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The Bullish Case For Gold

This article was originally published at MF & Co. Asset Management.

The Bullish Case For Gold

Gold has been in the news recently following a sharp rally in its price.

In June this year, the yellow metal gave a classic breakout from a 5-1/2 year base formation as can be seen in the chart below.

8 YEAR LONDON Fix PM- moving average

At the time of writing, the precious metal is trading at a spot price of $1509 per ounce.

We foresee increasing demand and a rising price of gold in the medium-term.

A brief historof gold prices

Historically, global annual average gold prices ranged around the price of $400 per ounce up to 2004.

After that, due to geopolitical tensions, the metal entered a major bull cycle which peaked around the global financial crisis in 2008 at approximately $1,000. Prices corrected to the range of $750 by October 2008.

Prices took flight again after the recession ended and double-topped around the $1900 range in late 2011, spurred by the debt crisis in the US, and other factors.

These factors include buying from major central banks to diversify their asset base, high jewellery demand, quantitative easing, and rising inflation.

30 year gold price history in Us Dollars per Ounce

Gold prices cracked meaningfully after that and bottomed in the range of $1050 by 2015-2016.

Since 2016, gold has been fluctuating inside a consolidation pattern.

Over the last year, gold prices have seen a lot of volatility, irrespective of the trend in global production, due to the US-China trade tensions and slowing global growth.

However, gold has entered an uptrend in the last few months, driven by a risk-off tendency among investors and buying by central banks.

Factors that affect gold

Gold is well known as a safe-haven asset.

That is why gold prices usually trend higher during times of economic uncertainty, such as trade wars or currency upheavals,  and geopolitical turmoil.

If the equity markets are at a peak or looking top-heavy, nervous investors head for gold.

Gold has a negative correlation with USD

When the value of the US dollar depreciates against other currencies, gold moves higher.

Conversely, gold typically declines when the US dollar rises against other currencies.

Large trade deficits and an increase in the money supply also tend to boost gold prices due to the attendant weakness in the currency.

As illustrated in the chart below, gold prices have a negative correlation with the US Dollar. In other words, when the US dollar strengthens the gold price declines and vice versa.

correlation

(Source: tradingview.com)

For example, on 18th September, the US Fed cut its fund rate down to the range between 1.75% to 2.00%.

A cut in the Fed rate generally weakens the US dollar. As expected, there was a knee-jerk rally in gold.

Gold in US dollar per ounce - Sept 18th

The Fed cut rates because global economic conditions are weak, and a question mark continues to weigh on growth amidst the US-China trade war.

With economic uncertainty continuing, and the pressure from President Trump on the Fed, there is potential for further rate cuts.

Geopolitical uncertainty

Gold thrives in times of geopolitical uncertainty such as wars, political turmoil, and popular unrest.

Often called a ‘crisis commodity,’ gold outperforms other investments at such times.

Brexit in June 2016 is an excellent example of how a political event affects gold’s price trajectory.

On June 23, 2016, gold jumped from $1,248 to$1,313 in one day after Brexit became a reality.

CFD's on Gold

Another pertinent example is the tension from the US-China trade war.

On 01-Aug 2019, President Trump announced the levy of an additional tariff of 10% on $300 billion worth of Chinese imports.

In response, the Chinese central bank let the renminbi fall over 2% in the next three days to its lowest point since 2008.

As a result, as seen in the chart below, the gold price increased significantly over the following weeks.

CFD's on Gold increase

Currently, the geopolitical fabric is strewn with crisis events that create a favourable climate for gold:

  • Brexit and the UK’s potential ‘no-deal’ exit from the Eurozone
  • Drone strikes on Saudi Arabia’s crude refinery and likely repercussions
  • Tensions with Iran
  • Hong Kong civil unrest
  • US-China trade tensions
  • US Presidential impeachment inquiry

Any escalation in one or more of these factors could act as a catalyst for a fresh rally in gold.

The yield curve inversion phenomenon and negative interest rates

The yield curve inversion is now pronounced and sticky.

As on September 25, the spread between 10-year and 3-month Treasuries was (-)0.16%.

10 yer - 2 month treasury yield spread

The spread between 10-year and 2-year Treasury yields also briefly turned negative in mid-August. Though it is currently poised at (+) 0.05%, it looks to be only a matter of time before it challenges that low again.

10 yer - 2 month treasury yield spread

Generally speaking, the US economy enters a recession within 12-22 months after a yield curve inversion.

Recessions trigger risk aversion and strengthen safe-haven demand for gold. In response to an economic slump, central banks usually support the economy with fresh monetary accommodation, and by slashing interest rates.

The dovish action by central banks has a supportive effect on gold prices.

Normally when interest rates increase, they indicate a strong economy. Inflation tends to rise, and money flows to other fixed-income investments.

However, in a negative interest environment, gold as a zero-yield asset looks more attractive versus an asset that is guaranteed to lose money, as in the case of a negative-yielding bond.

Graphically, the price of gold positively correlates with negative-yielding debt, as shown below.

negative-yielding bonds

The total value of negative-yielding bonds across the globe is now alarmingly perched at $16 trillion, or more than 25 per cent of the market.

Billionaire Ray Dalio, the founder of Bridgewater Associates, the biggest hedge fund in the world, said in a LinkedIn post that it would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio in a negative yield environment.

Be greedy  “for gold”  when others are fearful

Now that we have an understanding of the factors that make gold tick, let us analyze the current environment for investing in gold.

Global economic conditions lurching towards recession and other negative developments

Earlier this week, data coming out of the European Union showed the Eurozone composite Purchasing Managers’ Index (PMI) for September came in at a lower-than-expected 50.4, down from 51.9 in August. A reading below 50.0 suggests contraction.

