Shanghai Gold Exchange.
In Japan, pension funds have increased their gold holdings over the past few years. In the corporate sector, more than 200 defined-benefit pension funds have invested in gold. In addition, more than 160 defined-contribution plans have added gold to their list of investments.
We expect this trend to continue and expand into Western markets, where pension funds have had to rethink asset allocation strategies following prolonged exposure to low (and even negative) interest rates. In our view, this will result in structurally higher demand.
Innovation is evident across all markets, but at the end of last year one development stood out. The Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI), with support from the World Gold Council, launched the Shari’ah Standard for Gold, opening up the Muslim world to gold investment.
Mark Mobius of Franklin Templeton thinks that the new Shari’ah Standard on Gold will be a “game changer.”
Whereas previous Shari’ah rulings were fragmented or nonexistent, the Standard provides definitive guidance on gold products, potentially allowing millions of Muslims to invest in gold. Furthermore, Islamic finance has expanded rapidly in recent years with many countries actively promoting this sector as part of their economic development and diversification policies. These factors can potentially propel gold demand across many Muslim markets from Malaysia, the UAE and Saudi Arabia, where Islamic finance is well established, to countries such as Indonesia and Pakistan, which are pushing for Islamic finance to play a greater role in their economic infrastructure. With the size of Shari’ahcompliant AUM expected to grow to US$6.5 trillion by 2020, according to the Islamic Finance Stability Board, just a 1% allocation to gold would equate to nearly US$65 billion or 1,700 tonnes in new demand.
This content was supplied by the London-based World Gold Council and the original document can be found here.
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