Gold prices at record high; will the rally last?

Recent developments in the global economy are behind this trend. Firstly, the escalation of the trade war between US and China has created significant uncertainty for the global economy as well as for financial markets. US Q2 GDP release revealed that business investment contracted for the first time in three years, which illustrates the rise in the uncertainty of economic prospects. This favours buying of safe haven assets like Gold.

Last year, the US Federal Reserve had hiked rates four times. Due to the rise in uncertainty as well as weakening prospects for the global economy, the US Federal Reserve has shifted policy and cut rates recently. Market participants expect further rate cuts. A weak monetary policy in the US again favours safe haven assets like Gold and US Treasuries.

The rally in Gold has been supported by central banks. Central banks have bought net 224.4 tonnes of Gold in April-June quarter of 2019, and a total of 374 tonnes is H1 2019. This is the biggest purchase in the first half of any year in 19 years, according to World Gold Council data.

The demand for Gold ETF has also increased; demand in Q2 of 2019 was 67.2 tonnes, approximately double compared to the same period last year. This shows a significant increase in investor demand.

Additionally, there are few reasons local to India which have supported prices. One of the major ones is the depreciation in rupee, driven by FII outflows, as well as an accommodative monetary policy. The monetary system is well supported by ample liquidity which on the margin can lead to a weaker rupee.

The lack of rally in oil is thus puzzling, but there are a few reasons at play why oil prices have been weak. China has continued to buy oil from Iran, which is keeping markets well supplied, this when IEA has cut demand growth forecasts for 2019 as well as 2020.

I believe that there is further upside for Gold prices. It is reasonable to expect that the US will continue with an accommodative monetary policy. The US yield curve has flattened (measured by US 10 year- US 2 year yield) which is not good for growth and the central bank would like to steepen the yield curve. This has led to increased expectations of a rate cut, as well as a round of Quantitative Easing.

In addition to the US, other major central banks around the world are easing policy, the European Central banks and Bank of Japan are expected to ease policy, and the PBoC is already pursuing a loose monetary policy.

This may push the US Federal Reserve to ease policy more than one would expect, for one they would not like the US Dollar to appreciate beyond a certain point.

The Chinese currency has depreciated recently, largely driven by a weak Chinese economy and the desire of the Chinese policymakers to neutralise the impact of tariffs.

The US President has expressed his desire for a weak US Dollar and this is another factor that can drive US interest rates lower.

The ongoing trade wars are unlikely to be resolved soon, and this helps drive Gold prices higher in a couple of ways. Firstly, it has the potential to push the world into a recession if trade wars were to escalate, and at best cause growth prospects to weaken. The uncertain outlook helps drive Gold prices higher. Secondly, trade wars can help ensure that monetary policy stays accommodative.

Also, the rupee may depreciate, which can further support Gold prices in the local market. The Indian currency is currently 7.6 percent overvalued, according to the BIS Real Effective Exchange Rate (REER), which is a reason behind the loss of competitiveness of Indian exports. This should correct and the rupee should depreciate, though I would expect the RBI to smoothen the rate of depreciation.

Secondly, the trade wars and deprecation of the Chinese currency is likely to result in depreciation of emerging market currencies, along with the INR. In the short term, FIIs’are likely to remain shy of investing in emerging markets, including India, which should support a weaker FX regime. This can further boost Gold prices in the local market.

There are a few risks though because of a weaker economy. Physical demand for Gold, especially in the festive season may not materialise, and a weaker crude oil price regime is supportive of the Rupee. These may dampen the rally in Gold, but I believe that Gold prices are likely to rise and should be a good investment.

(The author is CEO at Karvy Stock Broking.)

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