Most of us would agree that 2020 was memorable, though perhaps not for the right reasons. The Covid-19 pandemic raised uncertainty by compounding existing economic trends while creating new ones. By the end of last year, there was a noticeable shift suggesting that investors were optimistic that the worst was over.
Despite this sentiment, investors will likely also be navigating potential portfolio risks including:
- Ballooning budget deficits
- Inflationary pressures
- Market corrections amid already high equity valuations
In this context, we believe gold investment will remain well supported while gold consumption should benefit from the nascent economic recovery, especially in local emerging markets.
A recipe for strong gold performance
Looking at the first two portfolio risks, many investors are concerned about the potential risks resulting from expanding budget deficits, which, combined with the low interest rate environment and growing money supply, may result in inflationary pressures. This concern is underscored by the fact that central banks, including the US Federal Reserve and European Central Bank, have signalled greater tolerance for inflation to be temporarily above their traditional target bands1.
Gold has historically performed well amid equity market pullbacks as well as high inflation. In years when inflation was higher than 3%, gold’s price increased 15% on average. However, it is important to note that research by Oxford Economics2 shows gold should also do well in periods of deflation. Such periods are typically characterised by low interest rates and high financial stress, all of which tend to foster demand for gold.
Furthermore, gold has been more effective in keeping up with global money supply over the past decade than US T-bills, thus helping investors to better preserve capital.
Global stocks performed particularly well during November and December, with the MSCI All World Index increasing by almost 20% over the period. However, rising Covid-19 cases and a reportedly more infectious new variant of the virus have created a renewed sense of caution. Yet, neither this nor the highly volatile US political events during the first week of 2021 have deterred investors from maintaining or expanding their exposure to risk assets. The S&P 500 price-to-sales ratio is at unprecedented levels and an analysis by Crescat Capital3 suggests that the 15 factors that make up their S&P 500 valuation model are at – or very near – record highs.
Going forward, we believe the very low level of interest rates worldwide will likely keep stock prices and valuations high. As such, investors may experience strong market swings and significant pullbacks. For example, these could occur if vaccination programmes take longer to distribute or are less effective than expected.
Economic recovery in 2021?
Market surveys indicate that most economists expect growth to recover in 2021 from its dismal performance during 2020. Although global economic growth is likely to remain anaemic relative to its full potential for some time, gold’s more stable price performance since mid-August may foster buying opportunities for consumers, many of whom reside within APAC.
The economic recovery might be more likely in countries like China, where the economy suffered heavy losses in early 2020 before the spread of the pandemic was controlled more effectively than in many western countries. Given the positive link between economic growth and Chinese demand, we believe that gold consumption in the region may continue to grow. Similarly, the Indian gold market appears to be on a stronger footing. Initial data from the Dhanteras festival in November suggest that while jewellery demand was still below average, it had substantially recovered from the lows seen in Q2 of last year.
Finally, central banks are on course to finish 2020 as net purchasers (although well below the record levels of buying seen in both 2018 and 2019). And we don’t expect 2021 to be much different.
There are good reasons why central banks continue to favour gold as part of their foreign reserves (see our Central Bank Gold Reserve Survey 2020) which, combined with the low interest rate environment, continue to make gold attractive.
Conclusions: continued investment demand in a low interest rate environment
The performance of gold responds to the interaction of the various sectors of demand and supply, which are, in turn, influenced by the interplay of four key drivers.
The World Gold Council has sought to explain how these drivers interact together using Qaurum, a web-based interactive valuation tool.
In this context, we expect that the need for effective hedges and the low rate environment will keep investment demand for gold well supported, though this demand may be heavily influenced by the perceptions of risk, linked to the speed and robustness of the economic recovery. A recovery of consumer demand, led by APAC consumers, seems plausible as economic conditions improve in 2021. In addition, gold’s performance may be boosted further by the prolonged low interest rate environment which would all but remove the opportunity cost of investing in gold.
1 - FT: Fed to tolerate higher inflation in policy shift (August 2020) and The ECB begins its shift to a new inflation goal (October 2020).
2 - Oxford Economics is a leader in global forecasting and quantitative analysis and a specialist in modelling.
3 - https://www.crescat.net/crescat-november-research-letter/