Gold Shines Against Headwinds While Markets Face Growing Risks

• Gold has held up well against the US dollar despite rising interest rates and a strong dollar index. Central bank buying is providing price support.
• The end of the "Great Moderation" era of low inflation and volatility presents challenges for portfolio construction. Inflation will likely be more volatile going forward.
• Bonds have suffered greatly recently but stocks may be the next asset class to decline sharply. Equities tend to react more negatively to losses than bonds.
• Quality junior miners with good assets and management can offer value, but significant capital is still needed in the sector. M&A activity may increase.
• Dovish Fed policy like rate cuts may initially lift stocks but ultimately could boost gold as concerns about the economy and money printing grow.

Gold has confounded expectations by holding ground near all-time highs despite surging real interest rates and a strengthening US dollar in 2023. Aggressive central bank buying is providing crucial support for prices.

The Importance of Central Bank Demand

Over 1,100 tons of gold were purchased by central banks in 2022. The major buyers are central banks in emerging markets particularly obviously China but also Turkey. More unexpected significant purchases have also occurred, with Poland aggressively accumulating gold reserves since late 2021. Sanctions imposed on Russia's reserves have increased distrust of the US dollar as the global reserve currency and encouraged this trend. Many countries that are somewhat critical of US policies have started piling up gold reserves and started diversifying out of their dollar-denominated reserves.

Another key theme is the conclusion of the Great Moderation era characterized by minimal inflation and relatively low volatility. Over the next couple of years, we will see much more inflation volatility. Most bond market participants are unsure of how to structure their portfolios when they see higher inflation volatility. In contrast, gold is recognising this inflation volatility and it's realizing that inflation will remain a concern. In such a long-term environment where inflation becomes one of the most important factors for portfolio construction then gold doesn't play a major role.

Risks of a Hard Landing

When assessing the economic outlook, a hard landing and not a soft landing is inevitable and that is not being priced in by markets. An enormous move in rates is the cause. While rate cuts by central banks are usually welcomed by markets, generally speaking, that's not a good thing. It means the economy is struggling. The bond market hasn't really realized that this Great Moderation is over. In terms of vulnerabilities across markets, usually, the next market to be affected would be equities. Paper losses in stocks feel like a real cost because the money is probably gone forever, whereas bond investors remain calm presuming they will just wait out paper losses until maturity.

Despite providing short-term relief, dovish central bank policies like rate cuts could ultimately boost gold. This will be the time when gold really reacts since it would signal concerns about the economy and likely expansionary policies like quantitative easing. Together with central bank buying, fear-driven investment demand could ignite gold if conditions deteriorate significantly.

State of Junior Gold Miners

It's tough out there for junior miners. However, quality names with robust assets and experienced management can offer deep value at current beaten-down levels. If you stick to the quality names it's a good time to start averaging in. When significant capital returns to the sector, M&A activity to pick up in the space as occurred recently in energy markets. That is when the gains will be made. So investors need to be capturing these gains now by allocating or reallocating their portfolio now. If it means selling an ailing stock and taking a hit now for future gains, so be it. Companies with cash to weather the storm and with strong fundamentals will be the winners. Deploy capital accordingly.

Key Takeaways for Investors

• Central bank purchases are supporting gold near all-time highs despite an unfavorable macro backdrop. Further diversification out of dollars could continue.
• Monitor inflation volatility as higher instability could enhance gold's appeal as a portfolio diversifier and inflation hedge.
• Tread carefully in equity markets amid economic uncertainty.
• Consider increasing exposure to quality gold miners trading at historically cheap valuations, but be selective.

In summary, gold is defying convention and holding its own as markets face risks of slowing growth, higher volatility, and shifting central bank policies. While timing is unclear, conditions seem to be aligning for another potential surge higher in the next leg of the bull run.