More worryingly, Germany’s manufacturing PMI in September came in at 41.4, its lowest level since mid-2009.

The data was worse than expected and suggested the German economy is teetering on the brink of a recession.

Further, protests and civil strife continued in Hong Kong over the weekend; the U.S.-China trade negotiations have taken a step backward and U.S.-Iran tensions are smouldering in the background.

All of the above are making traders and investors around the globe fearful and in a “risk-off” mood.

Analyst views & Gold Future prices

According to a recent note by Citigroup’s analysts, the outlook for gold is quite healthy. They see the possibility of prices rallying to a record $2,000 an ounce, or above, in the next two years.

“We expect spot gold prices to trade stronger for longer, possibly breaching $2,000 an ounce and posting new cyclical highs at some point in the next year or two,” they said.

At that level, gold would exceed its previous all-time high of $1,921.17 set in 2011.

As if to prove the point, at the time of writing, spot gold closed more than 1% higher at $1,531 per ounce. U.S. gold futures rose 1.1% to $1,532.40 an ounce, their highest closing price in more than two weeks.

Technical analysis

Spot gold is currently in an uptrend following the trend line shown in the 4H graph below.

However, over the past few sessions, gold has made a bearish move that penetrated downwards the trend line as well as the 50-period Exponential Moving Average. It is currently sitting at $1509.

It also looks as if gold is setting up a bearish Head-and-Shoulders pattern that would be validated if price broke the horizontal line at $1485. Were that to happen, gold could move down, in the first instance to $1450, and after that to $1415.

However, if gold were to recoup its current losses and recapture its upward trend, it could move up to $1560.

Investors should, therefore, keenly follow the technical picture as it unfolds and gold could become a buy once the upward trend resumes.

Gold trendline today

Other Benefitof investing in gold

Including gold in their portfolio also provides investors with other benefits.

Hedge against inflation

Gold tends to move higher in an inflationary economy.

In such a situation, the currency loses its purchasing power.

Gold has traditionally been viewed as a dependable store of value, and investors will make a beeline for the yellow metal when inflation strikes.

Given the low-interest rates prevailing, investors could do well to stock up on gold if they feel that the purchasing value of their wealth is likely to be eroded due to a sudden onset of inflation.

Portfolio Diversification

The essence of portfolio diversification is combining various investments that are not closely correlated to one another; in other words, a smaller beta.

Gold has historically had a negative correlation to stocks and other financial instruments. Recent history bears this out:

  • The 1970s were great for gold but terrible for stocks
  • However, the 1980s and 1990s were the exact opposite
  • 2008 saw a substantial decline in stocks while consumers fled to gold

Properly diversified investors combine gold with stocks and bonds in a portfolio to reduce its overall volatility and risk.

How to invest in gold

There are several ways to invest in gold:

Physical Gold

You could purchase physical gold and pay storage fees by yourself. In this case, you eliminate third party risk, and the investment perfectly tracks the gold price.

Keep in mind, however, that physical gold is not very liquid, and you should not expect to be able to buy and sell it as frequently as in the case of an ETF.

Physical gold is advisable more for value preservation, and its higher security compared to the risks from financial markets.

Given these factors, invest in physical gold only if you have a timeframe of 8 to 10 years, and can do without any recurring return during this period.

Also, carefully consider the problem of keeping the gold safe.

Gold ETF

Investors not wishing to deal with physical gold may Instead buy a gold Exchange Traded Fund (ETF).

These funds meticulously track the gold price, thereby giving the investor all of the metal’s returns without the hassle of physical storage. ETF’s are also a more economical way to invest.

More speculatively oriented investors could buy ETF’s that offer leverage. Therefore, the investor could gain (or lose) 2X or 3X times the movement in the underlying gold price.

There are three 100% gold-bullion backed ETFs listed on the ASX:

  • BetaShares Gold Bullion ETF [ASX: QAU]
  • ANZ ETFS Physical Gold ETF Fund [ASX: ZGOL]
  • ETFS Metal Securities Australia Ltd [ASX: GOLD]

However, one of the biggest drawbacks of a gold ETF is that you don’t hold the gold yourself.  You own the security instead.  The security is in theory backed by physical gold, which is held by a third party on your behalf.

Gold Mining Company

Investing in gold mining companies is another option to gain exposure to gold.

Keep in mind that the prices of gold stocks do not accurately track the underlying gold price. That is because the company could have a host of other risks such as management issues, accounting problems, or regulatory action.

Recognize therefore that you are only indirectly investing in gold when you buy a gold stock.

That’s because your investment is simply the ownership of a small slice of the company’s assets.

However, gold stocks do pay a dividend, and the better-managed ones may provide a much higher return than the metal itself.

While on management, do remember that most gold mining companies have been able to right ship during the gold bear market of the past few years. Their running costs and debts are far lower today than they were, say, six years ago.

Though purchasing a gold stock is a riskier option compared to the physical metal, it may prove more rewarding over the longer term.

Conclusion

A looming worldwide recession and several geopolitical risks make gold a compelling addition to a portfolio. Gold will preserve value and also hedge against inflation and black swan events.

Investors should choose from the three investment routes discussed above depending upon their risk attitude and investment horizon.

Henry Fung is a Partner Managing Director and co-founder of MF & Co. Asset Management. He is a highly experienced equities, derivatives and financial markets professional with over 12 years of experience. Henry specialises in building trading algorithms & systems, quantitative & qualitative analytics across macroeconomic, fundamental and technical disciplines and currently runs the MFAM VPAC AU/US models portfolios. The management Partners and Adviser team have decades of experience between them, with experience from major Investment Banks and Brokers. Their Advisers are highly experienced, having dealt with some of the wealthiest clients in Australia.



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