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WGC: Global economy at inflexion point while moving forward to year 2023

23 january 2023

The World Gold Council, in its report 'Gold Outlook 2023' presents a picture of the world's economy and gold playing cat and mouse, given the uncertain situation that might arise in the coming year...

After being hit by various shocks over the past year, the global economy is currently at an inflexion point. Where is it has to wait and see.

The initiators to fight inflation and curb the trend were the central banks as they took up all steps to aggressively fight inflation. How this will eventually figure out the 'Outlook of Year 2023 and gold's performance' depends on the interplay between central banks and inflation.

According to the Report, economic consensus calls for weaker global growth similar to a short, possibly localised recession, falling, yet elevated, inflation, and the end of rate hikes in most developed markets.

So, this environment may see both headwinds and tailwinds for gold...and the takeaways could be: A mild recession and weaker earnings have historically been gold-positive; Further weakening of the dollar as inflation recedes could provide support for gold; Geopolitical flare-ups should continue to make gold a valuable tail risk hedge; Chinese economic growth should improve next year, boosting consumer gold demand; Long-term bond yields are likely to remain high but at levels that have not hampered gold historically; Pressure on commodities due to a slowing economy is likely to provide headwinds to gold in H1; On balance, this mixed set of influences implies a stable but positive performance for gold.

Not surprising that there is an unusually high level of uncertainty surrounding consensus expectations for 2023. For instance, central banks tightening more than is necessary could result in a more severe and widespread downturn. Also, central banks abruptly reversing course and halting or reversing hikes before inflation is controlled, could leave the global economy teetering close to stagflation. Gold has historically responded positively to these environments. On the flip side, a less likely ‘soft landing’ that avoids recession could be detrimental to gold and benefit-risk assets.

Foreseeing a bumpy road ahead and with the Economic growth facing short sharp pain, the report says that there are now many signs of weakening output due to the speed and aggressiveness of hiking moves by central banks. Meanwhile, foreseeing a deepening downturn across geographies, economists are warning of a material recession.

Predicting that inflation will drop next year as further declines in commodity prices and base effects drag down energy and food inflation, the Report indicates inflation telling a consistent story of moderation bringing implications for monetary policy. The policy trade-off for nearly every central bank is now particularly challenging as the prospect of slower growth collides with elevated, albeit declining inflation.

Naturally, no central bank will want to lose its grip on inflationary expectations resulting in a strong bias towards inflation fighting overgrowth preservation. So, one can expect the monetary policy to remain tight until at least mid-year. The report says that in the US, markets expect the Fed to start cutting rates in the second half of 2023. In other markets, the policy rates may come down more slowly than in the US. But, by 2024 most major central banks are expected to be in easing mode.

WGC analysis indicates that the macroeconomic implications for gold are that gold is both a consumer good and an investible asset. As such, our analysis shows that its performance is driven by four key factors and their interactions: Firstly, the likelihood of a recession in major markets threatens to extend the poor performance of equities and corporate bonds seen in 2022. Gold does well in recessions.

Performance of gold before, during and after NBER-designated recessions indicates that gold could provide protection as it typically fares well during recessions, delivering positive returns in five out of the last seven recessions.

But a recession is not a prerequisite for gold to perform. A sharp retrenchment in growth is sufficient for gold to do well, particularly if inflation is also high or rising. While inflation may indeed come down next year, there are several important considerations that impact the gold market.

First, central bankers have inflation targets and while a lower inflation rate is necessary, it is insufficient for central bankers to withdraw their hawkish policies. Inflation needs to get to target or below for that to happen.

Secondly, WGC's analysis suggests that the retail investor segment appears to care more about inflation than institutional investors, given a lower level of access to inflation hedges (Figure 2). They also care about the level of prices. Even with zero inflation in 2023, prices will remain high and are likely to impact decision-making at the household level. Lastly, institutional investors often assess their level of inflation protection through the lens of real yields. These rose over the course of 2022 creating headwinds for gold.

WGC's report indicates that in 2023 we could see some reversal of the dynamics at play in 2022, which were high retail investment demand but weak institutional demand. Indeed, any sign of yields moving down could encourage more institutional interest in gold. On balance however, lower inflation should mean potentially diminished interest in gold from an inflation-hedging perspective.

Next year, we see a more complex dynamic driving the US dollar. First, the shoring up of energy needs in Europe will, in the immediate future, continue to reduce pressure on the euro. Second, as central banks in Europe, the UK and Japan continue to take a more hands-on approach to their respective currency and bond markets some of the pressure on domestic exchange rates could ease.

All things considered, the dollar is likely to be pressured particularly as falling inflation and slower growth take hold. If the past five years have taught us anything it is that shocks – trade war, COVID, the war in Ukraine, and so on – can appear from left field to upturn even the most considered economic forecasts.

And while macro factors form the basis for much of the impact on gold, geo-political flare-ups could lend support to gold investment, as we saw in Q1’22, as investors look to shield themselves from any further turbulence. Moreover, we attribute a large proportion of gold’s resilience in 2022 to a geopolitical risk premium, with gold’s return not fully explained by its historically important drivers.

Following a challenging 2022, one expects consumer gold demand in China to return to 2021 levels thanks to fewer COVID disruptions, a cautious economic rebound and a gradual pick-up in consumer confidence.

China’s economic growth is likely to improve next year. Signs that COVID-related restrictions are easing after the local authority optimised its zero-COVID policy in November, should improve consumer confidence and boost economic activity.

European gold bar and coin investment is likely to remain robust in 2023 as retail investors – especially in German markets – look to protect their wealth. Even a decline in inflation is unlikely to encourage lower demand, given underlying risks. Europe (and the UK) is facing a severe energy crisis, driven by a reduction in natural gas from Russia.

As gold has a stronger correlation to 10-year than shorter-term yields, we see less of a rates-driven benefit to gold in 2023. Although higher bond yields are associated with lower gold returns and might now be deemed attractive by some investors, current yield levels are historically not a hindrance to gold doing well, particularly when accounting for a weaker US dollar.

If 2023 is to bring us a mild recession, equities are headed for continued volatility. Moreover, current consensus EPS estimates seem conspicuously robust against the deteriorating macroeconomic backdrop and what earnings typically do during periods of recessions.

Despite a severely constrained supply outlook for many commodities, an economic slowdown is likely to dominate price action, at least in H1 as they get caught in the crossfire of housing and manufacturing weakness. As a result, gold could suffer due to its meaningful average correlation of 0.44 over the last 20 years.

On balance, gold’s return in the environment consensus expects in 2023 is likely to be stable but positive, as it faces competing crosswinds from its drivers. But there are plenty of signals that the economy may not follow a well-telegraphed path. With the impact of the monetary shock still rippling through the global economy, any forecasts for 2023 are subject to more uncertainty than usual.

In this scenario, inflationary pressures remain as geopolitical tensions spike. Hyper-vigilant central banks risk overtightening, given the lag of policy transmission in the economy. This results in a more severe economic fallout and stagflationary conditions, a theme we covered last year. The hit to both business confidence and profitability would lead to layoffs, driving unemployment materially higher. This would be a considerably tough scenario for equities with earnings hit hard and greater safe-haven demand for gold and the dollar.

Downside risks also exist for gold via a soft-landing scenario, where business confidence is restored and spending rebounds. Risk assets would likely benefit, and bond yields remain high – a challenging environment for gold.

Aruna Gaitonde, Editor in Chief of the Asian Bureau, Rough&Polished