BREXIT AND THE BOOST FOR GOLD

August 15, 2016 | posted in News | posted by : Manappuram Finance
The uncertainty over the referendum ended with the UK voting on June 23, 2016 to leave the EU. After the referendum, opinion is divided among financial analysts and economists about the long term consequences of the event. Those who campaigned for the exit option believe it will be negative only over the short term. In the long run the outcome will be positive for UK, with savings of GBP 8.50 billion per annum (said to be the country’s net contribution to EU) and freedom to pursue its own trade deals. They are hopeful that Britain will manage to negotiate a free trade deal with Europe on special terms, similar, for example, to EU’s Comprehensive Economic & Trade Agreement (CETA) recently negotiated with Canada.

Opponents of exit are sceptical anticipating a negative impact on the UK and the EU economy as a whole which will lead to a global economic slowdown. Whether other EU countries would offer a generous trade deal to the UK is one of the unknowns of the debate. While the pro-exit camp believes it would be in the interests of other European countries to re-establish free trade, their opponents suggest that the EU would want to make life hard for Britain in order to discourage further breakaways.

A study by the think-tank Open Europe, which campaigns for radical reforms in the EU, found that the worst-case "Brexit" scenario is that the UK economy loses 2.2 per cent of its total GDP by 2030 which may not be cause for alarm given that the recession of 2008-09 wiped out about 6 percent off its GDP. However, it says that GDP could rise by 1.6 per cent if the UK was able to negotiate a free trade deal with Europe – i.e. to maintain the current trade set-up – and pursued "very ambitious deregulation."

Notwithstanding the pros and cons of the issue, the immediate reaction by the global financial markets was one of surprise and panic. The British Pound lost significant value, sliding 8 percent against the USD on the day of the results, its biggest one-day fall since the age of free-floating exchange rates began. Stocks markets in the U.S. and Europe also fell sharply, and an unprecedented $3 trillion was erased from stock exchanges around the world in the two trading days following the results.

Since then, stock markets have rebounded after governments and central banks indicated they were ready to do “whatever it takes” to prevent slippages in their economies. The Bank of England has now cut interest rates to a historic low of 0.25 percent accompanied by a £170bn package of stimulus measures. Earlier, the Japanese government had announced a fiscal stimulus said to be worth USD 276 billion. All this in a world already awash in fiscal and monetary stimulus money, with the US alone estimated to have pumped in $7.66 trillion between 2008 and 2012. Injection of newly minted money is likely only to extend the lull before the next big storm. Good times, we know, don’t last forever. But, whether artificially propping up the economy with liquidity will hold back bad times forever, remains uncertain. 

There is, however, one asset class about which there is no uncertainty and that is gold. Investment in gold has long been held as the best option for risk-averse investors in uncertain times. It was proved again as gold jumped nearly 5 percent (to US$ 1,315) on the day of the Brexit verdict. In fact, even before the vote, gold had already posted gains of 20 percent during the year given the continuing growth woes in the developed world and with China faltering too. Since 1974, gold has not had a better first half of the year. Importantly, despite all the gains so far, the key takeaway today is that more appreciation is likely.
 
Outlook for gold price
Gold price is, by and large, inversely related to interest rate being non-interest bearing. Any rise in uncertainty in the global market, and risk-averse investors pull out money from risky assets to park in safe haven investments like dollar denominated bonds and gold.  Similarly, falling interest rates nudge gold price higher as the opportunity cost of holding the asset falls.

The slow pace of recovery after the 2008 meltdown has compelled central banks across the globe to maintain low, even negative, interest rates to stimulate growth or to shore up whatever little of momentum there is. This easy money stance with interest rates held artificially low increases risk appetite. A significant chunk of this money then gets diverted to emerging markets in quest of higher returns pushing up stock indices in these parts while the lack of positive returns from bonds makes gold more attractive to hold.

The latest data from the World Gold Council shows record investment in gold in the first half of 2016 with investors buying 1,064 tons during the first six months of 2016, 16 percent more than in the first half of 2009 when the financial crisis was most acute. Investment, rather than jewellery, was the largest component of gold demand for two consecutive quarters, which has not happened before. Individual investors, recoiling from historically low interest rates on bank deposits, have also been buying up gold bars and coins. Demand for the U.S. gold Eagle coins has jumped 84 percent this year.

Not surprisingly then, Bank of America analysts in July upped their target on gold to $1,475 noting, “the world has been walking from crisis to crisis and we see risks that this may not change." Analysts with Credit Suisse have suggested that $1,500 an ounce mark could be tested by the end of the year in view of the prolonged macroeconomic uncertainty while UBS says gold “is more compelling than ever” today because of low and negative interest rates and global geopolitical risks.

After experimenting with artificially low interest rates, the trend towards negative interest rates on sovereign bonds is proving to be another support for gold. The conventional argument against investing in gold is that the metal generates no income while investment in bonds and shares fetches interest and dividends which offset the risk of fall in capital values. In contrast, when you invest in gold, you are effectively betting only on favourable price movements.

However, with the trend towards negative interest rates in the advanced economies, holding on to cash and gold is now a sensible option. According to a recent reports in the international press, about US$13.4 trillion of sovereign bonds, primarily European and Japanese, are trading with negative yields. For many central banks these days, it’s become a race to the bottom and beyond. Moreover, a number of highly rated corporate bonds are also beginning to get into the negative yield business. The case for gold has become stronger.

Of course, if there is a dark cloud somewhere, it is that the most recent upsurge in gold price has been driven strongly by exchange traded funds (ETFs) getting back in to the market.  The risk is that demand will fade once there is an economic recovery prompting investment to head elsewhere. And that is the potential threat to gold price going forward.
 
Other likely consequences
Post Brexit, there can be significant,  but difficult to predict, negative spill-over to the euro area in the days to come via a number of channels, including trade and the financial markets. However, losses may not be as large as earlier feared even if Article 50  (which governs exit from EU) is triggered immediately because the UK’s trading arrangements with the rest of the EU is likely to remain unchanged for at least two years (possibly longer).

Brexit has given hope to Euro-sceptic political parties across Euro-zone to pursue their own exit options. While markets have so far managed so far to ride out the impact, the real danger is that it may strengthen anti-EU voices in European countries, some of which may follow suit. With elections coming up next year in the Netherlands, France and then Germany (these economies together represent more than half the euro-zone output), the worries are real. An upsurge in anti EU sentiments leading to further pullouts from the EU would pull the EU economy into recession which will spill over to the global economy via trade and finance.  A slowdown in global economy would impact US growth rate. Any uncertainty and weakness in the global economy would likely further delay the process of normalisation of interest rates by the US Federal Reserve. And that will, once again, strengthen the appetite for gold among investors.
 
 V.P. Nandakumar is MD & CEO of Manappuram Finance Ltd. and Chairman of CII, Kerala State Council.

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