The Gold market in 2017- part II | Gold Center
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The Gold market in 2017- part II

Rising inflation expectations
Nominal interest rates are widely expected to increase in the US this year, but all the economists we spoke to forecast that inflation will rise as well. An upward inflationary trend is likely to support demand for gold for three reasons. First, gold is historically seen as an inflation hedge. Second, higher inflation will keep real interest rates low, which in turn makes gold more attractive. And third, inflation makes bonds and other fixed income assets less appealing to long-term investors. Jim O’Sullivan expects US CPI to rise by 2.6% in 2017. And “while those inflation numbers are not high by historic standards, they would signal that momentum remains upward.” He is also concerned about the tightness of the US labour market and consequent wage growth. In Asia, David Mann expects “exports prices to rise,” which may eventually make their way down to Western consumers. In all, the massive amount of stimulus that has been pumped into the global economy for years may eventually create an upward spiral of price inflation that could surprise investors.

Inflated stock market valuations
Stock markets had a significant rebound in the last stretch of 2016. And while some stock markets are just recovering from lacklustre multi-year performance, stocks in the US have reached historical highs. In many cases, valuations have been elevated, as investors increase their risk exposure in search of returns in a very low yield environment. Until now, investors have used bonds to protect their capital in the event of a stock market correction. As rates rise, this is a less viable option – and in the meantime, the risk of a correction may be increasing. The interconnectedness of global financial markets has resulted in a higher frequency and larger magnitude of systemic risks. And as Jim O’Sullivan puts it: “The [US economic] expansion will not last forever.” In such an environment, gold’s role as a portfolio diversifier and tail risk hedge is particularly relevant. 

Long-term Asian growth
Macroeconomic trends in Asia will support economic growth over the coming years and, in our view, this will drive gold demand. In Asian economies, gold demand is generally closely correlated to increasing wealth. And as Asian countries have become richer, their demand for gold has increased. The combined share of world gold demand for India and China grew from 25% in the early 1990s to more than 50% by 2016. And other markets such as Vietnam, Thailand and South Korea have vibrant gold markets too.As David Mann notes. “Asia has reduced its economic exposure to the West. […] The region has achieved relatively strong growth since the global financial crisis, despite persistently weak growth in the West. Domestic demand – from both consumers and investment – is behind this resilience, and has cushioned the region against its high degree of openness to external trade. Asia will account for approximately 60% of global growth in 2017.” While jewellery demand in China has suffered from changing consumer tastes, the investment market has undergone a remarkable period of development. In little more than 10 years its bar and coin market has become one of the world’s largest. China’s gold-backed ETFs continue to grow as well. Investors bought 30.3 tonnes of gold in 2016 through ETFs – an almost six-fold increase in assets under management. Trading volumes on the Shanghai Gold Exchange are increasing. And interest in new products continues to increase; we believe innovation should continue to support China’s gold market in years to come. In India, the government’s decision to remove large denomination rupee notes (Rs. 500 and Rs. 1,000) took around 86% of India’s circulating cash out of its economy. While the purpose is to replace them with newly printed notes, we believe that the liquidity squeeze could have a temporary negative effect on economic growth, and may also affect gold demand in the short term. But more importantly, we believe that the transition to transparency and formalisation of the economy will lead to stronger Indian growth in the longer term, thus benefitting gold. 

Opening of new markets
Gold is becoming more mainstream. Gold-backed ETFs made gold accessible to millions of investors, primarily in the West, over the past decade, but other markets continue to expand too. China has seen dramatic growth in recent years through Gold Accumulation Plans, physicallysettled gold contracts in the Shanghai Gold Exchange. In Japan, pension funds have increased their gold holdings over the past few years. In the corporate sector, more than 200 defined-benefit pension funds have invested in gold. In addition, more than 160 defined-contribution plans have added gold to their list of investments. We expect this trend to continue and expand into Western markets, where pension funds have had to rethink asset allocation strategies following prolonged exposure to low (and even negative) interest rates. In our view, this will result in structurally higher demand. Innovation is evident across all markets, but at the end of last year one development stood out. The Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI), with support from the World Gold Council, launched the Shari’ah Standard for Gold, opening up the Muslim world to gold investment. Mark Mobius of Franklin Templeton thinks that the new Shari’ah Standard on Gold will be a “game changer.” Whereas previous Shari’ah rulings were fragmented or nonexistent, the Standard provides definitive guidance on gold products, potentially allowing millions of Muslims to invest in gold. Furthermore, Islamic finance has expanded rapidly in recent years with many countries actively promoting this sector as part of their economic development and diversification policies. These factors can potentially propel gold demand across many Muslim markets from Malaysia, the UAE and Saudi Arabia, where Islamic finance is well established, to countries such as Indonesia and Pakistan, which are pushing for Islamic finance to play a greater role in their economic infrastructure. With the size of Shari’ahcompliant AUM expected to grow to US$6.5 trillion by 2020, according to the Islamic Finance Stability Board, just a 1% allocation to gold would equate to nearly US$65 billion or 1,700 tonnes in new demand.