By Chirag Mehta, CIO & Ghazal Jain, Fund Manager, Quantum AMC
International gold prices jumped 7 percent last month to close at $1,753, the highest monthly increase in the last 18 months. The sharp up-move was underpinned by the lower-than-expected US inflation print for October and a higher unemployment rate, which may lead to a less aggressive monetary policy by the Federal Reserve.
The Federal Reserve has been wary of the tight jobs market and the red-hot 40-year high inflation that could result in hyperinflation. To combat the two devils, the Central bank started increasing interest rates in March to ease price pressures by killing demand and took the rates from 0.25% to 4% in eight months. The impact of rate hikes comes with a lag, and it now seems to have started to show up in the jobs and inflation data.
The US added 261k jobs in October and the unemployment rate inched up to 3.7%. On the other hand, inflation moderated to 7.7% y/y, the lowest figure in the last nine months after peaking at 9.1% in July.
The Fed cannot do much about supply-side inflation, however, we are seeing a moderation in global oil prices and freight costs too. WTI Crude prices fell to $81 which is 7% lower than last month. Similarly, the Baltic Dry Index also subsided by 7% to 1355 compared to last month. Although some of the commodities have seen a slight uptick in prices last month, it could be transitory due to Covid shutdowns in parts of China.
Therefore, it seems that the worst of inflation is behind us, and we may see further cooling of inflation numbers going forward due to the high base effect, the easing supply chain pressures as well as the lagged effect of the Fed’s tightening. Although inflation may remain above Fed’s comfort level for some more time, much of the decline emanates from demand destruction which should eventually show in growth numbers. This means that Fed will eventually have to be less aggressive.
Investors have already started pricing in this possibility and led the bond yields down with the benchmark US 10Y yield at 3.6% compared to 4.3% a month ago. This also resulted in a slight drag in the US TIPS yield which closed at 1.2% as opposed to 1.5% a month ago. A similar consequential reaction was seen in the US dollar, which weakened to a three-month low of 106. Prices of precious metals and risky assets such as equities also moved higher anticipating a pivot from the current aggressive monetary policy.
Although this is a reasonably apt expectation, we may still see near-term headwinds to gold prices which would keep the upside capped. The markets risk overshooting the pivot story too early. Inflation, even though moderating, is still too high for the average inflation target of 2% set by the Federal Reserve. Therefore, although the quantum of rate hikes would be less, there would still be a hike of at least 100 basis points more in the next three months. In addition, monetary policy is expected to remain restrictive even after the final rate hike. Furthermore, this was just the first data point that showed signs of easing, however, the Federal Reserve would look for consistency in future data prints before making a pivot.
That said, our medium to long-term view on gold remains bullish (with short-term volatility) because of the recessionary concerns surrounding the global economy. The inversion of the US 10Y-2Y and 10Y-3m spread is portending a recession. Gold has historically performed better than risk assets during such times. A combination of recessionary conditions forcing the Fed to ease with inflation staying somewhat elevated will be extremely bullish for gold.
Also, the lingering geopolitical uncertainties driven by the Russia-Ukraine war and the subsequent sanctions have contributed to the dislocation of commodity prices especially natural gas. Any escalation in the current situation with the winter season around the corner, may lead to risk aversion and thereby support gold prices.
Looking ahead, taking into account the global risks and uncertainties, it is a prudent choice to make at least a 15% allocation to gold in the portfolio.
If we look at the peak price of $2,070 in March 2022, the gold prices have corrected significantly and are available at 15% lower than the all-time high price. Therefore, accumulating gold at these levels in a staggered and systematic manner would help build a resilient portfolio in case of drawdowns in equities due to a global recession and the resulting risk aversion.