SINGAPORE (Apr 24): The team at CGS-CIMB Research believes gold is expected to rally a bit further from here, in line with the rebound in global equities. However, another round of risk aversion could bring the price of gold down again, together with equities.
Unless Covid-19 is contained suddenly and soon, the shutdowns — even on-and-off shutdowns — are likely to damage not just the current demand but also the future demand for gold through higher debt levels. The impact will be deflationary, which has historically worked against the price of gold. Risk aversion is also likely to return if economic shutdowns continue or resume. The sudden halt to business means severe disruption of Dollar cash flows. That will drive another round of Dollar funding stress, driving the US Dollar Index higher. Historically, that has tended to work against the price of gold. Eventually, when central banks attempt aggressively to inflate away the debts accumulated by their shareholders (i.e. governments), gold will shine again, in our view. But not while deflation and Dollar funding stress remain dominant concerns.
The market performance of gold in the midst of the Covid-19 crisis has left its fans a little puzzled. From a peak of US$1,703/oz on March 9, gold retreated to US$1,451/oz on March 16 — a 15% decline. And of concern to asset allocators, the price of gold has tended to move in line with equities since late-Feb. When VIX peaked and turned down from March 19, gold bottomed and rallied along with the S&P 500. This raises questions about the usefulness of gold for portfolio diversification in this environment.
China consumer demand hit by Covid-19
One factor cited by the World Gold Council for the early-March drop in the price of gold was the decline in the demand from China. Consumer demand for gold in China, which usually requires face-to-face interaction, likely declined significantly amidst the Covid-19 outbreak. The World Gold Council estimated that consumer demand for gold in China fell by up to 15% during the SARS outbreak. We believe the demand decline amidst Covid-19 was likely much higher. China accounted for 30% of the global consumer demand for gold last year, according to the World Gold Council. And with Covid-19 spreading to India as well, another 25% of the global consumer demand for gold is now also weighed down by the pandemic.
Recent swings coincided with global risk appetite
Investors have been widely reported to have been liquidating their gold positions to meet margin calls on equities. Another way to look at this is through the lens of Dollar funding stress amidst extreme risk aversion and collapsing risk asset markets. As the US Dollar Index DXY surged in the first half of March, gold traded inversely, falling sharply, in line with equities (Figure 1).
However, as Dollar-funding stress eased in the final week of March — in response to the Federal Reserve expanding its swap lines with other central banks — DXY fell back, sending both equities and gold up (Figure 2). However, if pandemic-driven risk aversion returns, Dollar funding stress will re-emerge, taking gold down with it Since the end of US Dollar convertibility to gold in 1971 — and the consequent collapse of the Bretton Woods system – the big cycles of gold have generally been inverse to those for the trade-weighted US Dollar Index (Figure 3). And that negative correlation is likely to continue as long as Covid-19-driven risk aversion persists. On the demand side, the sudden shutdown of supply chains, international trade and businesses has resulted in a corresponding sharp drop in Dollar cash flows.
Suddenly, businesses found themselves drawing down credit lines or asking their bankers for new loans. On the supply side, the Bank for International Settlements (BIS) said the Dollar funding stress of early-March was driven by: 1) a sharp decline in the supply of US Dollars for currency hedging purposes as a result of sudden risk aversion; 2) drawdowns of bank credit lines by borrowers crowding out other forms of lending by banks; and 3) redemption runs on prime money market funds, which have curtailed the supply of US Dollars from this traditional source.
If these Dollar demand and supply disruptions return, we believe the price of gold could weaken again.
Is aftermath of Covid-19 inflationary?
What happens after these risk-on/risk-off swings? There are two parts to the answer, depending on the time frames. The idea that gold performs well in all crises is simplistic. It depends on the nature of the crisis.
In general, gold does better in an inflationary environment than in deflation. Advocates who argue for gold in deflation usually speak in terms of gold’s “buying power”, not its nominal price. Post-War comparisons of the nominal price of gold against inflation can only be made after gold became freely traded in the US in 1974. The inflation rate in the US took off from 1973, peaking at nearly 14% in 1980. The price of gold surged 3.6 times from US$187/oz at end-1974 to a peak of US$667/ oz in Sep 1980.
