Gold back in the spotlight

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1 Gold back in the spotlight Ani Markova, MBA, LIFA, CIM, CFA Vice-President and Portfolio Manager AGF Investments Inc. IS THIS GOLD RALLY SUSTAINABLE? Since late 2011, gold has been in a steady down trend, with occasional seasonal rallies, trading from approximately US$1,900 per ounce in September 2011 to a low of US$1,050 per ounce in December The improving U.S. economy and job market, as well as accommodative policies from the U.S. Federal Reserve Board (Fed), supported positive market sentiment, which fueled strong moves in the S&P 500 Index and U.S. dollar (USD). This led to a broad investor sell off of defensive investments, which drove gold prices lower. However, positive market sentiment may be waning this year, as investors are looking for actual proof that monetary policies have been effective in creating strong economic growth, which is not evident from incoming data. We believe investors are concerned that the global economy remains challenged despite ongoing central bank activities leading to further competitive currency devaluations. This, combined with increased expectations for inflation in the U.S., has provided a positive backdrop for gold. CENTRAL BANKS EXPERIMENTS - LOWER RATES FOR LONGER We are in a new environment of negative interest rates in Europe and Japan with a possibility that some other countries will follow suit. In the context of a slowing global economy, central banks continue to rely on traditional and non-conventional tools in an attempt to jumpstart their economies. On March 10 th, 2016, the European Central Bank (ECB) announced a 0.1% cut in its deposit rate, driving the rate further into negative territory to -0.4%, and indicated that it would accelerate its monthly bond purchases to 80 billion from 60 billion. In an effort to stimulate credit creation, the ECB also introduced a series of four-year loans for banks, whose interest rate can range from zero to -0.4%, meaning that the ECB will pay some banks to borrow money, if they meet criteria on net lending to the economy. Similarly, the Bank of Japan (BOJ) left the benchmark rate unchanged at -0.1% at its March meeting and indicated that it will add easing if necessary. Yet, despite negative interest rates introduced in January, inflation remains far from its 2% goal, which combined with stalling growth is driving expectations for a further rate cut into negative territory.

2 In China, the People s Bank of China (PBoC) announced a 50 basis point (bps) reserve requirement ratio cut for bank deposits on February 29, 2016, which released ~700 billion yuan (CNY) in base money. On March 29, 2016, it injected CNY60 billion in liquidity via seven-day reverse repos and fixed the yuan lower against the USD. In addition, the annual National People's Congress set a target of GDP growth for this year of 6.5%-7% with a much clearer easing bias. In fact, January and February's strong robust overall credit growth (15.5% y/y adjusted) shows that easing is already underway, supporting faster household mortgage uptake and financing of government projects. This is obviously a concern even for the top banker, Zhou Xiaochuan, the governor of the People s Bank of China, who sounded the alarm over rising debt in the country. He publicly stated that "Lending as a share of GDP, especially corporate lending as a share of GDP, is too high," according to Bloomberg and the Financial Times. The concerns come as China's corporate and individual debt load weighs in at roughly 210% GDP vs. 126% in 2008 i. So yes, China has a credit bubble issue and cannot afford to have a strong currency. Dealing with its credit challenges, China could negatively impact currency and financial markets. Uncertainty around the success of all these monetary tactics is bringing investor interest back to gold as a safe haven asset class. We have seen global bullion ETFs take off since February 2016 (see Figure 1). Even in China, investors have been snapping up gold bars and coins in the first three weeks of March, overshadowing the usual purchases of gold jewelry that happens around the Lunar New Year, which fell in February of this year. The biggest surprise has been the 10-fold increase in sales of 250-gram bars, which cost roughly US$10,000. Sales of the 1,000-gram kilobars were up by 50% and most of the buyers seem to be corporate investors rather than jewelry makers ii. Figure 1 Total Known ETF Holdings of Gold 95M 85M 75M 65M 55M 45M Jan-2011 Jan-2012 Jan-2013 Jan-2014 Jan-2015 Jan-2016 Source: Bloomberg THE WORLD NEEDS A WEAKER U.S. DOLLAR, WHICH IS POSITIVE FOR GOLD When assessing current and future monetary and fiscal policies, we need to consider the G20 agreement reached in February 2016: all countries are to focus on tools to stimulate growth without creating excess currency shocks and competitive devaluations. Currencies are most impacted by tools such as interest rates, rather than expansion of central bank balance sheets, as they generally impact the credit market and aim to stimulate loans and investments. We have seen the ECB and BoJ maintain negative rates and 2

