by Joe Foster – Portfolio Manager and Strategist
Gold continued its trend higher in April. It reached a yearly high of US$2,048 per ounce on April 13, which coincided with the US dollar’s (DXY Index) low for the year. It then traded in a tight range at around the US$2,000 level, pressured by a bounce back in the US dollar in the second half of April. With the banking crisis somewhat “under control”, markets turned their attention to the US Federal Reserve’s (Fed’s) next policy meeting, looking at current economic releases for clues. The monthly releases were quite mixed, maintaining market opaqueness. The Consumer Price Index (CPI) reading for March did show inflation declining; however, Core CPI (CPI excluding food and energy items) was up 5.6% from a year ago, above the overall measure, which was up 5%. Meanwhile, the Core Personal Consumption Expenditures (PCE) reading, which is the Fed’s preferred inflation gauge, increased to 4.9% in the first quarter of 2023. Manufacturing and services Purchasing Managers Indexes (PMIs) in the U.S. surprised to the upside, while first quarter GDP for 2023 came in at 1.1%, well below expectations of 1.9%. Gold and the U.S. dollar fluctuated as market participants, and members of the Fed, assessed the data and expressed their views on monetary policy outcomes. Gold closed at US$1,990 on April 28, a US$20.72 per ounce (1.05%) advance for the month.
The NYSE Arca Gold Miners Index outperformed gold, up 5.03%. The first quarter reporting season of 2023 has started well with gold mining companies generally meeting or beating expectations. Gold stocks are outperforming gold this year, following years of underperformance. Consistently meeting expectations is an important driver of what we expect will eventually be a rerating of gold equities. This is supported not only by our outlook of higher gold prices, but also by the companies’ continued commitment to value creation via cost control, disciplined growth and a focus on returns.
Banking crisis: contained?
It is a bit too early to say whether the banking crisis is contained or over. The collapse and rescue of yet another bank, First Republic Bank, this past weekend, is clear evidence that risks remain. Once again, regulators intervened, and a more catastrophic failure was averted. However, it is another sign of the fragility of the global financial system at present. Even if this was the end of the banking turmoil, which appears unlikely, these recent developments bring to light the significant stress imposed on the economy by higher interest rates. This might accelerate the chances of a recession or hard landing. It also makes it clear that just like the banks, other sectors of the economy may be vulnerable to the increasing uncertainty and volatility in the markets. This is supportive of gold prices.
With inflation above the Fed’s target, the Fed is stuck between a rock and a hard place. The fight against inflation is not over, but the Fed may be forced to stop its rate hiking programme before another crisis develops. Historically, such as during the 70s, a stop-and-go approach to fighting elevated inflation has not been successful. Unfortunately, controlling inflation without causing significant damage to the economy may not be possible. A Bloomberg article quoted former treasury secretary Lawrence Summers saying that taming inflation will likely lead to a meaningful economic downturn.iSome estimate that the effects of the recent banking crisis may be equivalent to one or two 25 basis points rate hikes by the Fed, suggesting that even if the Fed pauses, worsening credit conditions will slow down the economy and cool inflation. This is speculative as there is no way to quantify these effects. But it does seem logical that lasting ramifications from banking sector turmoil may continue to impact the economy.
Fed pause benefits gold
Gold may be in a privileged position at present. A Fed pause raises a flag: the economy is so weak that the Fed is afraid of causing too much damage by increasing rates further. This is positive for gold because a weak economy sends investors running to gold and because lower rates make gold more attractive to own. The longer-term implications of a Fed pause on inflation expectations could also support gold. Gold is considered a hedge against inflation and its historic performance in high inflation periods confirms this role.
Gold historically rallies in periods of high inflation
Gold nominal and real returns in US dollars as a function of annual inflation*
*As of 31 December 2022. Based on y-o-y changes in US dollars for ‘gold’: LMBA Gold Price PM and ‘inflation’: US CPI since January 1971.
Source: World Gold Council, Bloomberg, ICE. Data as of December 31, 2022.
Furthermore, a Fed pause should lead to weakness in the US dollar. The reversal of the strong dollar trend of 2022, we believe, should continue to be an important driver of gold prices in 2023. The US debt ceiling debacle and mentions of a potential technical default as soon as June 1 weigh heavily on the dollar. An actual default would be disastrous. Diversification away from the US dollar and into gold is a topic we have been covering recently in the context of record net purchases of gold by central banks in 2022, with continued strength into 2023. Coverage of the de-dollarisation theme has picked up recently. A report by Bank of America highlights research that shows a series of gold technical patterns supporting gold prices in the range of US$2,078 all the way to possibly US$2,543 per ounce. In that same report, they point to fear of dollar debasement as another driver of gold demand, as other nations look to reduce their reliance on the US dollar by transacting in other currencies.
Everyone is talking down the dollar
Source: BofA ETF Research, Bloomberg.
Global de-dollarisation
Shifting the US dollar’s dominance as the world’s currency to other currencies, if it happens, is something that would take a long time. De-dollarisation efforts around the world are negative for the US dollar. A weaker dollar alone is supportive of gold prices. In addition, because gold is so underheld, even a small shift in investment away from the US dollar and into gold would lead to significantly higher demand for gold. Gold have been chosen by central banks; others may follow.
ENDNOTES
