Posted On Tuesday, May 12, 2020
May 12, 2020
Quantum Alternative Investments Team
As investor sentiment oscillated between risk-off and risk on, so did gold prices. Everything from positive trial results of an experimental Covid-19 treatment to crashing oil prices roiled markets. But if you look at the big picture, with prices in INR terms up 19% this year, you would agree that gold loves a crisis. Time and again, policy makers have resorted to throwing money at crises, resulting in debasement of currencies and helping gold -a monetary asset that cannot be printed in a printing press - move higher.
Opening up the economy won’t save the economy
Having moved from $1,590 to $1,735 through the month, gold prices settled lower at $1,690 levels at the end of April eyeing the gradual reopening of business in the United States and across the world. But politicians hoping to kickstart the economic engine back to life might be in for some disappointment when they discover that they can let businesses reopen - but they can’t force people to shop, eat or visit. With a sharp contraction in economic activity and a surge in unemployment, consumers will be less optimistic about their financial prospects. This, we believe, will have repercussions for spending and GDP growth in the months ahead. This phenomenon is indicated in the US Consumer Confidence Index falling sharply to 86.9, down from March’s reading of 120.
Moreover, with health experts warning of more outbreaks if the lockdown is lifted too soon, the global economy could very well get trapped in a vicious cycle of outbreaks and shutdowns until a vaccine is eventually found. This could fundamentally change the way people consume, socialize, or invest. This will continue to take its toll on the economy and increase the need for government support. And for as long as we are in that transition, safe havens will be in demand as investors decide what to invest in for the future. Gold, generally, is a much sought after asset during such times and will continue to remain well bid.
There is no “normal” to return to
Even before the pandemic hit the world, geopolitical and economic tensions such as the US-China Trade war plagued the global economy.
Global growth was slowing. US national debt was already lingering above $23 trillion in 2019 The Federal Reserve pivoted to a loose monetary policy in 2019 to pump up the economy. Central banks were buying gold in the low-interest-rate environment, the dollar index was weakening and global debt was surging. Gold was already on an upward trajectory before Covid-19.
Now, with the Covid-19 outbreak exacerbating the existing macroeconomic weaknesses, we expect interest rates in the US, as well as the rest of the developed world, to be low for a longer time as central banks try to boost GDP growth. This makes holding gold a more viable option than holding US treasuries as it successfully preserves purchasing power in the upcoming negative real rate environment. This trend will be extremely supportive for gold prices.
Also, central banks seem to be increasing the size of their balance sheets by monetizing ballooning government deficits to counter the economic slump. As of now, major economies of Germany, Japan, and the US have announced stimulus packages worth 35%, 20%, and 10% of GDP respectively. More stimulus measures are in the works as the pandemic furthers its toll on the economy. This will lead to a permanent debasement of fiat currencies because, once the central bank prints more money, it generally never gets unwound. With such high liquidity sloshing around and seeping into the real economy (unlike 2008 where liquidity remained bound to financial markets) the probability of inflationary prospects looms large. It's not only demand that may rebound - supported by government freebies - but also supply chains may have to be reworked, which could be inflationary. This is incredibly bullish for gold - the currency of last resort and the ultimate store of value.
Calls for dethroning of the dollar
The dollar has weakened more than 3% after the Dollar Index scaled to highs of 103 levels in late March as global central banks launched massive stimulus measures to limit the economic fallout from the coronavirus pandemic. The Shanghai Gold Exchange president has called for a new “super-sovereign” currency system, bringing up not only fears of debasement but also fears of the use of the dollar as a geopolitical tool by the US and China. With rising deficits and debt in the US already making holders of US treasuries nervous such calls to replace the dollar could gain strength, and gold could potentially fit into the role of a global currency, at least till the world transitions from the US dollar to a new monetary system in a post-pandemic world.
The pandemic has heightened US-China tensions
Rather than encouraging greater cooperation, COVID-19 has further soured US-China relations amid the unfinished business of the trade war. A war of words and a blame game between the two countries have ensued. Trump has criticized China’s response to the virus outbreak and referred to COVID-19 as the ‘Wuhan’ or ‘Chinese’ virus. On the other hand, the Chinese have gone as far as to back the conspiracy theory that the coronavirus was a bioweapon manufactured in American laboratories and let loose in Wuhan.
All this points to a further flare-up in geopolitical tensions in the post-pandemic world which will have consequences for global order and governance. This will push up demand for gold.
Things are likely to get worse before they get better
The world is currently staring at the worst economic downturn since the Great Depression, with the IMF estimating that the global economy will shrink by 3% in 2020. Thus, right now, everything is about the current crisis and what we can do to avoid a deeper economic recession. But, ultimately, this monetary impulse will become the primary driver of investment demand for gold. As expected, investment demand for gold was strong in the first quarter, with ETF inflows in the first quarter up more than 300% compared to inflows last year
“The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term,” the Federal Reserve said in its monetary policy meeting at the end of the month. It will take a long time to gauge the full cost of the coronavirus pandemic. Some analysts fear the current forecasts do not paint the full picture of the economic damage. If that is the case then the deteriorating macroeconomic backdrop is expected to encourage the further rotation of money from risk assets like stocks and bonds to defensive assets like gold.
From Greenspan to Powell – The great “Put” continues
“People are undertaking sacrifices for the common good,” Powell said in webcast remarks hosted by the Brookings Institution. “We should make them whole. They did not cause this. This is what the great fiscal power of the United States is for, to protect these people from the hardships they are facing.”
This really means that the Fed will continue to print money to make good on the business and wage losses that people face. With more than 26 million people filing for unemployment benefits, the bill of a rescure package could be humongous. But the government doesn't feel constrained by their ability to tax or borrow, given they can tap the central bank which is ready to provide access to a bottomless pool of money.
The long term consequences of such policies are disastrous. However, in the short term it may ignite animal spirits at least in the financial markets. Also, such money handouts - accompanied by lifting of lockdowns - may lead to risk sentiments reviving, resulting in some possible correction in gold prices. Still, we expect any downsides to be limited given the macroeconomic backdrop of central bank printing which remains extremely bullish for gold.
Looking ahead, a coronavirus vaccine would ease the pandemic, but it wouldn’t do anything to address the deficits and debt that were already rampant in the economy, prior to the downturn accelerated by the coronavirus. We recommend a 10-15% portfolio allocation to gold to capitalize on its risk-reducing, return-enhancing characteristics in these times of crisis and financial repression.
Source: Bloomberg, World Gold Council
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