Gold, the precious metal that investors turn to as a hedge against inflation, will likely face two key headwinds of higher nominal interest rates and a potentially stronger dollar this year, according to the World Gold Council.
However, the negative effect from these two drivers may be offset by other supporting factors, such as persistent inflation, market volatility linked to Covid-19 and robust demand from other sectors such as central banks and jewellery, the industry body said in a 2022 market outlook report.
“Against this backdrop, gold’s performance during 2022 will ultimately be determined by which factors tip the scale. Yet, gold’s relevance as a risk hedge will be particularly relevant for investors this year,” the trade group said.
Gold’s relevance as a risk hedge will be particularly relevant for investors this year
Gold prices declined more than 4 per cent in 2021 after rising 48 per cent over the previous two years as the global economic recovery reduced demand for the safe-haven metal, Reuters reported in December.
The safe-haven commodity traded between $1,676 and $1,959 an ounce last year, following its best annual performance in a decade in 2020, in which the metal touched an all-time high of $2,072.50.
Early in 2021, as newly developed COVID-19 vaccines were rolled out, investor optimism fuelled a reduction in portfolio hedges. This negatively impacted gold’s performance and resulted in outflows from gold exchange-traded funds, the Council said. Rising interest rates and a stronger US dollar also continued to create headwinds.
A stronger dollar makes bullion more expensive for buyers who hold other currencies. However, uncertainty surrounding new variants, combined with increasing risks of persistently high inflation and a rebound in gold consumer demand, pushed gold forward, according to the WGC.
The US Federal Reserve is projected to hike interest rates about three times this year. Higher interest rates tend to dim the appeal of gold, which pays no interest.
“Gold has historically underperformed in the months leading up to a Fed tightening cycle, only to significantly outperform in the months following the first rate hike,” the WGC said.
However, not all central banks may move as quickly as the Fed. For example, the European Central Bank said it is “very unlikely” that interest rates will rise in 2022. Although the Bank of England increased interest rates in December, its policy committee indicated only modest future rises. The Reserve Bank of India also signalled that it will maintain its accommodative monetary policy stance.
While diverging monetary policies could result in a stronger dollar, steady or decreasing rates should support regional gold investment demand, the report said.
Gold has also historically performed well amid high inflation.
“In years when inflation was higher than 3 per cent, gold’s price increased 14 per cent on average. Further, in the long run, gold outpaced US inflation and moved closer in pace to money supply, which has significantly increased in recent years,” the WGC said. Despite potential central bank rate hikes, nominal interest rates will remain low from a historical perspective and elevated inflation will keep real rates depressed as well, it added.
Low interest rates will, therefore, shift investment portfolios more towards risk-on assets and increase the need for a high-quality liquid asset such as gold, it said.
Meanwhile, market pullbacks are likely to continue in the face of new variants, as well as geopolitical tensions and buoyant equity valuations fuelled by an ultra-low-rate environment.
“In this context, gold can be a valuable risk management tool in an investor’s arsenal. Gold has a proven historical record of mitigating the negative impact of equity market pullbacks in periods of systemic risk,” the WGC said.
Gold can still receive positive support this year from key jewellery markets such as India, it added. However, further Chinese economic slowdown may limit the contribution from local gold jewellery demand.
“Central bank gold demand, which rebounded in 2021, may remain an important source of demand. There are good reasons why central banks favour gold as part of their foreign reserves which, combined with the low interest rate environment, continue to make gold attractive,” according to the WGC.
One of the challenges investing in physical bullion is the cost of metals delivery and vault storage. To get around this problem, and encourage much larger trading volumes, commodity futures exchange introduced ‘unallocated’ financial products. ‘Unallocated’ gold is where the gold remains the property of the bank and the investor is a creditor, as opposed to allocated gold which is owned outright by the investor.
Allocated gold allowed larger investors like banks and pension funds to place highly leveraged bets on the future price of precious metals without needing to hold the underlying physical metal.
With just 0.5 percent of the daily trading volume of gold products listed on financial exchanges, physical bullion quickly lost pricing discovery (basically the price set by supply and demand) to futures market pricing. That forced bullion miners and investors to accept the futures price for their physical bullion transactions.
Lax banking laws over the past few decades have also allowed global investment banks to build large, highly leveraged precious metals positions that in some cases were later found to have been used to manipulate financial market prices. Many investors believe precious metals have underperformed over the past few decades primarily because overleveraged financial products suppressed prices and led to a low gold value.