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Can Gold Rally to $1,300? -- Barron's Asia

We have made significant changes to both our short and long term gold and silver price assumptions pulling back our average H2/15 gold price from US$1,288 /oz to US$1,125 /oz and have reduced our 2016 to 2017 gold price by 7% to 8% (Exhibit 3). We have also pulled back our long term gold price by 7% from US$1,400 /oz to US$1,300 /oz from 2018 onward and we expect a combination of persistent US$ strength and weaker investment to limit the upside prices well below prior high trading ranges.

We expect gold/silver to remain weak over the balance of the year driven by our expectation of the FOMC hiking rates in September despite recent action by China to weaken the Yuan. We expect to see some improvement in gold prices over the near term driven by seasonal demand from India and would expect a further improvement in 2016 supported by fundamental demand out of China /Emerging market countries as well as steady central bank buying. A deferral of the expected September Fed rate hike or an increase in systemic risk due to (1) a resurgence of the Greek economic risk within the Eurozone through or (2) further Chinese devaluation of the RMB could also improve sentiment and result in a firmer gold price.

Gold had a strong start to the year with the gold price rallying to US$1,300 /oz in Q1, driven by seasonal demand out of China and the Far East. Since April gold has steadily pulled back as geopolitical tensions have eased or faded into the background, inflation in the developed world has been weak and the US economy, equity markets and currency have continued to strengthen relative to the rest of the world. Since the beginning of July, gold has faced a series of material headwinds including:

-- Positive US economic data maintaining momentum towards a first Fed hike in September and more broadly a strong US dollar

-- Significant market turbulence within China with weak gold import numbers for June. Whilst recent action to lower the Yuan reference rate has stimulated a recovery in prices, the weaker Yuan is from a global perspective deflationary and makes gold less affordable to Chinese consumers.

-- The resolution of the immediate Greek crisis reducing systemic financial risk

-- The resolution of the nuclear negotiations with Iran reducing both security risk and increasing oil supply and so reducing inflationary pressures

-- Typical seasonal weakness in the physical market over the early part of the northern summer with reduced buying activity in India .

-- A breaking of the US$1,130 /oz technical level on 20th July. This level had held on several previous occasions and breaking down through it opened up the potential for a further decline in prices to the next technical level, US$1,060 / oz, with concerns about a potential breakdown to below US$1,000 /oz.

We expect the gold price to recover somewhat from current levels as seasonal demand picks up into the Indian wedding and festival season; the focus of which should be around the festival of Diwali in November. Whilst the Rupee has weakened against US$ the pullback in gold prices and, to date, normal levels of monsoon rainfall should support relatively strong demand from late August through to November. Indian demand picked up strongly in July with GFMS reporting 94t of imports, the highest level since March. Chinese demand should also pick up ahead of Chinese New Year in early 2016 on February 8th . However, there has been a seasonal lull in December in recent years that could again see gold come under renewed pressure, especially if inflation remains weak at the end of the year or the Fed rate hike gets deferred until the December FOMC meeting.

We expect gold to remain under some pressure ahead of an expected first rate hike in September and if the hike is greater than expected or if the commentary surrounding the likely trajectory of rates is more hawkish then the metal could break down further, especially if headline inflation rates remain at well below the FOMC's 2% target. Whilst the action by China to devalue the Yuan makes a Fed rate hike less likely, we believe that there is considerable political pressure to begin the process of hiking rates. Gold has typically performed well into a US rate increase; strengthening in the 12 months prior to every rate hike since the end of Bretton Woods in 1971, aside from 1999. Since 1970, however, the Fed has not raised rates when CPI has been below 2% and on all but one occasion ( Feb 1994 ) the direction of CPI over the previous 12 months had been on an upward trajectory prior to the first hike. US CPI was 2.1% in June 2014 but declined to 0.3% in June 2015 .

So what was different in 1999 when gold underperformed into the first rate hike and went on to touch a cycle low within two months? When the Fed raised rates in June 1999 , gold had weakened over the previous 12 months and US CPI was only at 2%; the lowest that it has been in the last 45 years when the first rate hike occurred. We have a concern that a first hike over the coming month against the backdrop of very low headline inflation could result in continued weakness of gold. The FOMC has specifically noted that it could hike if there was a degree of confidence (increasing expectations) that inflation would move back to or above the 2% target, even if at the time of the first hike the inflation rate was actually below the level. At this point a sustained recovery in oil prices appears unlikely, in our view, as none of the major oil producing countries appears willing to cede market share to support prices. In the absence of any cuts and with lackluster economic growth from China we believe that inflationary pressures should remain weak, whilst the US dollar strengthens as rates rise.

Indian demand has been relatively robust this year while Chinese imports have been relatively weak compared to the 2013 levels. The response to the July pullback in the gold price will be a significant test. During the past two years the Indian and Chinese markets have account for nearly 50% of the demand for physical gold and have demonstrated buying interest below the $1,200 /oz level or equivalent Rupee/Renminbi level.
We have seen Chinese demand pick up sharply when the Renminbi gold price has dipped down to the 7,000 to 7,250/oz RMB range. Gold has moved sharply back above CNY7,000 /oz since the beginning of the week but remains in the CNY7,000 /oz - CNY7,250 /oz range that has stimulated demand in the past two years and we would therefore expect to see a pick-up in demand if gold remains at this level. Given the volatility in Chinese equity markets investors may also choose to reallocate capital to gold to preserve value. The Chinese market has, however, proven to be very price sensitive and a rally that took prices to above CNY7,500 /oz (currently approximately US$1,175 /oz) could see demand taper off.