However, the then Chairman of the US Federal Reserve Paul Volcker ratcheted the Fed Funds rate up to 20% by 1981 to break the back of US inflation. The result was recession and disinflation in the early-1980s, followed by a long period of price stability in the US. Gold fell from that US$667/oz peak in 1980 to around US$290/oz in 1985.
The price of gold only started picking up again in the 2000s, as the market started anticipating rising inflation rates in the wake of more rapid monetary expansion in the US. It really took off in 2009–11 as the Dollar Index DXY slumped under the weight of quantitative easing. There was an expectation then that QE would result in both a weaker US Dollar and higher inflation.
But that did not happen. Instead, post-Global Financial Crisis debt weighed heavily on economic activity and prices. Instead, the Dollar Index rose. Disappointment in the above led to gold prices falling again, as the US Dollar strengthened. The period from late-2015 to late-2019 stands out for gold rising together with the US Dollar. One possible reason for this might have been the gold market (again) anticipating inflation amid zero to negative interest rates around the world, round after round of quantitative easing, and the rising pile of negative yielding debt. It all seemed like the world was set for rapidly rising inflation (Figure 4).
Over the next six months, as the market digests the damage to the global economy caused by Covid-19 shutdowns, gold is unlikely to perform well. Covid-19 is likely — at least initially — to be deflationary. Wars destroy capital/productive capacity and the end of war releases demand — hence creating excess demand relative to supply, and hence inflation. The “war” against Covid-19 however destroys demand while leaving capital and productive capacity intact and idle. Moreover, it destroys more than just the current demand. Covid-19 is also destroying savings and wealth, or future demand. We believe Covid-19 is likely to be deflationary in 2020 and possibly 2021.
Divergence between gold and crude oil
The current sharp divergence between gold and crude oil prices is unlikely to be sustained. Gold is expecting inflation while the crude oil market is driving deflation. Since the end of the Bretton Woods currency system, gold has tended to trade positively correlated to crude oil. And that reflects the logic of both being driven by the value of the trade weighted US Dollar and by inflation. The inflation link goes to higher oil prices causing higher inflation, and gold being a hedge against that inflation.
However, there have been divergences between the two over the last 46 years. And where there is sharp divergence, occurring from gold rallying while crude oil prices fall, that divergence is more often resolved with the price of gold retreating, as in mid-1980 to mid-1981, mid-1986 to mid-1989, and early-2011 to early-2013 (Figure 5).
Also note that the average gold to oil ratio is 15–16x. This average goes back to the time when gold became freely tradeable in the US. This is to say that one troy ounce could buy 15 to 16 barrels of crude oil. And each and every time, going back to 1973, when the ratio breached 30x, the ratio pulled back sharply. The obvious has to be noted though, that the ratio can be brought down by either the price of gold coming down or oil prices going up, or more likely a combination of both. Note that the gold to oil ratio is now over 80x. And it may be that the ratio will be in part restored by the price of crude oil rising. That is a credible scenario given that the HFIR US Oil Production Composite Index has just gone into negative growth.
At current prices, this contraction in US production is likely to continue. There are very few US shale producers that can survive at the current price. The Dallas Federal Reserve recently estimated that the average breakeven price of oil in the US ranged from US$48 to US$54 per barrel in 2019. We are now revisiting the negative US production growth of 2015-2016, which coincided with the WTI crude oil price falling to as low as US$26 per barrel. That set the stage for the price of crude to then rise for 20 months to a peak of US$76 per barrel.
But that aside, it is difficult to see that gold to oil ratio will be restored entirely by the price of crude oil rising. Part of the mean reversion of that ratio will likely be borne by the price of gold.
For now, cash is king
At some stage in the future, as central banks print more and more money in an attempt to inflate away the debt that their shareholders in the government have accumulated, there will be inflation and a time for gold to shine.
Gold will shine when investors lose confidence in the US Dollar. Right now, the reverse is true. There is still high demand for the US Dollar. And if risk asset markets resume their declines, there is little reason to hold gold. The value of everything else will then fall relative to cash.
