Gold Reacts to Dwindling Reflation Trade

Weak US dollar, economic and political stability support gold price recovery

The gold price changed very little in May, recovering towards the end of the month after early weakness brought on by the French presidential election and the FOMC (Federal Open Market Committee) meeting. From the first round of the French elections on 23 April to the final round on 7 May, markets became increasingly convinced that the pro-EU candidate Emmanuel Macron would win the election. This led to an easing in the gold price as the risk of a Marine Le Pen-led Eurozone break-up lessened. On 3 May, comments by the Federal Reserve following its May FOMC meeting convinced the market that a rate increase following the 13 June meeting would be likely. Gold hit its low for the month on 9 May at US$1,214 per ounce, but recovered to end the month at US$1,268.94 per ounce. Weakness in the US dollar also added support for gold during the month. The US Dollar Index (DXY) fell 2.1% in May and appears to have entered a bearish downtrend since reaching multi-year highs in early January. Economies in Europe and Japan have stabilised recently and the Trump administration has indicated a desire for a weaker U.S. dollar. Gold should benefit if the US dollar trend seen so far in 2017 continues.

The NYSE Arca Gold Miners Index (GDX Index) gained 2.34% in May.

Asian demand for physical gold strong in 2017

Physical gold demand from India and China has also been supportive of gold prices. We believe healthy demand in March and April suggests that 2017 is shaping up to be a much better year for gold in Asia. Last year's liquidity squeeze caused by the currency transformation in India seems to have dissipated and people are again making gold purchases. In China, bond market turbulence associated with government efforts to rein in debt and speculation have spurred investment demand for gold.

US equity market valuations 

Following the November presidential election the "reflation" or "Trump" trade took the markets by storm. Presumably, the belief was that pro-growth policies would ignit markets that would stimulate business and prosperity. As President Trump has struggled to implement policies and his administration has been dogged by controversy, the Trump trade has unwound. Metals such as copper and iron-ore have given up much, if not all, of their post-election price gains. Gold has rebounded from its post-election losses. Interest rates have subsided and the DXY has fallen to pre-election levels. The one asset class that appears to still believe in the reflation trade is US equities. As we write, the S&P 500 Index has reached new, all-time highs. In the past year, the likes of Apple and Tesla have posted gains of more than 50%. Below is a chart of NYSE margin debt.

NYSE Margin Debt Continues to Grow, Reaches Record High in April

Source: Bloomberg. Not intended to be a forecast of future events, a guarantee of future results or investment advice. Current market conditions may not continue.

Notice the peaks at the tops of the tech (2000) and housing bubbles (2007) compared with current levels. Each of these bubbles was accompanied by strong 3% to 4% economic growth and each was preceded by a Fed tightening cycle. While the current stock market does not have the same feeling of mania seen before the tech bust, in the context of an economy that struggles to achieve 2% growth, some analysts are struggling to justify current stock market valuations – and the Fed is tightening. At the other end of the spectrum are gold stocks, fresh off of the worst bear market in their history from 2011 to 2015. Compared to the price of bullion gold stock valuations remain well below long term averages.

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