3 focus on credit measures. In the context of more clear and calibrated policy actions, it seems that the Fed is cooperating by not raising rates in order to prevent the USD from strengthening through the interest rate arbitrage. The world needs a lower USD in order for emerging market countries to stop with their own competitive devaluation and use their monetary tools to stimulate growth. Listening to the Fed Chair Janet Yellen s dovish speeches after the Fed meeting and at the Economic Club of New York, it seems to us that the Fed is emphasizing downside risks to the U.S. economic outlook stemming from weaker global growth. So how could G20 banks cooperate to generate growth? Figure 2. Estimated contribution to 2016 GDP Growth European Union 8% Other DMs 6% Japan 1% DMs = 27% China = 32% EMs = 41% (excl. China) United States 12% China 32% Other EMs 25% India 16% Source: Canaccord Genuity estimates, IMF WEO (January 2016 estimates) Emerging market (EM) countries represent 58% of world GDP but account for more than 70% of world GDP growth. The monetary policy in EM countries is too tight, with the average policy rate of 5.2% vs an average inflation rate of 4.1%, perhaps as a defense against the strong USD and rapidly depreciating currencies on domestic inflation. So if the Fed weakens the USD, it will buy time for EM policy makers to step in and generate global growth though easing in EM countries. Indonesia began this week, but bigger countries such as China, India and Russia could be next iii. This is what we believe the Fed did on March 16, 2016 it used its forward guidance tool in lowering the expectations for key economic factors leading to a reduced expectation of rate hikes. Some market participants now believe that the Fed may not increase rates this year, although the majority still think that there may be one to two hikes later in the year. It is all data dependent, but now also dependent on international developments and the impact of Fed rates on other countries - China, in particular. Through its pegged currency with the U.S., China is facing a difficult economic slowdown and a credit bubble. The main implication of a Fed that is on hold is that real interest rates are again expected to remain lower (negative) for longer. The real Fed funds rate is now in negative territory and is expected to be -0.5% at 3

4 year-end 2016 vs. expectations of -0.1% and -0.2% back in September and December 2015 iv. This is very good for gold, as precious metals prices respond positively to low and negative real rates. Figure 3. Negative real rates bode well for gold and silver Y/Y Gold & Silver Price Change (%) 150% 100% 50% 0% -50% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8% Real Rates Gold Silver Source: CIBC World Markets, Bloomberg It seems that the USD is finally rolling over based on the U.S. Trade Weighted Broad dollar, which due to its negative correlation to gold has been supportive of the gold price appreciation so far this year. The USD has tended to weaken in the months immediately following the start of a Fed tightening cycle. So far, this time has proved no different. That said, it would be premature to get too optimistic about the prolonged correction of this currency move, as strong U.S. economic growth and rate hikes could push the dollar higher again, but we don t believe this is in the cards in the short term. 4

