Has gold entered its next bull-run?

We have held a friendly, yet conservative view on gold for some time. A few years and several false starts later, we think the macro backdrop has now started moving more convincingly in gold’s favour. We raise our base forecasts across the board to reflect our latest views and lift our short-term target (3-months) to $1430 from $1380 previously. That said, it is only the early stages and it unlikely to be a straight path these are changing, and what the risks are. Why now?

We think the sustained decline in rates is a key factor, particularly as the Fed shifts to amore dovish stance. Uncertainty around growth and trade risks suggests more strategic positions are likely to be built. Broader positioning remains relatively lean, so there is room for investor told exposure to grow. The opportunity cost of holding a gold position is declining while the case for diversification and having a safe haven is increasing.

The dollar presents risks…It matters how the dollar will react to Fed policy relative to the rest of the world and lingering global uncertainty around growth and trade risks. The dollar’s decline following the dovish shift in the Fed’s tone was a key factor in gold’s rally, helping it push through levels where it previously met stiff resistance. When considering gold’s path from here, we cannot ignore the dollar but falling real rates and lingering uncertainty should underpin gold Gold has the potential to withstand and perform well even if the dollar holds up; we think declining real rates will underpin gold this time around. Our model shows that the influence of the dollar has declined vs last year and has been overtaken by that of rates. Lingering uncertainty about growth and the fluid nature of trade negotiations also suggest that gold has the potential to be resilient, especially given broader investor positioning remains lean. The potential for further escalation in trade tariffs holds upside risks for gold given the likely drag on growth and the expected policy response among major central banks. Our gold fair value model shows that gold can trade a premium for some time, likely because of its safe haven properties and fundamental demand drivers keeping the market well supported

‘The times they are a-changin’

Has gold entered the next bull-run? We think it has. We raise our base forecasts across the board to reflect our latest views (Figure 1) and lift our short-term target (3-months) to $1430 from $1380 previously. That said, it is only the early stages and it is unlikely to be a straight path higher. In this note we discuss the signposts that we have been watching out for, how these are changing, and what the risks are Old base case New base case New vs Old % change

Upside Downside

Gold 2019E 1325 1370 3% 1425 1280

2020E 1350 1450 7% 1580 1280

2021E 1375 1500 9% 1630 1300

2022E 1400 1500 7% 1635 1300

2023E 1425 1500 5% 1635 1300

Source: UBS forecasts

What’s different this time?

We have held a friendly, yet conservative view on gold for some time. A few years and several false starts later, we think the macro backdrop has now started moving more convincingly in gold’s favour. Our analysis of the gold market has been anchored on the view that real rates and the dollar are the key price drivers. Policy easing, declining real rates and dollar weakness are therefore important ingredients in a gold bullish scenario. A dovish shift in policy at the Fed, and among global central banks more generally is positive for gold. Low to negative yields among over half of developed market bonds and the potential for further declines make it increasingly attractive for investors to hold gold as part of a diversified portfolio. The rationale for holding gold as a safe haven and hedge in reinforced further when taking into account the current backdrop of slowing global growth and downside risks posed by global trade tensions and geopolitical threats.

The immediate question that most market participants asked as soon as gold started climbing above $1300 in early June was ‘what’s different this time?’. Gold has had several failed attempts to break the topside of the range the past few years, so the scepticism from investors was understandable. So, why now? We think the sustained decline in rates is a key factor, particularly as the Fed shifts to a more dovish stance. US 10y nominal yields hovered around 2.9% on average in 2018 and it was only towards the end of the year that yields started to fall more sustainably.

US 10y TIPs rose for most of 2018, reaching the highest levels since2011 in November before starting to retreat. Gold was therefore expensive the hold. Low to negative real yields and the potential for yields to fall even further starts to change this narrative for gold especially given an increasingly uncertain macro backdrop. Looking at the outstanding amount of developed market bonds shows that over half yield less than 1%; over a third have negative yields (Figure2). The opportunity cost of holding a gold position is declining while the case for diversification and having a safe haven is increasing. The macro backdrop is shifting in gold’s favourThe cost of holding gold is falling, while the case for diversification is rising.

A dovish Fed is positive, but the type of easing is important Recent dovishness from the Fed and an anticipated rate cut is positive for gold.Previous easing cycles over the past three decades shows that gold gained in four out of the five periods when the Fed was cutting rates (Figure 3). Gold gained as much as 165% from the start of the last easing cycle in 2007 to the all-time high reached in 2011, when quantitative easing augmented Fed rate cuts. It is therefore worth considering not only whether the Fed will follow through with cutting rates as expected, but also what type of easing is going to be delivered. Is it an insurance/pre-emptive cut or is it the beginning of an easing cycle, with potential for a fresh round of QE once the zero lower bound is reached? This matters for how we would anticipate gold’s reaction over the medium to long term. We think both cases would lift gold prices, but a full easing cycle would be more positive not least because this would likely be triggered by deteriorating growth data.

Gold has gained in 4 out of 5 Fed easing cycles over the past 3 decades Global Precious Metals Comment 24 June 2019 Source: Bloomberg, UBS Source: Bloomberg, UBS

Near-term caution vs long-term resilience

We made some tweaks to our gold fair value model and have come up with a simpler version that ties in more closely with a large part of how we analyse the gold market. We took out credit spreads as one of the inputs, now focusing simply on the dollar, US real rates and an average of European and Japanese yields. Gold’s correlations with various factors are not constant and at times can be counterintuitive. After trying many different combinations of inputs, we find that this version of the model is currently the most useful as a starting point for analysing the market.

