Gold, Oil, and Inflation in 2018

Gold, Oil, and Inflation in 2018Gold, Oil, and Inflation in 2018

Investment Insights December 2017  Gold, Oil, and Inflation in 2018


  • Gold may remain flat for 2018 but remains an attractive tool to hedge against potential market volatility and geopolitical risks.
  • Oil prices may weaken due to rising US production despite falling global inventories and elevated political risk premia.
  • Inflation may persistently rise throughout 2018.

Macro Outlook

The world is currently experiencing synchronous growth supported by massive central bank stimulus. There are, however, indications that developed markets are likely close to their cycle highs, and a period of slower growth potentially lies ahead. While we think that the world economy will escape a significant upset in 2018, there remain formidable tail risks.

Navigating the stretched valuations in both equity and bond markets and the potential pitfalls of low volatility will be a critical objective for investors in 2018. The unwinding of monetary policy brings risks to both bonds and equities, likely renewing appetite for alternative assets classes such as commodities, real assets, and precious metals.

Earnings may face headwinds from tighter US monetary policy and wage growth. As the US jobs market continues to tighten in 2018, wage pressures may rise significantly and reinforce inflation momentum due to the need for businesses to increase prices.

The US central bank may continue to raise rates in 2018. That comes on top of the balance-sheet run-off that the Federal Reserve (Fed) has already announced. Although some market participants think that under a new Chair, the Fed will may become more dovish, we believe the central bank will remain data-dependent and trained staff economists’ analysis will become more influential in the Board’s decision-making. In light of strengthening domestic demand and a tight labor market, the inflationary potential will be hard to ignore.

Another potential consequence of tighter US policy is the negative impact on emerging market economic growth, and in particular China. Higher borrowing, input costs and currency volatility may weigh on emerging market growth.

Gold Outlook

Our base case fair-value for gold is broadly flat over the coming year, as support from rising inflation will counter the downward pressure from rising interest rates. Despite policy interest rates rising in 2017, the US dollar has depreciated and treasury yields have declined. We expect these paradoxical trends to abate in 2018, and thus weigh on gold prices. However, we believe three rate hikes in 2018 will be required to keep inflation expectations anchored.

Exhibit 1: 2018 gold price outlook scenarios

Most of the variation of the gold price in our bull and bear cases (compared to our base case) comes from assumptions around speculative positioning. Many measures of market volatility are currently subdued. However, several risks – both political and financial – exist. Sentiment towards gold could shift quite widely depending on which of these views dominate market psyche.

Risks which may push demand for gold futures higher benefiting prices include continued sabre-rattling from North Korea; tensions between Saudi Arabia and Iran escalate; a disorderly unwind of credit in China; political populism and elections in Europe; and a spike in market volatility as yield-trades unwind.

Currently investor positioning is elevated due to investor fears around continued sabre-rattling between US/Japan and North Korea and some of the tensions in the Middle East. These concerns could fall away if new developments on these geopolitical issues do not resurface. We have observed that when such geopolitical issues simmer in the background, political risk-premia tends to dissipate from the price of gold. It requires keeping the issues at the forefront of market psyche for the premia to endure.

Oil Outlook

Many market commentators argued a year ago that OPEC’s strategy was to flip the oil futures curve from contango to backwardation. Contango, they argued, provided the incentive for US shale producers to keep pumping out oil despite depressed spot prices because prices for future delivery were higher and so they could store oil today and lock into higher prices at a future date. Contango therefore would see continuous increases in inventory. The futures curve is now in backwardation.

Inventories have been declining across the OECD (Organization for Economic Co-operation and Development). Most of the declines have come from floating storage (which is the most expensive form of storage).We are unlikely to see the decline in inventories continue however. At current prices, US production will likely expand substantially. US shale oil production can break-even at close to US$40/barrel (bbl). With WTI (West Texas Intermediate) oil currently trading at US$55/bbl, there is plenty of headroom for profitability and we expect a strong expansion in supply.

In 2018, US production may hit an all-time high, surpassing the cycle peak reached before the price war in 2014 and above the 10 million barrel mark last hit in 1970. There is little indication that the backwardation in futures curves is going to stop US production from expanding.

Exhibit 2: Oil supply and demand outlook

In October 2017, OPEC (Organization of the Petroleum Exporting Countries) and its 10 non-OPEC partners posted their best level of compliance with the production curb deal to date. However, looking at the detail, it is countries like Iraq who managed to step-up the most to improve compliance. Iraq’s compliance levels jumped from 22% in September to 85% in October, making a strong contribution to the rise in OPEC’s overall compliance (95% in September to 106% in October).

That is unlikely to be repeated given that the supply disruptions stemming from the Kurdish region’s vote for independence was the driver. We doubt the threat to cut off oil production from the Kurdish region is credible. Turkey, the main buyer of the oil has not followed through with threats to shut-down pipelines that take oil out of the region.

