Gold: Time to book some profits

Around two-and-a-half months ago, we advised our readers to use gold as a hedge against economic uncertainty induced by the Coronavirus (COVID-19) pandemic and raise their exposure to the yellow metal.

In the international market, gold made history and touched an all-time high on Monday. It continues to scale new highs. The yellow metal was trading at $1942 per ounce, up nearly 9 percent during July so far.

Near term pause

Gold prices are now up for nine consecutive trading days in what has been the best two-week run for the metal in recent years. On the weekly charts, gold has gained for eight consecutive weeks, its best show in the last 12 months.

After a swift rally, analysts now expect some profit booking by traders and that could lead to some price correction in the short term. This will be followed by a period of price consolidation and range bound price movement. Analysts expect consolidation to occur around at $1900 level but prices are not likely to fall below $1800 to an ounce. In India the consolidation is likely to be at around Rs 52,000 per 10 gm.

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The gold market however remains bullish from the long-term perspective. Given this, a buy-on-the-dip strategy will help investors to maximise their gains.

The global macroeconomic fundamentals continue to favour gold over competing asset classes such as equity and bonds. The COVID-19 pandemic cycle is turning out to be much longer than expected. Initially experts expected the infection curve to peter out in three to four months but now the disease is likely to stay potent for 18-24 months, somewhat similar to 1918-19 Spanish influenza pandemic.

A prolonged infection cycle means that the world’s major central banks and their governments may have to do another round of monetary and fiscal stimulus to reflate the economy. This is already happening and the process will gather pace in the coming weeks.

Fresh stimulus favours gold

A fresh round of stimulus is helping gold gain new highs.

This will provide cash support to individuals and small businesses. This is over and above $2.2 trillion approved by US Congress in March this year.

The record level of fiscal stimuli and ballooning government debt levels have, however, raised fears about a long-term run up of inflation and significant erosion of the value of fiat currencies. Deflation remains the near term risk as a dip in economic activity and demand lowers prices, causing defaults and bankruptcies.

According to a 2011 study by Oxford Economics, gold performs relatively strongly in a high inflation scenario and also does comparatively well in a deflation scenario occurring from a wave of defaults. This is because such a deflation scenario includes a sharp rise in financial stress. The study also confirmed gold status as hedge against extreme events.

Gold prices are also getting support from renewed trade and diplomatic tension between the United States and China - the world’s two largest economies and trading nations. This accentuates the uncertainty in global economy and world trade which plays into gold as a safe haven investment.

Also Read: How to get the right mix of equity, gold and fixed income in your investment portfolio

Readers should note that the latest rally in gold came on the back of a fresh round of money printing by the US Federal Reserve. The American central bank has expanded its balance sheet in the last three weeks after hitting the pause button on monetary expansion in June and early July. 

Equity valuations in bubble zone

A sharp rise in equity valuation is also working in favour of gold. Globally, equity prices are up nearly 50 percent from March lows despite continued contraction in corporate earnings due to the pandemic. This has pushed valuation in the bubble zone. In India for example, the Nifty 50 index is now trading at nearly 30 times its trailing 12-months earnings, higher than its peak valuation during the year 2000 dot-com bubble. It's the same for the US S&P 500 index which is now trading at trailing P/E multiple of around 25x.

This raises the possibility of a pull-back in stock prices if the economy and corporate recovery in the second half disappoints due to a second wave of virus infections.

Alongside, bond yields continue to remain low, pushing down returns on fixed income assets and most analysts expect the low rate environment to continue for at least a few more years. This could force many institutional investors to replace government bonds with gold in their long-only funds.

To conclude, a rally in gold will resume after a pause and consolidation. The first target is around $2000 for an ounce and around $2200 by the end of the current financial year. So it is a good idea to stay invested to gold and follow a buy-on-the-dip strategy.

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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