Whilst the Indian economy appears to be performing quite strongly at present China's slowdown makes a further stimulus more likely. The impact of a Chinese stimulus package should have a positive impact on demand, although if it served to reflate the Chinese equity market then that would probably draw investors away from gold. Given China's efforts to have its currency included in the IMF SDR we believe that it is less likely that it would attempt a stimulus based on a material devaluation of the currency over the short term. The devaluation of the RMB by the Chinese government, as an effort to stimulate the domestic economy, may be a longer term negative for gold as it would reduce the purchasing power of Chinese consumers, although this may be at least partially balanced by those purchasing to preserve wealth in a weaker RMB environment. Near-term holders of bullion have seen a rise in the value of their gold holdings in RMB terms, which may in turn result in increased demand if further devaluations are expected.

As discussed earlier, we expect the gold price to improve by $50 /oz increments to a US $1,300 /oz long-term price beginning in 2018; this is below our previous long term assumption of US$1,400 /oz. Our assumptions are:

1) Weak US inflation due partly to USD strength. We expect the Fed to lean toward low real rates, due in large part to concerns over rising mortgage rates stalling the US economic recovery. Deflation concerns in Euro Zone countries with low to negative real rates.

2) The FOMC begins hikes rates in Q3/2015 with a 75 to 200 bp increase over the subsequent 2 years.

3) Gold ETF holdings remain stable at the approximately 48M oz level and scrap supply also remains at current low levels;

4) Indian demand strength returns to a normalized level with heavy seasonal buying (late Q1 & late Q3 to early Q4), steady year end restocking and the normal Chinese New year demand.

5) Whilst we expect emerging market currencies remain weak, we do not expect anything similar to 1998 Asian currency crisis that resulted in a 78% increase in gold scrap contributing 25% to the global supply, and as a consequence gold declining to a $257 /oz low.

6) We expect the Peoples Bank of China to continue to incrementally add to its gold holdings at a rate of 100t/year and other central banks, including Russia , to continue to add gold to their holdings.

We believe that there are a number of potentially positive catalysts for the gold price including:

1) Should the Fed push back the first hike beyond the September 2015 meeting then we would expect an upward move in gold;

2) The rise of the Islamic State in Syria and Iraq has served to destabilize the broader Middle East with unrest and deaths linked to the group as far away as Tunisia and Libya . Whilst the market currently appears to be less focused on security risks - or at least sees buying US$ denominated assets as a way to mitigate them - should these regional conflicts increase in intensity or scale then we would expect it to be positive catalyst for the gold price;

3) If China announces a further stimulus programme, in addition to devaluation of the Renminbi, then we would expect this to be a positive for gold demand.

4) Stalling the upward momentum in the broader equity markets, should valuations look stretched, could see fund flows back into gold. In addition, concern about risks in some Emerging Markets could see a return to the safe haven buying of the metal;

5) As inflation expectations (or the lack there of) are discounted into lower oil prices, should WTI return to $70 / bbl- $80 /bbl over the next 12 months, this would result in a pick-up in inflation expectations and headline inflation that should have a positive impact on gold which acts as an "inflation hedge";

6) Whilst the immediate Greek crisis appears to have been addressed in mid-July, the combination of potential splits within the ruling Syriza party and a lack of agreement amongst the Troika about the need for debt write-downs as part of a new funding package, could result in a return to levels of economic instability as seen at the beginning of July and see a corresponding upward tick in the gold price.

Under an upside scenario, that we believe could have a 25% probability, we would expect gold to trade in a $1,200 /oz to $1,300 /oz range in late-2015 and early 2016.

Downside catalysts for the gold price near term

1) We believe a September FOMC rate hike remains the most likely outcome, however our base case assumption is that the trajectory of any hikes would likely be shallow. Especially whilst headline inflation remains muted. Should the FOMC indicate that it planned a more hawkish approach to rates then we believe that the gold price could come under downward pressure.

2) If China commits to an aggressive stimulus programme that includes further significant devaluation of the Renminbi this would both reduce the USD purchasing power of Chinese consumers and stimulate a further strengthening of the USD, which would ultimately have a negative impact on gold demand in that region.

3) If Russia were to begin to sell a portion of its significant 1,250 tonnes of gold reserves (7th largest CB holdings) or any other central bank announce a sale of gold, then this could be a significant negative catalyst for the gold price, although any such sale would probably be conducted off market and with a sovereign counterparty. Russia indicated at the end of July 2015 that it was suspending central bank purchases.

Under a downside scenario, that we believe could have a 25% probability, we would expect gold to trade in a $950 /oz to $1,050 /oz range during the balance of 2015 and early 2016.

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By Stephen D. Walker , Head of Global Mining Research at RBC Dominion Securities . Contributing authors include analysts Dan Rollins , Sam Crittenden , Jonathan Guy and Paul Hissey

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08-24-15 0045ET
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