Gold prices are likely to remain under pressure

COMMODITY TIPS| GOLD PRICES ARE LIKELY OT REMAIN UNDER PRESSURE:-

Gold markets suffered their worst blow in last 3 years as prices fell by 8.1% to $1173 an ounce reducing the YTD increase to just 10.7%. The fallout from the election of Donald Trump, the rising dollar and increased expectations of a US rate rise led to a selloff in gold.
The prolonged volatility in economic data saw a healthy bout of durable goods and manufacturing readings this time, reinforcing the rate hike expectations. However, the way the markets have reacted has been completely counterintuitive following the election results. U.S. Equities moving higher, bonds collapsed decisively, the U.S. dollar at a multiyear high and a free fall in gold prices - this is one of the greatest reversals we have seen this decade. Despite the short term adversities, we believe that Trump’s presidency and resulting policies, plus the evolving real interest rate scenario will be positive for gold in the long run.

Mr. Trump’s plan to revive the ailing economy centers around lower taxes, trade re-negotiations, massive infrastructure spending, military spending and deregulation. A Trump presidency is highly inflationary because his massive $1 trillion infrastructure refurbishment plan, along with his proposal to rebuild the military, will significantly increase annual deficits. This spending binge will be on top of already surging deficits. Trump's plans calls for massive fiscal spending, deregulation, and cuts to taxes that all will increase the US budget deficit and long-term debt and put more upward pressure on bond yields.

In addition to this, Trump’s protectionist trade policies would implement higher tariffs on certain imports in order to encourage these goods to be produced inside the United States. However, this would only be possible to produce in U.S only at significant higher costs. For example, the increase in labor costs from goods made in China would be 190% when compared to the federally mandated minimum wage earner in the United States. Hence, inflation is bound to increase.

It’s important that the Fed embarks on normalization of interest rates in order to check the massive economic imbalances now in existence. The market appears to have taken the view that a Trump presidency will be inflationary. Bonds are selling off, yields are surging higher and the market has stepped up its expectations of Fed tightening. Given a December hike as a given, market now has over 100bp of hikes, priced in over 2017-2019.

Outlook
December rate hike is a given now as it remains the most advance-advertised hike. The markets have fully baked it into asset prices and this is how the Fed likes it to ensure no surprises and no volatility. However, post this December rate hike, the Fed is going to struggle to deliver what the market now expects in terms of tightening. We are nearly seven years into the economic recovery and we are only just approaching the second hike. Yet the market expects another three hikes over the next two years.

The Fed would be happy to see inflation overshoot their targets, rather than tighten prematurely. Not only will the inflationary impacts of US fiscal policy take time to be reflected in the data that the Fed has made monetary policy dependent on, but the Fed would be content to see inflation tick higher without tightening. We presume that there would also be added pressure from Trump if he wants to avoid starting his tenure with an economic crisis similar to that of Mr. Obama. He will need to put a lid on long-term interest rates rather quickly and in the process will seek to convince the Fed chair to not only refrain from further interest rates hikes but also to launch another round of long-term Treasury debt purchases known as Quantitative Easing if the economy loses momentum.

Gold has corrected after the US election due to surging long-term real interest rates. Until we go past the rate hike in December, gold prices are likely to remain under pressure. Post the Fed rate hike, as markets try to ascertain the extent of rate hikes and realize that Fed would stay behind the curve to keep real rates negative for much longer and that should start putting bid under gold prices.

Markets were playing the “lower for longer” theme. If yields continue to increase it won't just be bond prices that will collapse but every asset that has been priced off that so called "risk free rate of return" offered by sovereign debt. The problem is that with such a leveraged economy, elevated asset prices, rising bond yields and the anticipation of further increase in rates may well cause risk premia to rise i.e. volatility in the market to increase, possibly causing overvalued equity markets to correct. The associated volatility may cause financial conditions to deteriorate as the Fed likes to put it, providing them enough excuse to abandon rate hikes. The anticipation of higher real rates may fizzle out yet again, providing support for the price of gold.

Trump will lead to two things: inflation and geopolitical chaos. Both the outcomes are positive for gold. There will definitely be a premium placed on gold due to this. The Trump policies seem to be extremely inflationary in nature but unlikely to deliver long term sustainable growth. There is a high probability of U.S moving towards a stagflation scenario which would be extremely beneficial to gold prices.

The recent fall in prices provides an opportunity to build your desired portfolio allocation to gold. Given the macroeconomic picture, gold will be a useful portfolio diversification tool and thereby helping you to reduce overall portfolio risk.

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