Currencies, Commodities, and the Global Economy
Since the market trough in March, gold, stocks and bonds have all been moving in the same direction: up. As a group, between April and July they had their strongest simultaneous rally over a four-month period.1 This rally reflects the breadth of the market recovery and the cheap money that’s fueled it. Loose monetary policy globally has increased demand for gold – pushing it to its highest prices on record. However, the rally in commodities has been more broad-based – it is even reflected in commodities such as copper that are typically viewed as leading indicators of economic activity.
Numerous factors have been supportive for commodity markets YTD including low real yields, dollar weakness as well as supply constraints. We see multiple factors that could contribute to a weaker USD in the second half of 2020 – potentially adding further fuel to the commodity market. Any concerns about the dollar, and gold always seems to glimmer. Gold is typically included into portfolios for its counter-cyclical nature that helps provide diversification. This commodity and precious metals in general, seem well positioned within the current environment – benefiting from the combination of economic uncertainty and ample liquidity.
Dollar Slide Changes Performance Dynamics
The USD is at its weakest level in more than two-years. Looking back over the last few years, there have been several unique trends that drove the value of the currency. The synchronized global growth story of 2017 improving global growth expectations and contributed to dollar weakness. But the USD’s downward trajectory came to an abrupt halt at the start of the U.S. – China trade dispute. Q2 2018 marked the start of a period of USD strength. A little less than two years later, the COVID-19 crisis hit. Initially, USD spiked, but a sharp decline followed. Since its peak in mid-March, the value of the USD has declined around 9.5%.2
The current dollar decline is unique because it corresponds with a period of global economic uncertainty. The USD has historically enjoyed the privilege of being considered a safe haven. Typically, on days when the market sells off by a significant amount, the safe haven trade increases the value of the USD. However, 2020 appears to be different. The big question is whether this is a different type of fear trade or has the lack of coordinated response within the U.S. adversely impacted on future growth expectations?
This year, the only evidence of this historical relationship occurred briefly during the March selloff when there was an extended period of large market moves combined with high volatility. This could relate to the market knowing the Federal Reserve (Fed) is standing by, and thus encouraging a risk on environment despite the economic challenges. Alternatively, it could be all the additional liquidity pumped into the market raising concerns about the USD – especially due to this corresponding with a lack of coordinated federal response to COVID. This lack of coordination has potentially resulted in the U.S. having a more protracted COVID-crisis than most of the developed world – thus leaving the U.S. at a potential disadvantage as the rest of the developed world manages through the economic challenges of COVID-19.
This is juxtaposed with the coordination and progress that is starting to be seen in Europe. After a decade of fiscal austerity, Europe is potentially moving into a new era. Their historic €1.8 trillion spending package that includes grants as well as the inaugural issuance of joint debt, or Eurobonds, has increased integration within Europe while also reducing the risk of the Euro fragmenting.3 On the back of this, the Euro strengthened significantly – it is currently at its strongest level relative to the USD in more than two-years.
Improving growth prospects for Europe and other developed countries relative to the U.S. is likely to put downward pressure on the USD, especially if the Euro’s role as a reserve currency and its potential as a safe haven expands at the expense of the U.S. dollar. These are factors that could weigh on the USD during the remainder of the year – which would be supportive to commodities. This is especially true for precious metals. The value of these metals has increased significantly YTD as USD liquidity soared.
Precious Metals Having a Strong Year
As mentioned earlier, gold, stocks and bonds have all been moving in the same direction. While equities and bonds have rallied on the support provided by the Fed and Congress, there were numerous factors that contributed to the recent strength in commodities. This included historically low interest rate, negative real yields, the declining USD, inflation and store of value concerns as well as supply chain constraints.
While some of these factors were beneficial across most commodities, others were especially beneficial to precious metals. The chart below provides an indication of the composition of the commodity market as well as the segments that have performed the best year-to-date. Historically, energy is the largest component of the Bloomberg Commodity Index; however, with the sharp decline in energy prices and increase in both gold and silver prices, precious metals are currently the largest component.
Weaker USD and Low Interest Rates Beneficial to All
Commodities are global in their nature, and while they are typically priced in USD, they are produced, traded and utilized all over the world. Consequently, as the dollar weakens, the price of commodities becomes more affordable globally. As discussed earlier, we are currently experiencing USD weakness and there is potential that this weakness persists during the second half of the year. Should this be the case, the weaker dollar is likely to have a positive impact on the global demand for commodities.
Low interest rates are beneficial across most commodities. The inverse relationship historically witnessed between commodities and interest rates is predominantly due to the cost of holding inventory. Within a low interest-rate environment, the opportunity cost of financing stockpiles of commodities is lower. However, as interest rates rise, the cost of carry becomes more onerous and thus commodity prices tend to decline. With interest rates effectively at 0%, there is minimal cost to holding an investment that does not provide any income while needing to have storage paid for.
