Strong year for gold despite post-election stress

If 2016 taught us anything it is that whatever the consensus says is going to happen in the coming year in economics, investments or politics is likely to be wrong. This year the Fed is again showing optimism towards the US economy, guiding for three rate increases in 2017. The market responded in December by selling gold and driving the US dollar higher. The Fed, however, has had a dismal forecasting record and we see no reason to believe that 2017 will be any different. At this time last year, the Fed was guiding for four rate increases in 2016, yet there was only one. Gold bullion finished the month at US$1,145.90 per ounce, down US$32.2 (2.7%) from the beginning of the month.

The Trump honeymoon with the stock market is in full bloom, as the financial media prepares to celebrate should the Dow Jones Industrial Average cross 20,000 points. The stock market is reflecting a consensus for robust economic growth and the Trump administration certainly has the potential to implement policies that promote growth. However, it seems the market is ignoring many potential risks the new administration may face. These include attempting to change trade treaties, immigration policies, the national debt and Fed tightening. Potential moves by China or Russia, disarray in the EU and strife the Middle East could also impact the administration's efforts. We believe many of these risks will surface in 2017, reversing the positive sentiment in the stock market and US dollar to gold's benefit.

Despite December's performance for gold, investors should keep in mind that 2016 remained a strong year and a major turning point for gold investments. Gold bullion gained $91 per ounce or 8.6% in 2016 for its first annual gain in four years. But gold miners stole the show, with gains of 55.08% by GDX’s Index.

There are several reasons for the spectacular performance of gold miners in 2016 including:

• A rebound from 2015 bear market levels that resulted in them being oversold as the industry fell out of favour with investors who had been avoiding the sector, driving valuations to record lows
• Gold companies impressed investors with cost controls, operating results and overall financial discipline
• Earnings leverage to the gold price

Strong performance similar to what was experienced in 2016 is common at major turning points in the gold market.

Two major market events supported Gold in 2016

There were two unrelated developments in December that the markets largely ignored which we believe could have positive implications for gold in the longer term. On December 4, Italian voters rejected a constitutional referendum that effectively became a vote of no-confidence for Prime Minister Matteo Renzi, who promptly resigned. This is the latest in a string of populist victories around the globe driven by voters frustrated with established political parties that have been unable to bring policies that generate needed jobs. Instead, post-crisis policies have brought an unprecedented coordination of regulations, monetary experiments, austerity, and debt expansion. The outcome of the referendum has empowered opposition parties in Italy who question whether the country should remain in the European Union (EU). The implementation of Brexit in 2017 poses significant risks to the European economy and the Italian referendum is further evidence of a broader movement that undermines the EU. Important elections will be held in the Netherlands (March 2017), France (April 2017), and Germany (August - October 2017). Gold could benefit if risks of an EU breakup increase.

On December 5, a second potentially favourable development for gold occurred when the Shari'ah Standard on Gold (the "Standard") was released by the Accounting and Auditing Organization for Islamic Financial Institutions. The Standard, for the first time, sets out specific rules for the use of gold as an investment in the Islamic finance industry. Until now, there have been no such rules and this has led to confusion over whether or not Islamic households are permitted to invest in gold. Those who wanted to own gold were compelled to invest only in jewelry. The Standard also rules that it is permissible to invest in gold mining stocks. This opens a significant segment of the global population that already has an affinity for gold to initiate potential investments in gold bars, coins, ETPs and stocks.

Forming the base of a long-term gold bull market in 2017

Through most of 2016 we had been very bullish on gold, believing it had embarked on a new bull market. This belief was based on fundamentals, which included unprecedented levels of peacetime sovereign debt and monetary policies which distort markets and pose systemic risks such as quantitative easing and negative rates. We continue to believe these risks will ultimately drive gold to new highs. However, the turn the markets took following the US presidential election took us entirely by surprise. The positive sentiment towards gold proved to be fickle and it appears the market will need more substantial evidence that the risks we see coming are in fact imminent.

We now describe 2016 and 2017 as a base-forming phase for gold, probably a precursor to a bull market. The bear market trend from 2011 to 2015 has been broken and 2016 showed us that investors are becoming quite skittish of systemic financial risks.

The chart below shows where gold might be in the context of similar markets of the past. Gold has a strong negative correlation with the US dollar. This is shown by the peaks and troughs on the gold chart roughly correlating with the troughs and peaks respectively on the US dollar chart. The US dollar has been in a bull market since 2011 that is now similar in magnitude to bull markets of the early eighties and late nineties. These all correspond to bear markets for gold. As the US dollar approached its peaks in 1985 and 2001, gold formed a double-bottom before embarking on new bull markets. In 1985, gold began a cyclical bull phase within a longer-term secular bear market. In 2001, gold began a historic secular bull market. It now looks like December 2015 was the first low for gold in this cycle. What remains unclear is whether the second low in a double-bottom was set in December 2016 or whether there is further weakness to come. In any case, it looks like gold is forming a base and historical analysis suggests that downside is limited.

The strong negative correlation between gold and the U.S. Dollar
Period 1973 to 2016

Source: Bloomberg. Data as of 30 December, 2016.

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