Golden Truth

Gold - Standing tall amidst the current turmoil Friday, Apr 03, 2020

March 2020 turned out to be a roller-coaster of a month which saw the coronavirus pandemic rapidly intensifying as it moved on from China and engulfed most of the developed world, with cases and fatalities rising world over. It saw unprecedented policy actions like synchronized national lockdowns to counter the spread of the virus, and “do whatever it takes” monetary policies to cushion the economic disruption that is expected to follow. The month also witnessed global stock markets lose about a quarter of their value due to virus-driven panic selling. And unfortunately, it also saw a health crisis snowball into an economic one with the world quickly moving from “fears of a recession” to indeed a recession!
Despite the volatility, gold prices ended the month flattish with a minor loss of -0.1% against other risk assets that saw significant losses, reiterating its diversification role in times of turmoil.

Unusual gold movement in March

Gold surprised market participants in March by moving in tandem with equities, when it was expected to do the opposite. Now, when there is a sharp fall in asset markets, you can only sell what is liquid, profitable and has low impact cost, and thus gold saw temporary sell off on account of a need to raise cash for margin calls to cover losses elsewhere.

Gold experienced some downside corrections at the start of the Global Financial Crisis too, weighed down by a world seeking safety of dollars, requiring forced sales of liquid assets like itself. But by the end of 2008, riding on the back of newly announced quantitative easing measures, gold was one of the few assets to post positive returns. We are beginning to see a similar pattern emerge as gold prices stabilized over the last week and rallied from below $1500 levels to above $1600 as the Federal Reserve announced its intention of unlimited bond buying. We are thus of the view that a healthy gold rally will now resume in spite of turbulent markets and losses in risk assets as there is ample newly injected liquidity in the system, eliminating the need to liquidate positions in gold. The Fed through its various programs is virtually ready to provide liquidity even for troubled assets. In fact it’s reasonable to say that a good part of the easy money will now find its way to “store of value” assets like gold till the risk aversion persists, pushing up prices further.

Covid-19 is not a conventional economic threat

The selloff across asset classes and the flight towards the U.S. dollar have brought back memories of the Global Financial Crisis. But in spite of some parallels, there is an important difference between the 2008 crisis and today. The former was purely a financial crisis which resulted in a demand shock that hurt growth and inflation, and was met with monetary and fiscal stimulus in order to resolve the solvency crisis and revive the economy. But this time, the world is battling a health cum financial crisis which has resulted in both demand and supply side shocks.

Throwing money at the crisis, which is being done now, can buy some time but has its limitations as it cannot spur demand with people just living on essentials and unable to shop, travel or eat out. Similarly it can't do much to tackle supply side disruptions at a time when the world’s factories and fields and highways and ports are locked down. Markets are thus pricing in potential lay-offs, debt defaults and bankruptcies.

Trying to undo the damage that the pandemic and its containment measures are likely to bring, through never-ending monetary and fiscal stimulus does not seem like a sensible option this time around. However, without it the economy could collapse. At a time when supply chains are disoriented and too much money chasing too few goods could result in persistently rising inflation. As gold successfully preserves purchasing power in times of high inflation, this will be bullish for gold.

As governments around the world promise humongous amounts of money to support their citizens and their economies there will be a build-up in financial vulnerabilities in the form of stretched asset valuations and rising debt levels. With the largest economic relief bill in U.S history now announced, rising U.S. debt compared to GDP too will reinvigorate gold prices.

With global policy makers looking all set to act on the Modern Monetary Theory - pumping more dollars to prop up the system without worrying about ballooning deficits - there is a real possibility that this “stimulus” isn't going to be unwound ever. Take the case of the $2.2 trillion stimulus package which is being viewed as the U.S. government's way to cover up for the lost GDP as a result of the sudden halt in economic activity. More stimulus measures are in the works as the pandemic furthers its toll on the economy. This will lead to a permanent debasement of the dollar in a way and is incredibly bullish for gold - the currency of last resort.

Investors are questioning the effectiveness of central bank policies

Central banks have launched synchronised efforts to boost economic activity with rate cuts and quantitative easing. This eased liquidity shortages in markets but failed to improve market sentiment as losses in equities mounted on fears that the global lockdowns for the coronavirus could last for months and hurt economies despite central banks' best efforts.

Even the Federal Reserve’s simultaneous rate cuts this month bringing rates to zero and the announcement of its never-done-before open-ended quantitative easing failed to calm markets down. Clearly, markets are of the view that central banks have exhausted their usable ammunition or such measures may be ineffective against the current threat. Markets understand that interest rates are already so low and if economic conditions worsen, there is little room to maneuver. Thus as the crisis aggravates and risk off sentiment prevails, demand for gold will dominate selling pressures, pushing prices higher.

Cost of holding dollars may soon exceed cost of holding gold

The U.S. dollar, gold’s biggest adversary, has recently benefited from the renewed risk aversion in the equity markets thanks to investors seeking safety in US Treasuries. These bonds however now offer very low interest rates with yields at the short end of the curve starting to turn negative. Even the 10-year note now yields barely 0.65% which is below the rate of inflation. This means an investor is guaranteed to lose purchasing power over the life of the bond. 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 bullish for the metal.

Good time to buy gold?

The macroeconomic backdrop has become increasingly favourable for gold. The world is currently staring at virus induced economic deceleration which is expected to encourage a rotation of money from risk assets like stocks and bonds to defensive assets like gold. There is heightened risk and uncertainty as the magnitude of the epidemic and for how long containment measures will be implemented are big unknowns. The USA is quickly emerging as the new epicenter of the virus outbreak. Growing number of imported virus cases in China has raised concerns of a second wave of infections in the country. The fact that British authorities are warning lockdown measures could last for months is not encouraging. Opportunity costs of holding gold are going down as central bankers aggressively cut rates bringing real rates into negative territory and implement liquidity injections leading to currency debasement. Lastly, even though the economic slowdown may soften consumer demand for gold, investment flows into the metal are expected to increase as investors flee risk assets. Thus, as of now most of the factors suggest a bullish trend for gold prices. To make things even better, potential rupee depreciation on account of foreign institutional investors actively pulling out money from Indian markets will add to Gold’s returns when measured in Rupee terms.

We’re living through a once-in-a-generation event and no precedent exists for the current situation. Hence, until the rate of infection slows down, volatility in financial markets will remain high, which could spill over in gold markets as well. So far in this crisis, gold has played an important role in portfolios as a source of liquidity. As the macroeconomic situation develops further, we expect it to play a risk-reducing return-enhancing role in the long term. We reckon that any correction can be a good entry point for investors to accumulate long-term positions. All those who don't have enough allocation to the tune of 10-15% of their portfolio, should consider an allocation to gold given the fast unfolding macro-economic scenario where economies dive into recession, the cost of economic damage remains a big unknown and central banks remain committed to support economies at all costs; indeed constructive for gold.


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