Gold Tends To Outperform After The Fed Tightening Cycle

Summary

• Analysts maintain bullish views on gold following the US Fed rate hike.
• Higher inflation seen along with labor market slack is rapidly diminishing in the U.S.
• Equity correction would be an attractive entry point for medium to long-term positions.

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Investment Thesis

Gold price has outperformed after six cycles of US Fed tightening. More investors wait on the sidelines for further tightening announcements to be made in order to invest in gold. This would be resulting in pent-up demand flow-through.

Source: Goldman Sachs Global Investment Research

The US Fed announced its first rate hike of the year last March. Federal Funds rate climbed from 1.5% to 1.75%, sending the US dollar into a downward spiral, thus lifting gold prices. Gold rates increased 1.12% to $1,327 per ounce after the hike was announced.

In this economic research, we will analyze how inflation, equity risk appetite, labor market and the US dollar would influence gold prices and investors following the recent interest rate hike.

Gold Price Review

Despite higher inflation expectations and increased interest in portfolio diversification against last February's choppy market environment, gold was down by 2.0% to $1,318 an ounce.

It fell below its 50-day moving average as it reacted negatively to the stronger US dollar and ebbing geopolitical tensions. Prior to the interest rate hike announcement, gold prices were range-bound and closed near their lows. Gold equities largely traced physical gold but with higher-than-expected volatility.

The US Fed comments fueled speculation that policymakers will quicken the pace of interest-rate hikes, given signs of building inflationary pressures. Gold price is still off about 30% from the record high set in 2011 though gold's price is up 5.6% on a year-ago basis. It was quite a period for gold, reflecting the limited new interest in the sector, as general markets continued to push higher after a brief pullback.

Source: Company data, Goldman Sachs Global Investment Research

Inflation And Labor

Inflation breakevens could still rise a little further before becoming an anxiety. Economists continue to expect the rate hiking cycle to be characterized by a measured pace of US Fed tightening. In addition, there is a less downside risk from monetary normalization compared to just a few months ago. It may be due in part to savings and wealth backdrop of the emerging markets which are supportive of gold demand.

Source: Datastream

As the US cyclical recovery has continued, there have been rising signs of labor market tightness. This is prominent in the US, which has led the global recovery cycle. It is also where unemployment rate is now at its lowest since 2000.

Source: Haver Analytics, Goldman Sachs Global Investment Research

Economists are also not extremely concerned with core inflation pressures, forecasting core Personal Consumption Expenditure (PCE) inflation to increase only marginally, to 2.0% year-on-year by end-2018, versus 1.5% year-on-year today. However, it is also worth noting that given the degree of labor market tightness, each additional unit of decline in the unemployment rate is expected to result in more inflationary pressures.

Since gold prices started falling in 2013, workers have not received any substantial wage increase across companies. Now that the companies are back to their pre-2013 margins (when the gold price fell dramatically), there is a possibility each pay rise demand will be approved.

Source: Goldman Sachs Global Investment Research, US Bureau of Labor Statistics

US Dollar

The US dollar depreciated by 9% versus its currency pairs since the end of 2016. Analysts expect this trend to continue, coupled by 2% trade-weighted index depreciation over the next 12 months. This depreciation came from previous stronger US growth inducing a portfolio rebalancing effect out of the US and towards the emerging market economies. This occurred despite the interest rate differentials shifting in favor of the US dollar as the US Fed continues to hike interest rates.

Source: Goldman Sachs Global Investment Research

Gold Equities

The performance of gold mining equities continued to show high sensitivity to shifts in metal prices in 2017 and towards 2018. Gold equities underperformed physical gold in 2017. But unlike previous years, this trend could be attributed to rising capital costs that eroded mining companies' profit margins.

Source: Goldman Sachs Global Investment Research

Last year's underperformance was more of a valuation contraction as investors seemed to focus on other better-performing segments of the global equity market. In 2018, investors can expect gold stocks to show high gearing to movements in physical gold prices. Even a slight price move in physical gold can drive a significant change in cash flow and the outlook of a company.

Source: Goldman Sachs Global Investment Research

My Takeaway

From the investor's point of view, the question is how can inflation risks be managed? This is more particular to investors who have a medium to long-term investment horizon. I take this opportunity to tell investors to re-examine the abilities of various asset classes to hedge inflation. More particularly, investors must focus on short- to medium-term hedging abilities for both headline and core inflation. Then, they should ask themselves again "is gold still a good inflation hedge?"

I continue to foresee attractive investment opportunities in gold equities with many companies trading at valuations well below historical averages at spot prices. Many gold companies are well-positioned to survive another downturn in prices should it occur. Yet, these companies could witness significant upside potential if prices move higher.

Lastly, gold mining companies have maintained focus on improving the cost structure of their operations, deleveraging and asset rationalization. It should result in improved performance potential. It is also conducive to equity-price appreciation, especially in a rising gold price environment.

Inflation risks, impact of changing fiscal policies around the world and record high stock market indices underscore some of the key trends in 2018. I believe all of them present potential stumbling blocks that could drive further investment in gold.

The global financial system is increasingly complex and moves towards untested waters. This as a result of the unprecedented amount of fiscal stimulus over the past decade, combined with extremely low interest rate policies and rising trade tensions. An investment in the gold industry is based, in part, on the fundamental belief that new forces may weigh on global markets. In some cases, it may act as a positive catalyst for commodities such as gold.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This article was written by Gold News business journalist, Hans Centena. Gold News is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions. If you found this article to be informative and would like to hear more about my investment research, please consider hitting the "Follow" button above.