While the first five months of 2016 have already been replete with unexpected developments on the financial front, one of the biggest surprises has been gold regaining its luster as an investment. As of May 11, 2016, the precious metal had advanced 20.3% for the year, compared with a meager 1% gain for the S&P 500 and a 4% increase for the Thomson Reuters CRB Commodity Index. Gold's performance was especially impressive in the first quarter of 2016, when it surged 17% for its biggest quarterly gain in three decades. Here are four reasons why gold is glittering in 2016.
- Dollar pullback: Gold has historically had an inverse relationship with the U.S. dollar - a strong USD depresses the price of gold, while a weak USD results in higher gold prices. As 2015 drew to a close, the USD was reigning supreme in forex markets, based on widespread expectations for as many four 25 basis-point rate hikes by the Federal Reserve in 2016. With major economies like Europe and Japan still on the quantitative easing path, this monetary policy divergence was expected to propel the greenback relentlessly higher in 2016. But then something unforeseen happened. Concerns about slower economic growth, which had hitherto centered on China, engulfed the U.S. as well, resulting in global equities recording their worst start to a year in January. While markets have since stabilized, these concerns have caused market participants to ratchet down their expectations for Fed rate increases in 2016, to one or perhaps two hikes of a quarter percentage point. The USD has retreated as a result, boosting prices higher for many commodities, with gold in the forefront of this advance.
- Safe haven appeal: Gold's appeal as a safe haven investment, which seemed to have been waning in recent years, came back in a big way in the first quarter of 2016. In addition to tremendous market volatility in the first six weeks of 2016, investors had to contend with a number of other developments - the terror attacks in Brussels, which occurred just a few months after the Paris attacks (for more, see "Don't hide from the reality of how terrorism affects the economy"); the mushrooming refugee crisis in Europe; geopolitical rumblings in the Middle East; a collapse in commodity and energy prices; and worries about the banking sector in Europe and the U.S. Gold was the biggest beneficiary of this upsurge in uncertainty.
- Negative interest rates: On January 29, the Bank of Japan unexpectedly set its policy rate below zero, joining a growing number of nations - about two dozen at last count - that have set negative interest rates in order to stimulate their economies. Negative interest rates help gold because the opportunity cost of holding bullion is reduced. As well, investors may prefer holding gold because at least the prospect of some gain exists, which is preferable to locking in a definite loss on a bond or instrument that has a negative yield. (See "How interest rates can go negative").
- Physical demand: The combination of the above factors has led to surging physical demand for gold. Assets in gold exchange-traded funds (ETFs) have increased 23% this year to 1,800 tons, the highest since December 2013, after three straight years of declines for gold ETF assets. As of May 4, open interest in Comex gold futures was at its highest since January 2011. The World Gold Council reported in February that gold demand in the fourth quarter of 2015 rose 4% to its highest in 10 quarters, thanks to buying by central banks and robust consumer demand.
The Bottom Line
Although the bull camp has seen its ranks swell in recent months, gold continues to be a polarizing subject. While leading hedge fund managers such as Paul Singer and Stan Druckenmiller are of the view that the precious metal has much more upside, Goldman Sachs recently lowered its price targets for gold; its 12-month target of $1,150 per ounce is 10% lower than gold's current price of $1,277. In any case, the true test of gold's resilience will come when the Federal Reserve - which in December 2015 raised the federal funds rate for the first time in a decade - finally makes its second rate hike, which some market watchers believe could potentially occur as soon as June 2016.