OPEC and its non-OPEC partners announced on November 30th, that they will extend the deal to cut supply from October 2016 by 1.8 million barrels to the end of 2018. We think that compliance in this extended deal will fall short of expectations. Russia’s insistence on discussing an exit strategy and having a review in June 2018 indicates that the patience of non-OPEC partners in the deal is wearing thin.With the US expanding supply and OPEC likely to under deliver on its promise to consistently curb production, we expect the supply to grow. At the same time, demand is unlikely to continue to grow at the current pace, with prices having gained 33% over the past year. Q4 2017 may be the last quarter of deficit for a while. Surpluses are going to contribute to higher OECD inventories.

The Crown Prince of Saudi Arabia, Mohammed bin Salman, in his drive to modernize the Saudi economy, has taken aim at corruption in the country. With many of the economic and political elite having been caught up in the investigation, there is a risk that the fragile consensus that held the Saudi state together for many decades could unravel. Saudi Arabia has accused Iran and Lebanon of committing acts of war. Saudi Arabia initiated a military intervention in Yemen in 2015 that has been seen as a ‘proxy war’ with Iran given Iran’s support for rebel Houthis that had toppled Yemen’s former government. Recent developments show that this proxy war is escalating.

The market perceives both the internal and external conflicts in Saudi Arabia as a source of disruption in oil production in the region. We believe that the geopolitical premium priced into oil is likely to be transient unless a war actually breaks out. The Saudi proxy war with Iran has been raging for over two years, with little reflection in the price of oil until recently. Unless investors are constantly reminded of the risks, the premia tends to evaporate within a matter of weeks.

Inflation Outlook

Inflation has been subdued in 2017, despite many signs of cyclical strength, but a large number of idiosyncratic factors account for this apparent weakness in price movements. Dominant wireless phone service providers changing pricing; solar eclipse changing the timing of hotel stays; severe hurricane disruptions; budget airlines opening new routes are some of the idiosyncratic factors that are unlikely to be repeated.

Additionally, the calculation of owner occupied equivalent rent has caused some distortions in the inflation numbers, as it is sensitive to energy prices. With volatility in energy prices having fallen, we expect these distortions to subside. The unemployment rate is at its lowest in 16 years and a healthy number of jobs are being added every month (notwithstanding hurricane disruptions). The strength in the labor market may show up in inflation as per its traditional relationship.We expect US inflation to rise to 2.4% in June 2018 and 2.6% by December 2018 (from 2.2% in September 2017). These levels will likely be uncomfortably high for the Fed, but given the lags in policy and price response, there is little the Fed can do next year to stop it (the inflationary pressure has been built up this year).

Important Risks

The statements and opinions expressed are those of the author and are as of the date of this report. All information is historical and not indicative of future results and subject to change. Reader should not assume that an investment in any securities and/or precious metals mentioned was or would be profitable in the future. This information is not a recommendation to buy or sell. Past performance does not guarantee future results. Risk premia is the difference between the expected return on a security or portfolio and the ”riskless rate of interest” (the certain return on a riskless security.

Diversification does not eliminate the risk of experiencing investment losses. All investing involves risk, including the loss of principal.

The Organisation for Economic Co-operation and Development (OECD) is an intergovernmental economic organisation with 35 member countries, founded in 1960 to stimulate economic progress and world trade. Organization of the Petroleum Exporting Countries (OPEC) is an intergovernmental organization of 14 nations as of May 2017, founded in 1960 in Baghdad by the first five members, and headquartered since 1965 in Vienna.

The Federal Reserve System, often referred to as the Federal Reserve or simply ”the Fed,” is the central bank of the United States. It was created by the Congress to provide the nation with a safer, more flexible, and more stable monetary and financial system. Backwardation is a theory developed in respect to the price of a futures contract and the contract’s time to expire; as the contract approaches expiration, the futures contract trades at a higher price compared to when the contract was further away from expiration. Contango is a situation where the futures price of a commodity is above the expected future spot price.

Maxwell Gold is a registered representative of ALPS Distributors, Inc.

ALPS Distributors, Inc.

The rebalancing of the Australian economy is the cornerstone of its resilience

The rebalancing of the Australian economy is the cornerstone of its resilience

ETF Securities Equity Research: The rebalancing of the Australian economy is the cornerstone of its resilience


• Stronger business confidence picks up momentum offsetting some of the weak consumer confidence.

• Chinese growth has stabilised, its demand for exports from Australia is strong, but momentum will gradually decline in line with the slowing rate of urbanisation in China.

• The housing cycle is easing but a robust mortgage system, lower foreign investor reliance coupled with stable debt service payments emphasise that a crash is avoidable.

Australia defies doomsayers

Australia is the only OECD country since 1970 known to have withstood the longest period, 104 quarters in a row, without a recession. Despite numerous forecasts of an impending recession, the resource driven Australian economy withstood the demise of the commodity boom. Since the 1970s, several reforms such as – the floating of the exchange rate, RBA inflation targeting and labour market microeconomic reform, improved the flexibility of the economy. We remain convinced that the rebalancing of economic activity and the improvement in productivity will enable it to withstand the slowdown in the housing cycle.

While second quarter GDP growth rose to 0.8%, the annual pace of expansion at 1.8% remains below its potential (at around 3%). We believe the lingering effects of tropical cyclone Debbie, on construction and coal exports, was a drag on Q2 GDP growth, and its temporary effects are likely to reverse.