Gold’s Safe-Haven Status Secure
Certain commodities, such as gold, typically perform well during challenging economic conditions. Conversely, within these condition economic-growth-oriented commodities, such as copper or crude oil, typically face headwinds. Gold has historically been the best example of a safe haven commodity. This is due to gold being viewed as a safe store of value that can maintain its purchasing power.
There are two elements to this safe haven status. First, gold is typically counter-cyclical. As a result, gold is a portfolio diversifier. Within the current low interest rate environment, including gold increases the defensive positioning of a portfolio without necessarily increasing the allocation to cash. This is due to its counter-cyclical nature resulting in gold typically doing well during periods of economic concern when market risks rise. Therefore, gold’s simultaneous surge with the stock market is not the norm. The recent fiscal and monetary policies helped increase the demand for risk assets while pumping large amounts of liquidity into the financial system.
This brings us to the second element of gold’s status as a safe haven – potential inflation protection. Historically, real rates are the most significant driver of gold prices. The chart below reflects the inverse relationship that gold typically has with real yields. Since the Global Financial Crisis, nominal yields have driven most of the decline in real yields. However, with nominal yields effectively at 0%, higher inflation would be needed for real yields to deteriorate further into negative territory.4
Inflation concerns are evident today with record amounts of stimulus being provided globally and the Fed effectively backstopping the government. But for gold, one inherent benefit is that the Fed cannot print it. While on the surface, inflation concerns are understandable, we do not currently believe that there is a high level of inflation risk. This is due to weak consumer demand, particularly for discretionary services, reducing the velocity of money. Increased saving has reduced the rate that money changes hands. Consequently, the increase in money supply has had a far smaller impact on price levels. Rather than driving inflation, it has prevented the start of a deflationary environment.
Supply Disruptions Provide Silver Lining
Industrial metals typically have an inverse relationship with precious metals. Gold’s counter-cyclical features differ from a metal like copper, which is typically viewed as a leading economic indicator associated with the strength of the business cycle. Historically, copper has had a positive relationship with U.S. policy rates. While most commodities benefit from declining yields, copper is a potential exception. This is due to the Fed’s rate decisions providing an indication of the economy’s positioning in the business cycle. Consequently, rising interest rates reflect a strengthening economy – which is positive for the demand of industrial commodities such as copper.5 As such, it is unusual to see a simultaneous rally in gold and copper.
Global stimulus measures have been a driver for industrial metals, but not the biggest driver, in our view. Supported by fiscal stimulus, Chinese demand for copper has increased 20% year over year in recent months. Add to this the fiscal support in Europe and the potential for more support in the U.S., and there is the potential for increased copper demand. Despite these glimmers of hope, global consumption of copper is expected to decline more than 5% during 2020 before returning to growth in 2021.6
We see supply constraints as a bigger factor in copper’s rally. Chile is the largest producer of copper, accounting for in excess of 25% of global supply. COVID-19 has affected thousands of mineworkers and led mining companies to postpone non-essential activities, reducing output. COVID-19 also dented copper mining activity in Peru, the world’s second-largest producer. Some analysts have warned that the market could move into a supply deficit this year due to the production slowdown.7
The story is similar for silver. COVID-19’s spread throughout Latin America has reduced mining production. Silver is used for both industrial and investment purposes. Starting with the investment purposes, precious coins are viewed as a store of wealth. The U.S. Mint produces precious coins out of silver, gold, platinum and palladium. Currently the supply of these coins is restricted due to the pandemic affecting their production. Reduced supply corresponding with elevated demand for precious coins has resulted in these coins trading at a premium to the spot price of their included metal.8
Silver is also an important component in electronics, including renewable energy and electric vehicles. Photovoltaics, a key ingredient in solar panels, comprise around 20% of the current industrial demand for silver. These are potential growth areas for silver, especially if Joe Biden wins the presidency. The presumptive Democratic nominee wants to implement more environmentally-friendly policies that help create a net-zero carbon economy by 2050. In line with this, the demand outlook for silver is reasonably promising while supply is a constraint.
Its not every day that gold, copper, stocks and bonds head in the same direction for a sustained period. But then again, nothing about the COVID-era has been ordinary. The scale of monetary and fiscal policy required to plug the holes in the economy has potentially reduced the demand for dollars; especially relative to other potential stores of value, such as gold. From a portfolio management perspective, gold can provide a hedge against economic uncertainty. While global economic indicators are improving, there is still a long and uncertain road to recovery. This economic uncertainty has driven up demand for precious metals, both gold and silver, at a time when supply is more constrained due to the health crisis. While several factors contributed to the rally in commodities, and especially precious metals, we believe dollar weakness could provide a tailwind for the rest of 2020.