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New gold metric shows investors' holdings at their highest level since 2012 - JP Morgan
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(Kitco News) -
The record streak of central bank gold purchases that began in 2022 has also driven investors to allocate the largest percentage of their portfolios to the precious metal since 2012, according to a newly-developed metric unveiled in a recent report from analysts at JPMorgan.
“We had argued previously in our publication that, at the global level, investors’ allocation to commodities ex gold has shifted to significantly below neutral (i.e. below historical averages) over the past year,” the analysts said, and this prompted questions about what the equivalent allocation metric would be for gold allocations.
“To answer this question we introduce a new metric to proxy investors’ allocation to gold at a global level,” they said. “In particular, we focus on the portion of gold that is held for investment purposes by either central banks or private investors holding gold via coins, bars or physical gold ETFs (or similar products).”
The analysts used data from the World Gold Council covering up until the end of 2022, and created an estimate running to the end of Q2 2023 by agglomerating the reported gold purchases by central banks and private investors. Then, they divided the total stock of gold holdings for investment purposes by the stock of financial assets including cash, equities and bonds held by private nonbank investors globally, resulting in a new gold allocation metric.
JPMorgan said their metric shows that while commodity allocation ex gold has been declining, investors’ allocation to the precious metal has increased over the past year, with central bank gold purchases being the main driver.
Central banks have been adding to their gold reserves at a historically unprecedented pace since Russia's invasion of Ukraine in early 2022 in an effort to reduce their dependence on and exposure to the U.S. dollar.
“In fact, the implied allocation to gold has been rising since the pandemic and currently stands at its highest level since the end of 2012,” they wrote. “In other words, investors’ allocation to gold looks rather high by historical standards at the moment and one needs to assume a structural increase in central bank demand beyond historical norms (due to fear of sanctions or general diversification away from G7 government bonds) to be bullish on gold.”
While they cautioned that this assumption of a structural increase in gold allocations was challenged by recent evidence of normalization in central bank gold purchases, they noted that the moderation in Q2 2023 was largely driven by Turkey's intervention in their local gold market.
According to the World Gold Council, Turkey increased its gold reserves by 11 tonnes in June after a three-month selling spree.
“Going forward, it remains to be seen whether this normalisation in central bank gold purchases in Q2 2023 is temporary, which, given the concentration in one country, could prove to be the case, or whether it becomes more persistent due to price sensitivity i.e. reluctance by central banks to buy more gold than their normal pace with gold prices at close to historical highs,” they said.
If the recent return to the mean for central bank gold purchases continues, the analysts said “it would also restore the historical sensitivity of gold prices to real bond yields” which was disrupted during 2022 “as shown by the abnormally high residuals in Figure 4.”
The residuals calculation was based on “a linear regression of quarterly changes in the XAUEUR price to quarterly changes in the 10y real UST yield,” they said. “We use the gold price in euro terms (i.e. XAUEUR) rather than dollar terms to adjust for changes in the price of dollar. As with other commodities, dollar is the settlement currency for gold and thus the gold price tends to be inversely related to dollar changes.”
JP Morgan noted that in the abnormally high residuals of 2022 denoted by red diamonds in the regression of Figure 5, “the quarterly gold price changes had been a lot higher than what the rise in the 10y real yield would typically suggest,” with the typical sensitivity in the regression between 2010 and 2021 indicating “that each 100bp rise in the 10y real yield results in a €209 decline in the price of gold and vice versa.”
“Beyond the sensitivity of gold prices to the dollar and real yields, there is little doubt that the pace of central bank purchases holds the key to gauging the future trajectory for gold prices,” they wrote. “Indeed, the importance of central bank gold purchases has risen since the pandemic as shown by the correlation table of Figure 6.”
The JPMorgan analysts noted that the key correlations for gold prices have also shifted since the outbreak of COVID-19.
“While before the pandemic gold ETF flows was the demand component exhibiting the highest correlation with gold prices, and thus the most important flow to watch, after the pandemic it has been central bank flows showing the highest correlation with gold,” they said.
JPMorgan is also predicting record-high gold prices to go with the outsized holdings. In July, they published a research report from Greg Shearer, executive director of global commodities research, which projected gold prices would hit new highs in the second half of 2024.
Shearer wrote that he expects the Federal Reserve to start cutting interest rates by the second quarter of 2024 and falling real U.S. yields will be a “significant driver” for gold. He sees gold prices averaging around $2,175 an ounce by the fourth quarter of 2024, with further upside risks if the U.S. economy does fall into a recession.
Shearer noted that the deeper the recession, the more aggressive the Federal Reserve will have to be in cutting interest rates, which would be supportive of gold.
“We're in a very prime place where we think gold ownership and long allocation to gold and silver is something that acts as both a late cycle diversifier and something that will perform as we look to the next sort of 12, 18 months,” Shearer said.
Shearer also noted that although speculative positioning in gold has picked up recently, the trade is still not too crowded, and said that JPMorgan sees solid institutional and central bank demand.
“There's an eagerness here to really buy in and diversify allocation away from currencies,” he said.
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