The shocking vote by the UK to leave the European Union sent gold soaring to its two-year high as investors sought safety in the wake of political and economic uncertainty generated by the event. Even before Brexit, investors were snapping up the precious metal this year due to concerns about anemic global economic growth, slowdown in China and oil price plunge. Gold is now up about 29% this year so far and about 9% since the Brexit vote.
Gold is no doubt becoming a crowded trade now. Many investors wonder whether gold can continue to shine considering “too much too soon” rally. Today’s strong jobs report raised further questions about the sustainability of the rally.
Let’s look at the reasons that are likely to keep the gold rally alive this year.
1> Fragile Global Economy
Earlier this year, IMF had cut its global growth forecast for this year to 3.2%-- its fourth straight cut in a year—putting growth just marginally above 3% rate the IMF has previously considered a technical recession globally. The IMF also warned investors “they shouldn’t be complacent about the myriad risks threatening to derail an increasingly frail global economy.”
After Brexit, the IMF further trimmed its economic growth projection for the Euro-zone. While Brexit induced financial market turmoil appears to be coming to an end now, the economic consequences will be clear only in the medium-to-long term. A lot of depend on what kind of deal Britain will be able get from the European Union.
Recent manufacturing data out of China suggests that the economy further slowed down during the second quarter as factories continue to struggle with excess capacity, slowing demand and rising debt. Overall, we are likely to see very weak global economic growth environment this year.
2> Macroeconomic and Political Uncertainty
Investors hate uncertainty and Brexit has just added more uncertainty to global financial markets. Growing political uncertainty in the US and Europe suggests that markets may see several bouts of turmoil in coming months. Investors tend to seek refuge in safe havens during periods of turmoil and that may keep bullion prices elevated this year.
Gold acts as a hedge in uncertain times. During times of stress, investors also realize the importance of diversification in portfolios. Gold is negatively correlated with equities and adds diversification benefits in a portfolio.
3>Earnings Recession
Per Zacks Earnings Trends, total earnings for the S&P 500 index are currently expected to be down -6.2% from the same period last year on -0.7% lower revenues This would be fifth consecutive quarter of year-over-year earnings declines for the S&P 500 index.
Multinational corporations have struggled with currency headwinds for the past several quarters but those seemed to be abating this year. The recent surge in the dollar as a fallout of Brexit means those companies will have to struggle with currency challenges much longer now.
Earnings recession will keep the potential for stock gains limited this year and thus investors will continue to look for alternative assets where they can earn better returns.
4> Lower for Longer Interest Rates
Negative interest rates in Japan and some European countries are also boosting gold prices this year. Gold critics often argue that it is an unproductive asset since it pays nothing to holders and that argument does make some sense when interest rates are high but in the current ultra-low/negative interest rate environment, there is almost no opportunity cost of holding the metal.
Central banks will have to continue with dovish policies due to weak global growth and may even have to step up stimulus efforts in the wake of Brexit. That will be positive for gold.
The Bottom Line
Considering gold’s rapid rise, there may be some profit taking in the near-term particularly if the US economic picture continues to brighten. However weak global growth, dovish monetary policies and rising risks make gold a compelling investment this year. Investors should take advantage of any price pull backs to buy gold ETFs and add diversification benefits and better return potential to their portfolios.
