Assessing the current situation in the gold market

Over the past week, gold prices have been gradually declining at remarkably low volumes. Struggling to firm with the U.S market on Labor Day, gold settled at $1,116.20 an ounce in the European trading session on Monday, dropping to its lowest level since August 19. Investor frustration was fairly justified by the Fed’s long-awaited interest rate decision following the U.S. jobs report on Friday. As the U.S. unemployment rate 5.1% hit a seven-year low (5.3% in August 2008), the Fed is expected to hike interest rates to leverage volatility in the financial markets. Although such a decision might be complicated due to China’s destabilized stock market and low inflation that both fuel investor uncertainty, if the Fed pulls the trigger on an interest rate hike, the environment for the precious metals will become gloomy. The chart below shows that before the release of the U.S jobs report, the gold prices were declining.

Gold Market Rally Spells “Bullish”, Yet on What?
Generally, there is a bullish outlook when it comes to investing in gold. Experts suggest a positive correlation between economic recovery and the price of gold, however, the effects of the Fed’s Quantitative Easing program in 2014 were nothing but negative on the precious metals. In fact, the gold price declined by almost 2.5% as soon as the QE program was announced, then lost another 3% during the session, and stabilized near the end of the QE program. At the same time, considering the negative impact on the gold price as a result of the Fed’s talks regarding an interest rate hike, it becomes evident that being bullish on the gold market is a non-fundamental dynamic, but rather the beginning of a new economic cycle. Investor expectations are bullish on the gold prices, but the market fundamentals cannot sustain such optimism at the moment. The gold market rally in August, as shown in the chart below, indicates that the average gold investor, lacking a high level of sophistication, has increased his exposure to the gold market without taking into account the underlying market trends.
 

Concerns Raised About the Global Economy
In the global race for economic growth, the U.S. has demonstrated a slow rate (comparison in the chart is to the EU as it includes many different economies). According to the IMF, in the recent G20 meeting, the Yuan devaluation and the subsequent destabilization of the Chinese economy may pose a threat to the U.S. already restrained outlook. China’s slower growth has already affected commodity prices and there are growing concerns about other emerging market currencies as well. IMF forecasts a U.S GDP growth of 2.5% (2.4% in 2014), an EU GDP growth of 1.5% (0.8% in 2014) and a China GDP growth of 6.8% (7.4% in 2014).
 

The current situation in the global economy is also expected to have an impact on major exporters, including the U.S, Brazil and Russia. The rising dollar relative to the emerging markets currencies will make U.S exports more expensive to foreign buyers. At the meeting of the Federal Open Market Committee, there were concerns raised about the divergent U.S monetary policy could put further pressure on commodity prices, and consequently it may extend the weakness in exports.
 

Is it a good time to invest in gold?
Declining investor confidence and increased uncertainty regarding the stock and the bond market usually leads to higher demand for gold assets as a way to protect investor capital from further declining. However, considering the broader market trends, in an environment with low interest rates and prolonged low inflation, it is highly unlikely that sophisticated investors will trust gold as a hedging strategy against equity risk. Furthermore, invest in gold adds no income, has no contribution to portfolio performance and has a high opportunity cost compared to other assets.
What to Expect in The Future?
In times of financial crisis, further than historical data and expected returns, investors should also consider the broader economic environment and the forces that drive a market up or down. Given that cyclical assets, like the equities, typically underperform during periods of nervousness and weakening investor sentiment, gold is likely to outperform. On the other hand, as shown in the chart below, there is an inverse relationship between gold and interest rates because gold offers no investment return. Also, higher interest rates enhance the value of the U.S dollar, which moves in the opposite direction of the gold prices.
 

Taking these factors into account and given that conventional wisdom apparently underestimates the current market risk, gold is expected to face headwinds going forward. Gold’s safe investment perception has changed as an increasing number of frustrated investors ignores the underlying market trends, low inflation and the Fed’s and IMF’s warnings. As a result, invest in gold becomes less profitable in times of risk taking.