Business confidence remains upbeat

Record high household debt levels coupled with sluggish wage growth has weighed on consumer confidence. As housing accounts for more than 50% of household wealth, the decline in house prices has lowered household wealth thereby dampening consumer consumption. Amidst this backdrop consumer spending (at nearly 60% of GDP) is likely to remain subdued in the near term. Meanwhile, business confidence surpassed consumer confidence in 2014 and its positive momentum provides signs that business investment could plug the gap left behind by consumer spending.

Furthermore capital expenditure in the private sector and mining industry are starting to rebound from current low levels. Public infrastructure investment, led by the state is up 9.5% over the prior year. Services exports, led by tourism and education are continuing to strengthen, aided by a weaker currency, and Australia is well positioned to benefit from the growing Asian middle class.

China’s commodity import demand to unwind gradually

Among all OECD nations, Australia remains the most dependent on China as it accounts for more than a third of all exports. Despite widespread fears of a slowdown in China, growth in China has stabilised. While China’s growth momentum slowed marginally on a quarterly basis, an improvement in retail sales and industry output is pointing to robust growth heading into next year. Additionally, a 19.8% growth in infrastructure spending over the prior year strengthens the case for a continuation of commodity demand. Bulk commodities represent a quarter of Australia’s total exports led by iron ore and coal. We are still seeing demand for steel (which uses iron ore and coking coal) and electricity (generated by thermal coal) remain strong.

At the same time, there has been a fall in Chinese production of iron ore and coal, owing to lower profitability and compliance with environmental regulations. This has increased demand for imports from Australia. Looking ahead, the Reserve Bank of Australia (RBA) is forecasting a slowdown in China’s urbanisation rate to gradually impact demand for iron ore and coking coal over the coming decade.

Housing sector looks stretched

House prices in Australia have continued their meteoric rise since the start of the decade, more so in Sydney and Melbourne while less in Brisbane and Adelaide. During 2000’s, the rate of building construction failed to keep pace with the rising population growth, providing an incentive for a surge in house supply.

Rising supply coupled with tighter lending standards and poor affordability has left the housing sector overstretched. Consequently, building approvals and dwelling investments are declining. Australia’s mortgage system has robust underwriting rules in place that operate on a full recourse basis. In addition, interest payments to quarterly disposable income have remained stable. For these reasons, we do not expect to see a repeat of the US subprime mortgage crisis in Australia. We hold the view that the RBA will maintain interest rates at 1.5% until the end of next year thereby helping households continue servicing their loans.

So far, Australian residential real estate prices remained buoyed by the steady stream of Chinese immigrants buying property at record valuations. Recent data from the Foreign Investment Review Board (FIRB) in May highlight a 60% y-o-y decline in volume of real estate investment approvals sought by Chinese residents. We believe these risks are largely contained as the National Australia Bank (NAB) estimates foreign investors account for only 11% and 7% of new and established home sales respectively.

Australian equities lack innovation

Australian equities have posted a mediocre gain of 5.7% since the start of the year lagging global peers by 12% and the technology sector by 34%. Their lagged performance highlights a critical theme lacking in Australian equities – technology and innovation. While current valuations at 5.3x are well below their historical average, we are of the opinion that unless Australia displays entrepreneurship in the technology sector, they will fail to attract foreign investors.

Despite record high household debt, and a slowdown in the housing cycle and mining investment (6.8% of GDP), we are convinced that the resilience of the Australian economy will help it avoid a recession as it has done for the last 26 years.

For more information contact:

Catarina Donat Marques
ETF Securities (UK) Limited
T +44 20 7448 4386

Important Information

This communication has been issued and approved for the purpose of section 21 of the Financial Services and Markets Act 2000 by ETF Securities (UK) Limited (“ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the “FCA”).

The information contained in this communication is for your general information only and is neither an offer for sale nor a solicitation of an offer to buy securities. This communication should not be used as the basis for any investment decision. Historical performance is not an indication of future performance and any investments may go down in value.

This document is not, and under no circumstances is to be construed as, an advertisement or any other step in furtherance of a public offering of shares or securities in the United States or any province or territory thereof. Neither this document nor any copy hereof should be taken, transmitted or distributed (directly or indirectly) into the United States.

This communication may contain independent market commentary prepared by ETFS UK based on publicly available information. Although ETFS UK endeavours to ensure the accuracy of the content in this communication, ETFS UK does not warrant or guarantee its accuracy or correctness. Any third party data providers used to source the information in this communication make no warranties or representation of any kind relating to such data. Where ETFS UK has expressed its own opinions related to product or market activity, these views may change. Neither ETFS UK, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents.

ETFS UK is required by the FCA to clarify that it is not acting for you in any way in relation to the investment or investment activity to which this communication relates. In particular, ETFS UK will not provide any investment services to you and or advise you on the merits of, or make any recommendation to you in relation to, the terms of any transaction. No representative of ETFS UK is authorised to behave in any way which would lead you to believe otherwise. ETFS UK is not, therefore, responsible for providing you with the protections afforded to its clients and you should seek your own independent legal, investment and tax or other advice as you see fit.