- Gold to keep weakening as economic data remains strong while dollar pain spreads
- Accelerating inflation and high growth in the US means more rate hikes
- Significant emerging market US dollar liabilities and a broader slowdown risk a fire sale
In our last take on the outlook for gold, we wrote that the combination of slowing growth outside the United States and rising inflation meant more weakness lay in store for the precious metal. When both US growth and inflation are high, the Fed is more likely to raise rates with the aid of supportive data. In an environment where US growth is outperforming its major peers, the US dollar also tends to strengthen.
This combination of factors is particularly painful for gold. While the precious metal traded around $1,320/ounce at the time of our last commentary, gold has since weakened to around $1,290 today. We contend that gold prices will keep falling for three reasons: (1) inflation looks set to keep accelerating, (2) growth outside the United States remains weak, and (3) emerging markets look vulnerable.
Rising crude oil prices point to accelerating inflation
One way to forecast the outlook for inflation is to look at year-over-year changes in crude oil prices. Given the importance of crude oil as an input cost for a variety of goods and services, rising oil prices tend to stoke higher prices across the economy.
Beyond changes in commodity prices, looking at comparable inflation base effects is also necessary. More specifically, at this point in time last year, inflation was on a decelerating trend. As a result, upcoming inflation readings should increase. Historical rates of inflation and changes in crude oil prices are shown below:
Easing base effects + rising crude oil prices = accelerating inflation
As can be seen above, US inflation decelerated after peaking in February 2017. As historical inflation falls, future inflation readings are more likely to accelerate in the future. Beyond base effects alone, inflation is also set to accelerate thanks to significant increases in year-over-year changes in crude oil (WTI) prices. Thanks to a 50%+ increase in crude oil this year, future inflation figures are likely to rise to the 3% range.
As gold trades inversely to US dollar real yields, expect the precious metal to continue selling off. As US growth remains at elevated levels, the shock of high inflation will stoke fears of more rate hikes.
US outperforms = USD outperforms
Beyond inflation-induced monetary policy, the second risk for gold is the strengthening US dollar. The biggest driver for the buck today is the relative outperformance of US growth versus international growth. In Q1 2018, actual year-over-year US growth (2.9%) was higher than comparable figures for major developed peers such as the Eurozone (2.6%), Japan (1%), or the United Kingdom (1.2%). Beyond actual figures, the US also enjoys the best outlook for any major developed economy.
Worst to best: US has world’s best outlook (OECD composite leading indicators)
As can be seen above, the US had the worst growth outlook for any major economy over the last 18 months. This is based on the OECD’s composite leading indicator, a monthly index of forward-looking economic data. The indicator is designed to provide early signals for turns in the economic cycle, and has historically done a good job in predicting changes in future growth.
Thanks to a significant slowdown in the Eurozone, China and Japan, the United States now has the world’s best economic outlook. While the chart above shows Eurozone figures slightly ahead of comparable US numbers, a significant deterioration in Eurozone growth in the second quarter means that the United States is now in first place. This is especially the case as important US economic figures (such as changes in employment and retail sales) remain strong.
Unlike its peers who are struggling with weakening growth, the Federal Reserve has no reason to stop hiking interest rates. The dollar continues to strengthen as a result.
Pain in emerging markets only getting started
The last factor hurting gold is the darkening outlook for emerging markets. Beyond accelerating inflation and relative US outperformance, the dollar can also rise when the currency itself becomes scarce. This has to do with the currency’s role in cross-border lending.
Developing countries are particularly important to watch as emerging market borrowers are one of the largest US dollar borrowers as a group. According to the US Federal Reserve, emerging economies owe one-third of the all overseas US dollar-denominated debt ($10.7T as of Q1 2017). This is for a good reason: borrowers in developing countries have few choices for raising financing in their own countries. Instead, they tend to tap the largest and most sophisticated source: the offshore US dollar market (i.e. the Eurodollar market).
In a downturn, two factors push up the currency. Firstly, fewer new loans are issued as demand falls when the outlook for growth is deteriorating. The same reasoning also applies for lenders: fewer banks are willing to lend dollars into a slowdown. Secondly, borrowers struggling to repay their loans are forced to dump assets and their currencies instead of rolling over their liabilities. The resulting dynamic is akin to a “fire sale”, and sends the dollar soaring. An overview of year-over-year changes in cross-border US dollar loans versus the leading indicator for various emerging markets are shown below:
As the outlook weakens (OECD composite leading indicators), dollars run scarce
As can be seen above, changes in cross-border US dollar loans tends to rise and fall with the global economic cycle. Whereas the improving outlook for emerging markets in 2016 resulted in accelerating cross-border loans (in turn weakening the currency), worsening sentiment is likely to push up the dollar this year. Beyond problems in Turkey and Argentina (some of the weakest economies), we expect to see more issues to crop up in larger emerging economies such as India, Brazil as well as China.
Economic conditions means more pain ahead
In summary, all indications suggest that gold prices will keep weakening. In an environment of high US growth and accelerating inflation, the Federal Reserve will not hesitate to raise rates. Finally, an increasing scarcity of dollars, driven by problems in emerging markets, is likely to send the dollar soaring. Higher interest rates and a soaring currency is the worst possible scenario for gold, and is why we remain bearish on the precious metal.