5 China, a new large currency player, is now managing their currency against a basket with the following weights: USD (26%), euro (21%), Yen (15%), other (38%). In an effort to stimulate exports through weaker currency, it is possible that China is attempting to devalue the RMB against this basket and a weaker USD is key to this devaluation. This will most likely result in continued global currency volatility. U.S. INFLATION RE-EMERGING GOLD HAS LEGS TO RUN On inflation, Yellen acknowledged that core inflation had risen somewhat more than expected in December but said it is too early to tell if this recent faster pace will prove durable. With the Fed taking a dovish monetary policy stance and clearly targeting weakening of the USD, it appears that the Fed is willing to be behind the curve on inflation targets (increasing inflation should weaken the USD in a flat rate environment), which bodes well for precious metals. Gold and silver are tools used to hedge inflation. Gold tends to move months ahead of actual inflation a move that we are currently witnessing. We have seen some components of the U.S. CPI, such as services, already inching up and with some of the commodities rebounding year over year, we may start seeing CPI inch closer to the % range. Certainly the bond market is starting to price in some inflation, which is part of the reason that gold has been running in the past 1-2 months (see Figure 6 & 7). Figure 6. U.S. inflation has picked up in 2016 % change, year-over-year 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Source: Bloomberg Core CPI (% change, year-ago) Core PCE (% change, year-ago) 0.0% Figure 7. 2-year U.S. Government Bond Break-even yield Source: Bloomberg SEASONALITY Expect volatility! Historically March, May, June, October and December have been weak months for gold bullion and March, April, June, July and October are traditionally negative months for gold stocks. This seasonality has historically centered around the two main Indian wedding seasons in the spring and the fall when the demand for gold jewelry picks up (Figure 7 and 8). 5

6 Figure Seasonality of Gold of Gold Returns Returns Figure 9. Seasonality of Gold of Gold Stock Stock Returns Returns 4% 5% 2% 0% 0% -2% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Average Gold Monthly Returns Since 1980 Average Gold Monthly Returns Since % Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Average Gold Monthly Returns Since 1980 Average Gold Monthly Returns Since 2001 Source: Bloomberg, RBC RBC Capital Capital Markets Markets With the rapid increase in gold ETF demand, the seasonality trade has not played out to the same pattern this year. Although the ETFs added ~300 tonnes to date, this is a level of ownership seen in 2014 (see Figure 1). With investors now going back to gold as a tool for wealth preservation, the demand for physical gold for investments has balanced the seasonal lulls in the physical market. We believe that there are more legs to this gold trade, as investors continue to look at this generally undervalued asset class. IN SUMMARY We are in another global monetary experiment to reflate the global economy this time through weaker USD targeting growth in EM countries. Weakness in the USD could be achieved through holding rates lower than inflation, which could either be imported or generated through more aggressive investments and utilization of labour and productive resources. As investors are just starting to anticipate inflation, gold price is in the first innings of an inflation hedge trade. With a few gold catalysts still to come, such as the Brexit debate in June and the U.S. presidential election in November, we expect this year to be exciting for gold. The fact that we have rebounded from the lows of US$1,050/oz, we believe that bullion is returning to the investor spotlight. Although it may be bumpy along the way, we see gold heading in the US$1,300-1,400 range within the next 12 months. For more information, visit AGF.com/Institutional or contact your AGF representative. 6

7 The commentaries contained herein are provided as a general source of information based on information available as of March 28, 2016 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), AGF Asset Management (Asia) Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA). AGFA is a registered advisor in the U.S. AGFI is registered as a portfolio manager across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets. For international clients requiring a European registrant, AGF Investments Inc. mandates are available on a sub-advised basis through AGF International Advisors Company Ltd. AGF International Advisors Company Ltd. is authorized by the Central Bank of Ireland, in Ireland, and is regulated by the Central Bank of Ireland for conduct of business rules in Ireland, and regulated by the FCA for conduct of business rules in the UK. Conflicts of Interest & Share Ownership Policy AGF International Advisors Company Ltd., its employees, directors or related companies, may have a shareholding / be a director in the securities (or related investments/ derivatives) of certain companies covered in this report, or may provide/ solicit investment banking or other services to/ from them. It is noted that the Institutional Sales Representatives compensation is impacted upon by overall firm profitability and accordingly may be affected to some extent by revenues arising other AGF business units including AGF Investments Inc. and InstarAGF Asset Management Inc. Notwithstanding, AGF International Advisors Company Ltd. is satisfied that the objectivity of views and recommendations contained in this report has not been compromised. For accredited investors only. Publication Date: April 1, i Source: Bloomberg, CNLZFGDP Index, as of Q4-15. ii Source: The Wall Street Journal, March 28, 2016 iii Source: Martin Roberge, Canaccord Genuity, Portfolio Strategy Incubator, March 18, 2016, iv Source: Dundee Economics, Gold Monitor, March 18,

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