Our model estimates that gold is currently trading around 3% above fair value. Moreover, it shows that of the 8% price rally over the past four weeks, market factors we identify only explain about half of that move. This could suggest that some caution is warranted here, especially considering the extent of the build in short-term positioning and the potential for positive developments at the upcoming G20 meeting to trigger some unwinding.

Refining and reintroducing our gold fair value model Gold is currently trading at a 3% premium to fair value…

Global Precious Metals Comment 24 June 2

However, we have also argued in the past that gold does have the ability to trade above estimated fair values for extended periods given its safe haven properties and fundamental demand drivers that can keep prices well supported. Gold has been attracting strategic investor flows that tend to be more resilient. Gold ETFs are up nearly 2moz this month, bringing the net change YTD to 1.35moz after inflows earlier in the year were fully reversed throughout February and May. Interestingly, the bulk of the inflows both in June and for the year thus far have come from UK-based gold ETFs, the rest from ETFs based in Europe. These flows have been more resilient than those into US-based gold ETFs. We think this reflects more strategic gold positions amid uncertainty (Brexit, soft data in Europe) and low to negative rates.

Physical demand is lacklustre so far this year, but we think that it is overall in line with historical average levels and should be sufficient to underpin the market. Chinese demand is weighed by softer jewellery demand as consumers become more conservative about purchases. However there is scope for investment demand to act as an offset, particularly given uncertainty around trade tensions with the US and potential impact on the currency and the economy. There are upside risks here, too, should gold’s rally extend, as retail investors in China are likely to buy into momentum. Indian demand has been stronger than expected so far this year, underpinned by core drivers such as wedding-related demand. The number of auspicious wedding dates this year is the highest since 2011.

Central bank gold buying has also been an important source of support for the market since last year. The increase in official sector gold holdings boosts the market on two fronts: 1) the volume of purchases picked up significantly last year and continues at a good pace so far in 2019, and 2) diversification away from the dollar as a driver for the purchases has positive implications on investor sentiment towards gold. Official sector gold activity tends official sector gold buying does matter because these tend to be long-term strategies and positions are unlikely to be reversed anytime soon. The significant increase in purchases last year (652 tonnes) did catch market attention. And, perhaps more importantly, investors took note of the emergence of buyers that have been inactive for some time and their decision to add to their official gold holdings now.

but safe-haven and fundamental demand could keep prices well supported for prolonged periods. Physical gold demand is likely to be average, but this is enough to support the marketCentral bank purchases help underpin the market Global Precious Metals Comment 24 June 20

Source: Bloomberg, various ETFs, UBS Source: Bloomberg, various ETFs, UBS

Global Precious Metals Comment 24 June 201

The dollar matters, but not to the same extent as last year

Another factor to consider is the dollar. It matters how the dollar will react to Fed policy relative to the rest of the world and lingering global uncertainty around growth and trade risks. We think the dollar’s decline following the dovish shift in the Fed’s tone was a key factor in gold’s rally, helping it push through levels where it previously met stiff resistance. Gold’s lacklustre performance for most of 2018, despite ongoing trade tensions, was largely because of the dollar’s strength. So when considering gold’s path from here, we therefore cannot ignore the dollar. Gold’s performance over the past three decades reminds us that dollar strength remains a risk: gold’s multi-year bull-run from the early 2000s did coincide with a weakening dollar.

Does this mean that gold is bound to suffer a similar fate as last year when the dollar was holding it back? We do not think this would necessarily be the case – gold has the potential to withstand and perform well even if the dollar holds up. We think declining real rates will underpin gold this time around. Lingering uncertainty about growth and the fluid nature of trade negotiations also suggest that gold can continue on its journey higher, especially given broader investor positioning remains lean. Our gold model, which estimates the contribution of various factors on gold’s price action, shows that the dollar’s influence has declined considerably compared to last year. In contrast, the contribution from real rates has rebounded from the lows, overtaking the dollar.

Source: Bloomberg, UBS Source: UBS estimates

Upside risks if trade risks escalate

UBS economists maintain the base case for no escalation in US tariffs. However, in a scenario where this is not averted, they expect global growth to be 75bp lower and for major central banks to ease policy. In this case, the Fed is expected to cut another 100bp in addition to the 50bp cut already expected in July. An even broader escalation such as a Mexico tariff shock is expected to push the Fed to the zero lower bound and trigger asset purchases to restart. Escalation in trade risks would result in higher gold prices, in our view, amid rising risks of recession and the anticipated policy response from major central banks.

COPPER USD Spreads 5Y TIPS

The dollar presents risks……but we think gold is likely to be resilient this time

Global Precious Metals Comment 24 June 2019

Source: UBS, Haver, Bloomberg

Valuation Method and Risk Statement

Risks of multi-asset investing include but are not limited to market risk, credit risk, interest rate risk, and foreign exchange risk. Correlations of returns among different asset classes may deviate from historical patterns. Geopolitical events and policy shocks pose risks that can reduce asset returns. Valuations may be adversely affected during times of high market volatility, thin liquidity, and economic dislocation.

Global Precious Metals Comment 24 June 2

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Global Precious Metals Comment 24 June 2019