15 May 2019, 1:41PM UTCChief Investment Office GWMInvestment Research

Gold: A hedge with benefitsPrecious metals Authors:Giovanni Staunovo, Analyst, UBS Switzerland AG; Wayne Gordon, Analyst, UBS AG; Dominic Schnider, CFA, CAIA, Analyst, UBS AG

• The gold price rises when real US rates are low, equitymarkets are volatile and/or the US dollar is weak – allof which we anticipate for 2H19.

• With the Fed unlikely to hike this year or next andinflation improving, real US rates should stay lowthis year. Equity markets should be volatile due tolate-cycle dynamics and US-China tensions. And weforesee broad US dollar weakness as investors re-focus on fiscal issues.

• We forecast the gold price at USD 1,400/oz in 12months. The metal is also a valuable insurance asset,as adding it can help to reduce the overall volatilityof a portfolio.

Source: Getty Images

Our viewThe gold price has been a roller-coaster this year. After risingfrom USD 1,280/oz at the start of the year to nearly USD1,350/oz in February thanks to the Federal Reserve's dovishshift, gold prices fell to a four-month low of USD 1,270/oz in April. The yellow metal suffered last month as the USstock market recorded record highs, equity market volatility(VIX) declined and the USD gained strength. But thanks tothe renewed US-China trade spat, which has dragged downequity markets and heightened volatility, prices have shot upto test the USD 1,300/oz level in recent days.

Amid rising US-China trade tensions and geopoliticaltensions in the Middle East, it makes sense to look at safehavens ahead of key dates in the US political calendar. Wesee gold as a valuable portfolio hedge for investors withan affinity for real assets and an ability to cope with gold'svolatility of around 10–15%. Recent market volatility andgold's reaction to it have again confirmed its place as asafe-haven asset; it served investors well as a diversifier andhelps reduce portfolio swings. These qualities should remainhighly relevant for investors as the business cycle maturesfurther.

Gold should also benefit as a non-yield-bearing asset from aprudent Fed (our base case is for no hikes this year or next)and if our view of a weaker US dollar pans out due to thecountry's twin deficits. Hence, we expect gold to trade atUSD 1,350/oz in three to six months and at USD 1,400/ozin 12 months.

Further support for gold comes from demand from long-term-oriented investors like central banks, which appreciategold's lack of credit risks, its liquid market and its role asa hedge against tail risks and inflation. After buying 651.5tons of gold in 2018, the most in 47 years, central banksadded another 145.5 tons of gold to their reserves in 1Q19.While central bank demand alone is not enough to drivea price break-out, it should help lift prices together withthe support of a weaker US dollar, peaking US real rates,ongoing political risks and equity market volatility.

The main downside risk to owning gold is the Fed becominghawkish again and hiking interest rates this year, whichwould likely support the US dollar and weigh on gold prices.A recovery in US equity markets would also limit gold's rise.

This report has been prepared by UBS Switzerland AG and UBS AG. Please see important disclaimers and disclosuresat the end of the document.

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Gold: A hedge with benefitsGold has three drivers that greatly influence its pricedirection: real US interest rates, the value of the USdollar, and fear. While not a direct driver, the positioningof financial investors is also important. Gold is a non-yield-bearing asset and is perceived as commodity andcurrency. Hence, investors are most interested in its negativecorrelation to real rates and the USD and its positivecorrelation to fear.

Before investing in gold, our views on the direction of thesemain drivers should be considered.

• Real US interest rates: With the Fed likely on hold thisyear and next, and US inflation (CPI) improving from thelows of 1.6% in 1Q19 and expected by UBS to fluctuatebetween 1.8% and 2.2% until the end of 2020, webelieve US real rates peaked last quarter. Real US ratesare an important driver for gold due to its non-yield-bearing status – the lower the rate the better for gold.

• US dollar: We expect the US dollar to weaken ona broad basis as the country's twin deficits erodethe currency's fundamentals – we forecast EURUSD at1.20 in 12 months. Gold is negatively correlated tothe greenback. But under certain risk cases where thedemand for traditional safe-haven assets rises, as it didduring the 2008 global financial crisis, gold's correlationto the USD can swing into positive territory.

Chart 1: Negatively correlated to the USDOur expectation of a weaker USD over 12 months should help gold

Source: Bloomberg, UBS, as of 15 May 2019

• Fear: Fear in markets is routinely measured by thevolatility index (VIX). Historically, the VIX tends to behigher during the late cycle. And with trade risks risingand the 2020 US presidential elections approaching,volatility could be even higher than usual. Gold pricesusually do well in such environments.

Chart 2: Gold remains a safe-haven assetGold outperforms equities when volatility (the VIX) soars

Source: Bloomberg, UBS, as of 15 May 2019

• Positioning of financial investors: While ETF holdingshave increased this year, futures and options held bynon-commercial accounts declined in recent weeks andnet length still looks lean. If the above-mentioned driversmaterialize as we expect, non-commercial accountscould significantly increase their net length and supportgold prices.

Chart 3: Lean speculator positioningNon-commercial account positioning in gold futures in million ounces

Source: Bloomberg, UBS, as of 15 May 2019

RecommendationAs long as the above drivers remain in place, we adviseholding exposure to gold. We continue to advocate gold asan insurance asset, as we believe it can help shield investorsfrom geopolitical flare-ups, macro data disappointmentsand sharp gyrations in earnings (leading to higher marketvolatility). Our analysis shows that, for long-term investorswith an affinity for real assets and an ability to cope withgold's volatility of 10–15%, adding gold can help reduceportfolio volatility.

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Forecast table

Source: Bloomberg, UBS, as of 15 May 2019; UBS View: Bullish = we target the upper bound of the range, Sideways = we expect a sideways move,Bearish = we target the lower bound of the range; Abbreviations: Impl. Vol. = Implied market volatility, Active F. = Active Futures, L. Range = Lower Range,U. Range = Upper Range, ER% = Expected spot return in %

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Appendix

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