- By Dilantha De Silva
Gold prices hit an all-time high of $2,074 per ounce in August but have since then retreated to the mid-1800s along with the improving prospects for the global economy.
Historically, the precious metal has provided stellar returns during recessions, and gold lived up to its expectations this time around as well. According to data from Reuters, the commodity was among the best-performing asset classes for 2020 by July, and investors who had exposure to gold were able to successfully hedge the decline in stock prices.
Many Wall Street analysts, economists and international bodies are now turning bullish on the global economy, and this has led to a decline in gold prices as the metal is considered a risk-off strategy whereas robust economic growth favors risk-on strategies. There are, however, many reasons why I think it would be prudent for investors to remain invested in gold despite the improving economic prospects.
The recovery will be bumpy
The expected recovery of the global economy will most likely be a bumpy ride unlike what investors have come to experience in the past. In the early stages of the economic slump, economists projected a V-shaped recovery where the sharp decline was expected to be followed by an equally rapid recovery. A recent survey conducted by The Conference Board by gathering data from global CEOs found out that the recovery is more likely to be L-shaped or U-shaped:
Source: Visual Capitalist
In a U-shaped recovery, the drop in the economy will be gradual and a healthy rise will follow only after a period of stagflation. An L-shaped recovery, on the other hand, suggests a sharp decline that would be followed by a slow recovery. In either of these scenarios, the economy will continue to receive major shocks, and this will create demand for hedging securities such as gold in the market.
The monetary and fiscal policy measures taken by governments around the world will also set the tone for gold to head higher in the coming year. HSBC chief precious metal analyst James Steel wrote:
"Monetary and fiscal policies are providing gold with the two requirements of a bull market: debt and liquidity. This is likely to continue for the foreseeable future and remain supportive, regardless of vaccine progress."
Overall, the global economy will grow in 2021 but there's no reason to suggest that gold prices will take a permanent hit from this expected positive development even though the recent decline in the market price suggests otherwise. This anomaly between economic reality and the market value provides contrarian investors an opportunity to exploit.
Consumer demand will be back on the table
The breakdown of the demand for gold by purpose is illustrated below, and it's easy to realize that investors account for the absolute majority of the demand for the metal in the last few quarters. However, things have not always been the same. For instance, in 2017 and 2018, the demand was dominated by consumers who were buying jewelry.
In the current times, India is easily the country that creates the most consumer demand for gold, where jewelry is considered a luxury. The difficult economic conditions have reduced the demand for gold coming from India, but things are likely to reverse in the coming year as the Indian economy gains momentum. This is good news for gold as robust demand will help prices stabilize despite the outflows expected from institutional funds.
The dollar might shed some gains
A strengthening U.S. dollar is bad news for many commodities, and there is no exception when it comes to gold as well. Historically, gold and the dollar have shared an inverse relationship. Over the last couple of years, the greenback continued to remain strong relative to other major currencies, and this was one of the primary reasons behind the meager returns reported by gold through the beginning of this year.
The dollar is widely considered a safe-haven investment, and this is exactly why the currency held on to its long-term gains despite weakening as a result of the massive hit the American economy took from the global recession. There are promising developments from the vaccine front, and the eventual return to normalcy is likely to exert downward pressure on the dollar. Citi strategist Calvin Tse wrote in a research note:
"Vaccine distribution we believe will check off all of our bear market signposts, allowing the dollar to follow a similar path to that it experienced from the early to mid-2000s. Can the dollar decline 20% next year alone? We think yes."
Another factor that could affect the strength of the dollar is the faster recovery expected in developing regions of the world. Countries such as China and India are expected to report stellar growth next year whereas the U.S. is likely to lag because of structural differences between developed and emerging economies. In such a situation, the dollar will weaken to reflect the growing strength of alternative economic giants. What is more alarming is that the dollar has weakened against some developed market currencies in 2020, which is an ominous sign that suggests 2021 might not be a good year for the dollar.
Source: Financial Times
Gold prices will also follow the same path initially as investors pull out the money invested in the metal to look for other lucrative options that would be available in the market, but if the dollar falls sharply as expected, it will then support gold to regain some lost ground which has historically been the case.
Gold is arguably the most effective hedge against a stock market crash, and the commodity has proven its worth this year.
It would be tempting to go all-in on the economic recovery, but unfortunately, the road ahead is bumpy despite the promising developments. In the next phase of the business cycle, investors are likely to face the unpleasant reality that it would take many years for the global economy to fully recover from this downturn, and this will once again create robust demand for alternative asset classes such as gold in the near future.
The current weakness in prices, therefore, presents a good opportunity for prudent investors to gain exposure to this precious metal, in my view.
Disclosure: The author owns shares in iShares Gold Trust (IAU) ETF
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This article first appeared on GuruFocus.