Worth its weight in gold

Despite the disappointing performance of the gold price of late and surge in financial market optimism, on hopes of a partial trade deal, the yellow metal retains its importance as a diversifier in a portfolio context. Indeed, our Outlook 2020 highlights its importance due to our view that uncertainty will remain heightened (see chart) and that the demand for gold from central banks looks set to remain on a strong upward trend.

Is market optimism misplaced?

Over the past month markets have been increasingly pricing out downside risks in terms of Brexit and trade negotiations between the US and China. There is also a general belief among market participants that global growth (and in particular manufacturing) has “bottomed out”.

There is a lot of good news priced in market valuations, especially with a UK general election in December and trade talks still not producing anything of substance. The prospects of a resurgence in global growth are far from clear, as survey indicators show less contraction as opposed to outright expansion.

Should things turn sour, and sentiment turns, we could see greater demand for gold like that seen between May and September. This was a period when not only did trade talks between the two superpowers emphatically break down, but the selection of Prime Minister Boris Johnson manifested into an, initial, aggressive tone toward Brexit negotiations with the European Union.

Indeed, on 4 September, the safe-haven flight to gold reached its highest level in over six years. The surge in demand was aided by more pessimistic global growth forecasts as well as aggressive policy easing expectations translating into a lower opportunity cost of holding the zero interest bearing asset.

Beware of overexposure to gold

Earlier in the year many investors were calling for a move towards increasing exposure to gold in their portfolios. At the time, we noted that while we like gold in a portfolio context, too much exposure has its limitations. We remain of that view.

The demand and supply dynamics of gold appear to be unfavourable to generating significant upside. Jewellery demand, which accounts for half of gold demand, remains lacklustre and declined by 16% year on year (yoy) in the third quarter (Q3). Industrial demand has also been lower as a result of a slowdown in hardware sales where gold is used as well as in the dentistry industry with gold being displaced by alternative metals.

Compounding the downside pressure on the gold price, alongside weak demand, has been strong supply. Mine production of gold rose to a record level last year and recycling has also boosted supply, with growth in Q3 at 4% yoy.

In summary, central bank demand and an uncertain 2020 global backdrop will support gold and is the reason we see it as worth holding in a portfolio. However, its purpose is primarily as a diversifier due to its limitations on a fundamental demand and supply basis.

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