The world is facing a crisis of lives and livelihoods that seems to be compounding with every passing day. Distressing statistics of Covid-19 fatalities and mounting unemployment pop up on our TV and mobile screens. And yet financial markets seem to signal that "all is well".
Well, this is a classic case of treating the symptom, and not the cause. In spite of rising infections, global policy makers have resorted to lifting lockdowns and throwing cash at the economic ramifications of the pandemic in a bid to quicken resumption of economic activity.
Investors who have sensed the shortsightedness of this policy response, are preferring to park funds in assets like gold. Flows in Gold ETFs have set a new annual record in just 5 months. Gold prices were stable through most of June balanced between geopolitical anxieties and further waves of infections on one side, and hopes of economic recovery and dollar strength on the other. But investment demand for the metal shot up by the end of the month and international prices settled at $1780 levels, 3% higher m-o-m.
Similarly, riding on the back of a depreciating rupee, Indian prices calculated with GST hit a record high of Rs 50,000 per 10 grams(inclusive of GST).
The crisis of confidence plaguing the economy
Contrary to expectations, re-openings of the economy didn't have a pronounced impact on economic activity. The Flash Purchasing Managers Composite Indices (PMIs), a leading indicator of economic activity, for the major developed economies of US, Eurozone, UK and Japan still indicate contraction in June.
Now this phenomenon can be traced to a confidence deficit amongst consumers and businesses which is damaging key economic pillars like consumption, hiring, and investment.
As long as people are scared of the disease and uncertain about their economic prospects, it looks unlikely that they will get back to spending like they did prior to the pandemic. Businesses too will be nervous about restarting normal operations and rehiring.
The extent of economic damage on businesses and thereby on employment and wages has been severe.
The destruction of real wealth stemming from the lockdowns will ensure that the recovery is shallow and short lived. The fact remains that central banks and Governments cannot make up for the decline in real wealth.
Thus, a quick rebound in economic activity seems unlikely in the near future. This will cap gains in equities and keep the increased investment demand for gold intact.
Risk of another correction in asset prices
The International Monetary Fund too recently acknowledged the big disconnect between the optimism in financial markets around the world and the real economy. Though the IMF has further lowered its outlook for global growth, markets are betting on a quick recovery, which is most likely based on the liquidity tsunami and expectations of continued support by central banks. This mispricing of risk and resulting rally in the equity markets could derail as and when the ground realities emerge or risk-off sentiment returns. Gold could be an effective portfolio diversifier in the case of another stock market correction and renewed risk aversion.
Low yields limit bonds' utility as diversifier against equities
The coronavirus pandemic is expected to impact economic activity for years to come. This tells us that monetary and fiscal policies around the world will continue to be accommodative to boost GDP growth. Central banks continued to remain accommodative for six years following the Global financial crisis of 2008 and this is many times more severe than that. Thus, bond yields and short-term interest rates are bound to stay low in nominal terms and negative in real terms for the foreseeable future. Such low yields will limit bond markets' ability to act as a hedge against equity price volatility and at the same time minimize the opportunity cost of holding zero-yielding gold. This trend will be bullish for the yellow metal.
Weaker dollar and inflation on the horizon
The massive monetary policy easing and never seen before government relief packages have helped dodge an economic collapse. The spike in monetary inflation as a result of the rapid money creation from the central bank could result in more price inflation this time. Unlike the Global financial crisis where new money creation went to banks and financial institutions, this time it seems to be trickling fast to the real economy with Fed awarding handouts, paycheck protections etc. . The monetary inflation could also result in a weaker dollar. The dollar has weakened more than 5% after scaling to highs of 103 levels in late March and this has strengthened the current gold rally. A weaker dollar and high liquidity could result in higher commodity prices as well and therefore could be inflationary. Gold, known for preserving purchasing power, will become a preferred asset in such times.
Systemic risks sowing the seeds of the next crisis
While accommodative monetary policy is crucial to bring the global economy back on its feet, a sustained period of extremely low interest rates will hurt banks' profitability in the coming years. Businesses might find it hard to service debt in a plummeting aggregate demand environment. Thus, potential credit losses resulting from insolvencies could also test bank resilience.
In addition, national debts of governments are mounting as they try to counter the economic damage of the Great Lockdown. For instance, The US national debt has just reached 120.5% of the nation's annual economic output. The debt has jumped a massive $2.5 billion in a mere 3 months to touch $26 billion. These debt loads not only impact an economy's potential to grow but continue to weaken the purchasing power of fiat paper currencies. Such unprecedented expansion of balance sheets could potentially lead to defaults and debt crises in the long run, especially in the weaker economies. And evidently, gold would indeed be a big beneficiary when a crisis plagues the world's reserve currency.
POTUS has threatened that the U.S. could pursue a "complete decoupling" from China. The two countries are the largest trading partners in the world. Bilateral trade between the economic giants had already decreased by 15% in 2019 on account of the trade wars. A further disengagement could damage global economic recovery at a time when international trade is already in the doldrums.
With Republicans and Democrats agreeing on this opposition to China based on Beijing's handling of Covid-19, forced technology transfers, human rights abuses and its tightening grip on Hong Kong, the decoupling seems to have become a certainty regardless of who wins the 2020 elections.
This will have consequences for global order and wide-reaching economic ramifications. The resulting uncertainty in equity, credit and currency markets will trigger a risk-off sentiment. This will push up investment demand for relatively safer alternatives like gold.
Rising inequality and social tensions
With jobs lost and economies suffering on one hand and asset prices soaring on the other, economic inequalities around the world will be exacerbated. Developed economies might come out stronger and emerging economies could go down further. This could potentially lead to geo-political and social tensions and push up demand for gold which has no country specific risks.
To summarize, a high degree of uncertainty surrounds our outlook in the short term with developments like a vaccine, a second wave of infections influencing gold. But lingering macroeconomic uncertainties and systemic vulnerabilities as laid out above are going to ensure that gold will remain a preferred monetary asset for years to come.
Make a strategic allocation to gold because it's the counterweight to paper money which is continuing to lose credibility as a store of value.
Chirag Mehta is a Sr. Fund Manager for Alternative Investments with Quantum Mutual Fund.
Diclaimer: Views expressed are solely for general information and should not be a replacement for the personalized and professional advice of a certified analyst. The views expressed above should not be construed as the official view of this publication.