While gold is set to face headwinds for the rest of 2022, its strategic and tactical role will likely remain relevant to investors.
Andrew Naylor, World Gold Council regional chief executive officer APAC (ex China), tells us more.
Rising prices are preoccupying policy-makers worldwide. The Reserve Bank of Australia is expecting Australian inflation to reach 7 per cent by the end of the year. And Australia isn’t unique – inflation is a serious concern worldwide.
As the global economy and financial markets begin to recover from the COVID-19 pandemic, a chief concern for many is the somewhat novel situation of ‘high’ inflation. This is particularly true in the US, where investors have been used to low levels of inflation for more than three decades.
Although the output gap and unemployment remain high, the quick economic recovery has left many areas of supply-tight. Commodity prices are reflecting this situation, as are shipping rates and business inventory data.
The causes have been written about extensively – as financial markets and the wider global economy recover from the pandemic, pent up demand and supply-chain crunches have led to rising commodity prices. This has had a knock-on effect in other areas of the economy, pushing up prices more broadly.
Compounding this are large increases in worldwide government debt and indications that central banks are accepting of higher inflation. This suggests, on balance, that inflation risks are skewed to the upside.
It is often said that gold can protect purchasing power, and is used as a hedge against inflation. World Gold Council research has analysed this in detail.
Gold isn’t the only hedge against inflation, but with a compound annualised growth rate of 8.1 per cent (from 1971–2020) it can protect portfolios from its impact, particularly if inflation is sustained.
Although gold can perform well in inflationary environments, interest rates are a headwind. When interest rates go up, so does the opportunity cost of holding gold. When it comes to drivers of gold’s performance, 2022 could be characterised as a bit of a tug-of-war between inflation and interest rates.
We recently published our outlook for the gold market for the second half of 2022. Gold finished the first half of the year 0.6 per cent higher, closing at $US1817 ($2640) per ounce. The gold price initially rallied as the Ukraine war unfolded and investors sought high-quality, liquid hedges amid increased geopolitical uncertainty.
But gold gave back some of those early gains as investors shifted their focus to monetary policy and higher bond yields. By mid-May, the gold price had stabilised in response to the tug-of-war between rising interest rates and a high-risk environment.
This was a combination of persistently high inflation and likely support from the extended conflict in Ukraine and its potential knock-off effects on global growth.
Looking ahead, we believe there are three key themes in the closing months of 2022: monetary policy uncertainty driving up volatility, lingering inflation, and the interest rate picture.
Monetary policy uncertainty ramps up volatility
Most central banks were expected to lift policy rates this year, but many have stepped up their actions in response to persistently high inflation.
As of early September, the Fed had hiked its funding rate to 2.25–2.50 per cent, the Bank of England had increased its base rate to 1.75 per cent, and the Swiss National Bank had hiked rates for the first time in 15 years.
These actions have had major impact on financial markets, including gold. Historical analysis shows gold has underperformed in the months before a Fed tightening cycle, only to significantly outperform in the months following the first rate hike.
Contrastingly, US equities had their strongest performance ahead of a tightening cycle but delivered softer returns thereafter.
Inflation may linger even if it peaks
Inflation remains at historically high levels, and while investors expect inflation to cool down eventually, we believe it will remain high for a couple of reasons.
Lingering commodity-related supply-chain disruptions from the pandemic and the Ukraine war have caused a surge in key energy and commodity prices. Secondly, tight labour markets, causing concerns that wages/labour costs may rise further.
Gold has historically performed well amid high inflation. In years when inflation was higher than 3 per cent, gold’s price increased an average of 14 per cent, and in periods where the US Consumer Price Index averaged over 5 per cent on a year-on-year basis – currently at approximately 8 per cent – gold increased by an average of nearly 25 per cent.
Amid opposing forces, real rates will likely remain low
Despite forthcoming rate hikes by various central banks, nominal rates will remain low from a historical perspective.
This is important for gold since its short- and medium-term performance tends to respond to real rates, which combine two important drivers of gold performance: “opportunity cost” and “risk and uncertainty”.
In conclusion, gold will continue to face two key headwinds during the closing months of 2022: higher nominal interest rates and a potentially stronger dollar.
However, the negative effect from these drivers may be offset by more supportive factors:
- High, persistent inflation with gold playing catch-up to other commodities
- Market volatility linked to shifts in monetary policy and geopolitics
- The need for effective hedges
In this context, gold’s strategic and tactical role will likely remain relevant to investors, particularly while uncertainty stays elevated.
This feature appeared in the August issue of Australian Resources & Investment.