British voters stunned the world with their June 23 decision to leave the European Union. Shockwaves quickly rippled through markets worldwide, clipping $2 trillion from global share markets on the first day of post-Brexit trading. While global equity markets have since zigzagged from strength to weakness, the momentum of safe-haven assets, like gold, which soared to a 27-month high following the referendum result, and U.S. Treasuries, continues to surge.
The political and economic situation is still extremely fragile in the U.K., particularly amid ongoing government shuffling. Overall stability in Europe will undoubtedly fluctuate as Brexit negotiations commence in the coming months, and other national elections draw nearer. The depth of these concerns helps to explain the performance of "insurance" assets.
The historical portfolio diversification or insurance qualities of gold appeal to investors in highly volatile environments, hence gold's post-Brexit rally. Hard landing fears in China and weaker U.S. data are good examples of prior events triggering investor flight to safety -- which is often to gold. Traditional thinking states that when stocks soar on expectations of stronger economic growth, the gold price plunges; correspondingly, when markets crash on slumping growth, gold skyrockets.
Gold's post-Brexit rally is, for the most part, easy to explain: It is a proxy for greater uncertainty. But can gold maintain its recent popularity, even if current fears are unfounded and clarity returns over the next few months?
Where the gold price goes from here will depend on several factors, the prevailing one being the U.S. Federal Reserve's perception of global economic conditions. Although the Fed's looming interest rate hike does not trump Europe's economic throes in terms of importance, it is the one variable that could derail the surging gold price. Gold prices typically move in tandem with Fed policy, since a tightening signals its confidence in the US economy and vice versa.
Back in early June, when betting platforms and polls were mostly foreseeing a "remain" outcome in the U.K., Fed Chair Janet Yellen expressed caution about "considerable and unavoidable uncertainties" facing the U.S. economy. She was referring to sluggish global growth, weak business investment, low U.S. productivity growth, and uncertainty about the outlook for inflation. Fast forward to June 24, in the immediate aftermath of Britain's Brexit vote, and the uncertainty has certainly intensified. For example, the rush of cash flows into safer assets has driven up the value of the U.S. dollar, thereby undermining Yellen's 2% inflation forecast -- a key condition to hike rates.
At the next Federal Open Market Committee, Fed spokespersons are expected to reiterate their confidence in a continued U.S. economic recovery, but also state their need for more time to assess the evolving economic and financial market consequences from Brexit before making further adjustments to the federal funds rate. The Fed will most likely push back that interest rate increase to December, leaving U.S. real rates -- interest rates adjusted for inflation -- more negative in the next six months.
Gold prices tend to surge when U.S. real rates are falling and negative, as they are now -- but the opposite happens when these rates start to rise. With the Fed on hold and inflation rising, however slowly, real rates will continue to fall deeper into negative territory, making gold an increasingly appealing investment option. Thus, in the short term, the gold price will continue to be supported by dovish tones from the Fed.
Additional forces that determine gold's future will be the stimulus efforts of the Bank of England and European Central Bank to cushion Brexit's impact on real activity.
Additional liquidity at the ready
Both central banks are primed and ready to support their respective economies and stabilize markets if the economic contagion becomes too unwieldy. The BOE has already made 250 million pounds in liquidity available to combat the Brexit conflagration. And the ECB, while remaining in wait-and-see mode, is standing ready to inject additional liquidity into funding markets over coming days and weeks.
This commitment to supporting growth does reduce gold's opportunity costs. But because uncertainties will persist -- the level of contagion across financial markets and the effect that central bank stimulus will have on real activity are big unknowns -- holding gold for its insurance characteristics is still a reasonable strategy, especially considering the Fed's delayed tightening schedule.
This said, on a 12-month view, given the tightening U.S. job market and signs of firmer wage growth, a Fed rate hike appears inevitable. And ultimately, the gold price will start to reverse once the Fed finally pulls the trigger.
Different financial markets will weather the Brexit storm differently -- Asian and U.S. equities have already recovered tentatively -- but its contribution to global volatility will remain abundant in the coming months, despite central bank stimulus. So, as the metal feasts on short-term uncertainty, the gold price, according to UBS's forecast, could reach $1,425 per ounce in the coming three months.
Even so, gold should fall once the Fed resumes its interest rate cycle, particularly if U.S. payroll figures are strong and the U.S. economy, which has low overall exposure to the U.K., continues to advance. Even more powerful will be the gradual upturn in U.S. real interest rates in 2017. The subsequent downward pressure on gold should push prices towards $1,275 per ounce.
Min Lan Tan is head of the APAC Investment Office at UBS Wealth Management.