The World Gold Council (WGC) reports in its ‘Mid-Year Outlook 2023’ report, that gold outperformed other major assets, aside from developed market stocks, in the first half of this year and that the gold price increased by 5.4% to $1 912/oz at the end of June.

“Gold not only contributed positive returns to investor portfolios, it also helped dampen volatility throughout the first half of this year, especially during the mini-banking crisis in March”.

The WGC also states that a combination of factors contributed to gold’s performance.

This includes a relatively stable dollar and interest rates, event risk hedging and continued central bank demand.

“Both the European Central Bank (ECB) and the Bank of England (BoE) increased interest rates in June, but the US Federal Reserve kept its target rate unchanged in order to let the effects of the tightening cycle make their way through the real economy.

“US bond market participants expect an additional hike by the US Fed this year, most likely in July, followed by a sustained ‘hold’ period. And while bond markets expect the ECB and the BoE to further increase target rates, markets anticipate the end of the cycle is near, or at least it will be by the end of the year”.

The WGC adds that, as monetary policy likely transitions from tightening to on-hold, market consensus is for a mild contraction in the US this year, along with slow growth in developed markets.

Should this scenario play out, the WGC’s analysis suggests that gold will remain supported this year, particularly given its robust performance in the first half of this year.

“It, however, may not break out significantly from the range we have seen so far this year.”

The WGC finds that this gold performance is a by-product of the four key drivers that determine gold performance, including economic expansion, risk, opportunity cost and momentum.

“While slow economic growth in the West may have a negative effect on consumer spending, we anticipate that the Indian economy will hold up better and China will respond to potential economic stimulus later in the year, providing some support to local demand.

“In addition, despite signs of cooling inflation, the combination of stock market volatility and event risk (such as geopolitical or financial crisis) is likely to keep hedging strategies, including gold, in place.”

Based on market consensus expectations, the WGC states that slightly lower interest rates and a weakening dollar will help gold by reducing its opportunity cost for investors.

This is consistent with the three previous hold cycles, which have lasted between six and twelve months. During these periods, gold had an average monthly return of 0.7% – equivalent to an 8.4% yearly return – and above its long-term performance.

“As we have discussed in the past, this generally happens because gold is influenced by bond yields rather than actual policy rates, as the former include market expectations of future policy decisions and the likelihood of a subsequent recession.”

With monetary policies so tight, the WGC stresses that investors are also looking at association the Institute for Supply Management’s Purchasing Managers’ Indexes (PMIs) as signals of future weaknesses.

Further, developed market PMIs – both manufacturing and services – have been deteriorating in recent months.

“Our analysis shows that gold tends to outperform equities when manufacturing PMI is below 50 and falling. Further, if PMI falls below 45, history suggests gold’s outperformance may be even more pronounced.

And while gold has underperformed against equities if manufacturing PMI is below 50 but rising, it has still delivered positive returns, showcasing the asymmetrical benefits it tends to bring to portfolios”.

UPSIDE WITH RISKS

The WGC points out that, if the recision risk increases, gold investment could see greater upside. An economic deterioration could be driven by a significant increase in defaults following tighter credit conditions, or other unintended consequences of the high-rate environment.

Historically, such periods have resulted in higher volatility, significant stock market pullbacks and an overall appetite for high-quality, liquid assets such as gold.

“On the flipside, expectations of a soft landing – where a recession is avoided but monetary policy remains tight – could create headwinds for gold and result in disinvestment. For example, gold exchange-traded products saw sizable outflows in June and gold holdings have fallen year-to-date.

“It is worth noting, however, that given gold’s positive performance in the first half of the year, an investor unwind would need to be severe to result in the average 2023 gold price falling below $1 800/oz, its 2022 average.”

The WGC notes that, as investors assess the impact of restrictive monetary policy and the possibility of a recession, “they often dial up defensive strategies in their asset allocation”.

“For example, a common approach is to rotate part of the equity exposure into defensive sectors to limit losses during a significant market drawdown.

To illustrate this, we compare two hypothetical defensive strategies: one where 20% of the equity allocation is invested in defensive sectors, and one where 10% is invested in defensive sectors and 10% in gold.”

The WGC’s analysis shows that over the past 25 years, the strategy including gold could have improved returns, while reducing volatility and drawdown.

Should the expected mild US contraction occur, the strong first half of the year for gold is likely to give way to a more neutral second half of the year, says the WGC.

“In this scenario, gold would draw support from a weaker dollar and stable bond yields, although this would be met by downward pressure from cooling inflation. If history is a guide, monetary policy hold cycles tend to spell a higher-than-average monthly return for gold”.

The WGC also states that a more positive gold environment would result from a more pronounced economic downturn, thanks to an accompanying increase in volatility and risk-off appetite.

Conversely, gold would face challenges if tightening continues for longer than expected.

“Similarly, if a soft landing were engineered, it would favour risk-on assets and a stronger dollar, likely resulting in gold disinvestment.

“However, given the inherent uncertainty in predicting the global macroeconomic outcome, we believe that gold’s positive asymmetrical performance can be a valuable component to investors’ asset allocation toolkit,” the WGC concludes.