Looking under the hood of the market in precious metals

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2019 marked a year of strong growth for gold prices and precious metals. After the change in monetary policy by the end of 2018 and a return to a  more accommodating attitude by central banks, precious metals entered a new phase. Gold thus ended the year with a 15% performance increase, silver grew by more than 11% and platinum exceeded performance of 21%. As far as palladium is concerned, it has had yet another extraordinary year, with growth of more than 60%.

After a year like this, it is worth looking at whether there is still more growth potential for precious metals in 2020.

Gold and silver

Once again, the fate of precious metals was largely linked to monetary policy decisions by the major central banks. Let's not forget the strong link between the level of real interest rates and the price of gold. The yellow metal has no intrinsic return, unlike stocks (dividends) and bonds (coupons), so gold only finds favour with investors when bond yields fall.

Comparative evolution of the gold price and the level of US real interest rates (below)

Also, in the wake of the change in rhetoric from the US Fed, which became more accommodating in late 2018, as well as the deteriorating economic situation, gold and silver have had a good start in 2019. But after the rate cut by the institution last March, and its suggestion that the decline would be isolated, many investors were prompted to take profits.

The difficult nature of the China-US trade discussions, have led to fears of a worsening economic situation in the second quarter. This helped increase gold and silver prices.

The Fed's much more obliging stance in the third quarter has allowed this upward trend to continue. But reaching a compromise in the trade war between the US and China, even at the most basic level, then led to a rise in real interest that bore down on precious metals. The improvement of other economic indicators also impacted the price of gold and silver.

At the very end of the year, anxiety about the 2020 growth potential and expectations of a tightening of the growth gap between the United States and Europe - which could have a negative impact on the dollar - also drove precious metal prices higher.

Today, the Fed's narrative makes it very difficult to return to a policy of monetary tightening. The level of US government debt in particular, but companies as well, would make any lasting and/or substantial recovery unsustainable for the public purse. Let's remember that the United States currently has a public debt of 105% of its GDP, and will be close to 140% by 2027 according to the Congressional Budget Office. Also, in our opinion, there is little risk of a large correction in the price of gold, which means an asymmetric investment.

There are also important supporting factors. First, gold mine production. Despite reaching a new record in 2019, the lack of major new deposit discoveries over the last 20 years, has led the largest mining groups to question their ability to maintain these production levels on a sustainable basis. It seems to be generally accepted that we are currently in "peak gold", the maximum production level of the barbarian relic, that will never be reached again.

Citi recently estimated that the 26 largest gold mining companies, which combined represent 38% of world production, could see their production drop by 47% by... 2027. Overall, we estimate that gold production could decline by a quarter over this period.

Another important factor is the return of central banks buying. For years, after the end of the Bretton Woods Agreements in 1971 - which freed up the link between gold and money creation - central banks in developed countries have, on the whim of their governments' troubles, sold some of their gold stocks. The sharp rise in the price of the yellow metal between 2000 and 2011 has put an end to this trend. The last major banks to have sold gold - Bank of England and Banque de France in the early 2000s - were roundly criticised for doing this.

Meanwhile, the globalisation of our economies has led to the creation of gigantic trade surpluses in emerging countries, which have gradually become the world's factory. It was then necessary for the banks in these countries to invest their reserves. After investing in their debtors' government bonds and faced with the extent of their debts, the central banks looked for diversification tools.

We have thus seen orders from the central banks, rise from offers of 500 or 600 tonnes a year, to a demand of more than 600 tons per year. This movement, however, does lead to a variation of close to 1,200 tonnes per year in a market of 4,500 tonnes.

And this movement is still going strong. After reaching a record of more than 651 tonnes in 2018, buying continued in 2019, with 550 tonnes at the end of the third quarter of 2019. In addition, when we interview these organizations, none of them are considering reducing their purchases of yellow metal, and more than half of them say they want to increase their precious metal allocations.

Outlook

As identified by constrained mining production and demands from central banks that are not being met, gold should continue to benefit from very low real interest rates. Finding profitable, safe and capital-efficient investments is becoming increasingly difficult.

It seems likely to us therefore, that in the coming months there will be an increase in the demand for US bonds - whose yield remains around 2% with, what's more, a fairly stable currency. If this were the case, US real interest rates could start to trend towards zero, like the rates in the other two major economic zones, Europe and Japan.

Given the link between real interest rates and the price of this precious metal, it could, in such circumstances, return to its historical highs of $1,900 per ounce, even slightly exceed it over the next 18 to 24 months.

Silver, which is still highly correlated with gold but more volatile, could see a slightly higher increase and get back to $23 an ounce.

Palladium

The metal ended 2019 with an increase of more than 60%, and new all-time highs. Even with a sharp slowdown in the global automotive market in 2019, palladium prices have not eased. They could therefore continue to rise.

Platinum

Despite a lackluster automotive market, platinum ended 2019 with a gain of more than 21%. This is primarily due to the decision of producers to streamline production. In 2020, demand for platinum could stabilise or even increase slightly due to stricter environmental standards.

Conclusion

In what is still a very uncertain economic environment, and as major economies remain heavily in debt, it is difficult for central banks to consider monetary tightening without seeing a return of inflation. A rise in real interest rates would quickly become unsustainable for public finances in countries such as the United States, with debt ratios of more than 100% of GDP. Real rates are therefore expected to remain low for a long time, which can only be an advantage for precious metal prices.

Beyond that, the specific circumstances of metals such as palladium, could lead to exceptional price rises again this year.

 

Benjamin Louvet is a commodities fund manager at OFI AM

Further views on how fund providers and fund buyers are positioning themselves in respect of gold and other traditional hedges against uncertainty in markets, and increased volatility and other risks, can be found in the February edition of the InvestmentEurope magazine.

 

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