Bullish gold views are becoming more widespread and established among investors. An environment of negative and lower-for-longer real rates, slowing growth with downside risks, and elevated uncertainty particularly around trade strengthens the case for holding strategic gold allocations. Positioning has increased, but we think the market can sustain higher levels of positioning against this macro backdrop. As the argument for holding gold becomes more structural, involvement in the market is broadening such that more participants are likely building some exposure rather than a small set of investors holding large positions. This is well reflected in gold’s resilience. Price action has generally been orderly. ETF inflows have been steady and holdings have been sticky even during gold’s pullback towards USD 1460 in late September. Overall feedback we have been receiving from market participants remains positive – many view dips as healthy for the broader uptrend and consider these as opportunities to rebuild positions at more attractive levels. Participation so far has largely been limited to institutional investors and the official sector. As gold gains further upward momentum, we think other areas of the market have the potential to become more active and support the next leg higher. Marginal buying could come from greater participation out of China, the private wealth community, and retail investors, granted that the supportive macro narrative remains intact. Physical demand has been soft this year, but we expect some normalisation ahead as consumers acclimatise to a higher price range. Against this backdrop, we can see gold prices trading through USD 1600 over the next 12 months.
What are the factors driving gold, and are they sustainable?
Gold is unique in that it is both a financial asset and a commodity. We think the underlying theme that is driving gold interest at the moment – both from institutional investors and the official sector – is hedging and diversification. Gold has the ability to act as a safe haven during periods of elevated uncertainty. Low or negative correlations with various asset classes make gold an attractive portfolio hedge/diversifier and positions could become more resilient during certain periods. These complex relationships imply that factors affecting the price of gold are unlikely to remain constant over time. That said, in the long run, we think the dollar and real rates are the two key drivers for gold prices that tend to remain relevant over time. Intuitively, this would make sense as gold is also viewed as an alternative currency and/or as a hedge against the dollar. Considering gold is a negative-yielding asset, the opportunity cost of holding a long position should also be a key consideration. Low to negative real rates currently and the potential for further declines amid a dovish policy backdrop makes gold increasingly attractive as a hedge and portfolio diversifier. Uncertainty around trade negotiations, he lingering possibility of tensions re-escalating, and the implications of this on global growth at this stage in the cycle strengthens the case for diversification into gold. We think all these factors are sustainable drivers that are sufficient to extend gold’s uptrend.
Although macro factors tend to drive prices, it is also important to take note of fundamental demand such as jewellery consumption which can at times be influenced by outside forces. Gold jewellery consumption tends to pick up when prices fall, supporting the market when the macro environment becomes less friendly towards gold.
Central banks buy gold to diversify reserves
Central banks have bought over 400 tonnes of gold as of August data available to us, putting the official sector on track to potentially beat the 650 tonnes of buying last year. The strong interest from central banks over the past year or so is due to a combination of larger purchases and previously inactive central banks restarting activity in the gold space. We expect buying from the official sector to persist as the underlying driver of diversification remains intact. That said, it is worth noting that, as gold prices continue to trend higher, this could potentially act as a drag on the pace of official sector purchases as the percentage of gold relative to total reserves also rises, diminishing some of the urgency to diversify.
Will a trade resolution unwind all of gold’s gains?
Although trade escalation was a key trigger for gold’s rally this year, we think gold’s strength now goes beyond trade uncertainty. Although a credible trade resolution could cause prices to correct as a knee-jerk reaction, the market should stay resilient overall. The drag on growth, the impact on inflation and the consequent compression in real yields implies a more sustained influence on gold prices. We expect the macro backdrop to therefore continue driving interest in gold and for the price range to be higher than it was before trade tensions emerged.
Is positioning overextended?
There has been a strong build in positioning this year, both on Comex and in ETFs. Net longs on Comex have made new highs and gold ETFs have increased by over 10moz year-to-date. This has raised concern among investors that gold positioning might already be stretched. However, we do not think positioning should be a major concern at this point. There are a few things to consider, in our view.
First, macro conditions have broadly turned in gold’s favour, supporting the build in length. About 40% of DM sovereign bond yields are now below zero. US 10y yields are falling towards all-time lows. Real rates have also fallen substantially and are likely to fall further into negative territory. Against the current macro environment, we think that the gold market has room to sustain higher levels of positioning.
Second, the reality may not be as extreme as the headline numbers suggest considering that there has been an ongoing shift towards holding on-exchange positions as opposed to over-the-counter (OTC), which was more dominant in the past.
Finally, wider exposure to gold is still not overly extended and we think there is ample room for strategic positions to continue to grow. Although combined gold positions on Comex and in ETFs have reached new highs this year in volume terms, this is not the case in terms of USD value. Gold exposure looks particularly muted compared to investor allocations to other asset classes. Gold as a percentage of US and global funds’ total AUM remains limited and well off the highs reached during the previous bull-run.
What are the risks to our base case?
Downside risks to our base case include: 1) a credible and comprehensive trade resolution, 2) a swift and substantial recovery in the global economy, and 3) real rates moving back to positive territory. On the other hand, weaker-than-expected growth, more aggressive policy easing among global central banks, especially by the Fed, and escalation in trade and geopolitical risks create further upside potential relative to our base scenario.
Silver to benefit from gold’s bull-run
Stronger conviction in gold’s uptrend has been spilling over to silver and attracting catch-up trades in recent months. Investors have been missing gold’s upswings and are looking to silver
as a cheap way to express views. The surge in participation out of China is also a key factor, highlighted by the surge in trading volumes and open interest on the Shanghai Gold Exchange and Shanghai Futures Exchange. We think silver trading activity out of China was an important factor in silver’s rally to all-time highs in 2011 and therefore is worth tracking closely this time around. Interest out of India has also been good this year, as indicated by import data. Improving retail participation is similarly encouraging – ETFs are up 103moz YTD. We expect silver to continue benefitting as gold’s bull-run, trading through USD 19.0 next year.
Can silver continue to outperform gold?
We think silver has scope to continue performing well, benefitting from gold’s bull-run and policy easing from central banks that ultimately supports risk and the wider commodities complex. We think risks to silver prices are skewed to the upside, but for now we are not convinced that the gold:silver ratio can fall back to the long-term average below 60. The journey higher is unlikely to be a straight path – downdrafts in gold are likely to put more pressure on silver and the latter’s industrial properties are likely act as a drag from time to time. Additionally, although silver is increasingly attracting interest, we expect many participants to maintain a healthy dose of cautiousness given silver’s high volatility: positions are likely to be relatively short-term in nature, with profits booked swiftly.
Where is the balance of risks?
Silver is likely to continue attracting interest on the back of gold, with the gold:silver ratio averaging around recent levels. That said, we think risks are skewed towards higher silver prices and therefore a lower gold:silver ratio than we anticipate. We think participation out of China is important – more substantial and sustained interest would be one of the key factors to support stronger prices than we expect.
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