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Why gold is down, but not out, as virus spreads

Gold's price may be down, but economic uncertainty and ballooning deficits are tailwinds that favour a gradual rise in the precious metal.

Investors looking to gold for protection from the stock market rout have not been rewarded.

The spot price started the year continuing 2019′s trend, in which gold rose by 18.4 per cent in U.S. dollar terms. That was its best performance in almost a decade. But after hitting a peak of US$1,683 an ounce in early March, gold has drifted lower, to US$1,498 an ounce on March 20, as the market panic has accelerated.

With each new promise of government spending and rounds of interest-rate cuts, the spot price of gold has dropped. It’s now down by 2.3 per cent year-to-date.

While gold is down, it’s not out. Experts say its fundamentals in the medium and longer term are strong. Economic uncertainty and worries about ballooning deficits and debts suggest a gradual rise in the price of the precious metal.

“I’m not saying go out tomorrow and buy gold,” says John Hathaway, portfolio manager with Sprott Asset Management USA in New York. “But what we see around us is a demonstration of why you should have it [in your portfolio].”

Juan Carlos Artigas, executive director of investment research at the World Gold Council (WGC) in New York, says global economic anxiety combined with lower interest rates are supportive of gold investment. The WGC is a non-profit funded by mining companies that tracks the supply, demand and uses of gold,

Mr. Artigas says a combination of factors has driven the recent pullback in the price of gold. They include the market sell-off and “the use of gold to cover margin calls, as it has been one of the few assets with positive performance for the year.”

The impact of trading in derivatives markets has also exacerbated the trend, he says.

Still, according to a new WCG investment update on gold, it “remains one of the best performing asset classes year-to-date.”

Mr. Hathaway co-manages Sprott Gold Equity Fund, which has US$1-billion in assets under management; 83 per cent of its holdings are invested in precious metals stocks and 15 per cent in physical gold. It was down by about 26.7 per cent year-to-date as of March 19.

Mr. Hathaway doesn’t believe successive rounds of interest-rate cuts and government spending will be enough to shore up confidence. Nor does he sees a zero interest-rate world as triggering inflation, which is traditionally gold’s ally.

gold bullionRather, he believes deflation in the real economy and in financial markets is a more likely outcome. The price for goods and services would fall as recession reduces demand. In turn, stock prices are unable to recover fully as a bear market mentality takes hold.

In the face of these headwinds, interest in gold is likely to widen, Mr. Hathaway says.

That means investors should wait for the market panic to subside before making a call on whether gold has a place in their portfolio and, if so, by how much, he says.

Mr. Hathaway thinks a weighting of 5 per cent is appropriate, while Mr. Artigas suggests between 2 and 10 per cent as a portfolio diversifier.

Mr. Artigas notes that investors poured US$19-billion into gold exchange-traded funds in 2019. That figure was already at US$11.5-billion year-to-date as of March 19. So, investment sentiment and momentum remain strong, he says.

The WGC has a tool on its website that looks at how gold behaves under different conditions. After users create a free account, they can look at four economic scenarios and the impact on gold.

The four models are: slowing global growth; a U.S. recession; an emerging-market rebound; and a continued China slowdown. The base assumptions were made in December and are being updated.

The U.S. recession model predicted what has already happened, in many respects. It assumes a 30-per-cent decline in U.S. stocks. As of March 20, the S&P 500 has already declined by 29.3 per cent year-to-date. The model predicts a recession within a year, prompting aggressive interest-rate cuts and fiscal stimulus. The U.S. Federal Reserve Board has cut interest rates twice in the past few weeks and the Trump administration is proposing a variety of stimulus measures.

The model predicts that U.S. real gross domestic product growth will average 0.2 per cent in 2020 and the 10-year U.S. Treasury yield falls to 0.8 per cent. (The yield has already touched that level after the Fed cut its benchmark rate to zero; it has rebounded slightly to 0.92 per cent as of March 20.) The model sees stocks recovering in 2021 with high single-digit returns.

In turn, the price of gold would rise by 3 per cent this year, followed by a fall of 3 per cent in 2021 and a further 7 per cent drop in 2022.

The rationale is that a strong increase in the price of gold in 2019 limits more speculative investment this year as weak emerging-market economies see slower consumer demand and advanced economies import fewer goods, which use gold as a component. The model sees credit spreads remain subdued, limiting an increase in gold investment demand.

While models don’t always match actual behaviour, Mr. Hathaway says that, taken as a whole, the outlook for gold is positive.

“The coronavirus will eventually go away. Global indebtedness will not,” he says.

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(This article appeared in the Globe Advisor section of the Globe & Mail’s Report on Business on Mar. 23, 2020.)

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