Investment Update - ECB policy may shift but its long-term effects keep gold relevant

European gold investment has been boosted by the accommodative monetary stance of the ECB since the onset of the pandemic. Ultra-low interest rates and negative deposit rates - which have been in place since 2014- alongside supportive asset purchases of €1.3tn under the pandemic emergency purchase programme (PEPP) have made gold more attractive to investors looking to protect their portfolios.¹

Regional gold investment rockets to record high

Gold exchange-traded products (ETPs) listed in Europe saw inflows of 256.3t (US$13.8bn) last year as the pandemic took hold, taking holdings in these products to 1,583.1t (US$96.3bn).² This was the highest annual inflow on record in value terms, eclipsing 2016’s US$11.7bn inflow – when rising populist sentiment, low interest rates, and Brexit were driving factors – and the second highest in tonnage terms. Interestingly, despite economic recovery and growing interest in risk assets, gold investment has remained resilient so far this year. As of July, the regional AUM figure was virtually unchanged (+0.2%), while holdings from locally listed funds accounted for 43% of the global total. Our market research suggests European investors, concerned about issues such as rising inflation, recognise the benefit of a strategic allocation to gold to help buffer further uncertainty.³

Negative nominal rates have also likely played a role (Chart 2).⁴ Since 2019, nominal rates on key European sovereign debt have been persistently low or negative (across different maturities). Combined with rising inflation this has meant deeply negative real yields.

This low-yield environment has prompted some to move into traditionally higher yielding asset classes, such as real estate, hedge funds and private equity. But while such assets potentially bring higher returns, they also add risk to a portfolio. As a result, some investors have bought gold to hedge riskier assets, often replacing part of their cash or fixed income allocations as the limited scope for these instruments to appreciate further has reduced their appeal as a risk hedge.⁵ One such example is DSM Nederland, a Dutch pension fund, which invested in gold as part of a reduction in its allocation to government bonds.⁶

Gold bar and coin demand,⁷ typically representative of retail gold investment, has also been robust throughout the pandemic, as investors concerned about inflation and low interest rates sought security in gold. Annual demand for bars and coins in Europe (including the UK) was 249t in 2020 – the highest since 2013 –making it the largest regional gold and coin market globally. And the pace has continued so far this year: European gold bar and coin investment reached 146t (US$8.5bn) in the first six months of 2021, the highest first half total since 2009’s remarkable 187.5t.⁸

The size of the European gold market – which now accounts for around one third of annual global gold investment demand – makes it relevant to investors everywhere, not just within the region. It also means the performance of Europe’s economy and changes to monetary policy will therefore likely influence global trends.

Pandemic policy response

COVID has taken a significant toll on the European economy, both from the virus itself and from the widespread lockdown measures aimed at controlling it. Euro area gross domestic product (GDP) plummeted from 1% in December 2019 to -14.4% by the end of June 2020, the lowest level on record.⁹

The ECB, like other central banks around the world, implemented a forceful monetary policy response to counter this disruption. PEPP and negative interest rates have enabled the ECB to maintain supportive financing conditions that counter risks to the economic outlook.¹⁰ The central bank has been steadfast in its efforts to guide the economy towards recovery, but the extent of its support has been the subject of fierce debate.^{11, 12,} Some policymakers and investors are concerned that these measures could have unintended negative consequences, such as higher inflation and greater exposure to risk on assets.

Possible divergence in regional growth and policy paths

Stimulus measures have, thus far, been broadly similar across the globe: ultra-low rates coupled with vast levels of fiscal spending. And a recent strategy review by the ECB brought it closer to that of the Federal Reserve (Fed), establishing a new 2% ‘symmetric’ inflation target, as well as a tolerance for allowing temporary overshoots.¹³

However, an uneven economic recovery rate between countries and regions has led to questions about when these stimulus measures will be scaled back and how differing withdrawal timelines might further impact the global economy. Various members of the Fed board have already openly discussed the need to consider tightening policy to avoid the economy overheating. Current expectations are for the Fed to begin tightening ahead of the ECB due to a faster economic recovery in the US  (Chart 3).¹⁴ This divergence in policy and growth trajectory could have implications for the European economy, with capital flows negatively affecting asset prices and trade.

Many investors are looking to upcoming ECB monetary policy meetings – including the one scheduled for 9 September – for guidance or signals on any potential scaling back of asset purchases and/or a hike in interest rates.

Risks remain despite recovery

Economic indicators in the euro area have recently shown signs of improvement as lockdown restrictions have eased and activity has picked up across the region. The ECB’s most recent forecasts see real GDP increasing by 4.6% in 2021, 4.7% next year and 2.1% in 2023.¹⁵ Sentiment is improving too, with the European Commission Economic Sentiment Indicator rising to its highest ever level in July.¹⁶

But despite this progress the ECB remains cautious, reaffirming that it is not prepared to change course on monetary support until it is satisfied that the economic recovery is firmly in place.¹⁷ Should the central bank decide to leave accommodative policy unchanged, this prolonged stimulus may heighten additional risks.

Potential for higher inflation

The most talked about risk to the outlook in Europe is inflation. Prices have ticked up in recent months with the consumer price index for the euro area hitting 3% in August, its highest rate for a decade. And in some key European markets inflation is even higher. In Germany, July CPI hit 3.1%, its highest level since June 2008.

While the ECB forecasts that the current rise in inflation will be temporary, institutional investors are increasingly concerned about the level and direction of inflation if monetary policy remains loose.¹⁸ Investors are aware that inflation may be seen in asset prices as well as in goods and services. European equity indices currently stand at record levels, having risen by 18% y-t-d, and 69% since mid-March 2020 when equity markets crashed as the pandemic took hold.¹⁹

Higher interest rates are a likely response to a more sustained threat from higher inflation. And more persistent inflation could be supportive for gold investment among European investors (Chart 4). German investors, who are particularly sensitive to inflation, have shown they value gold as a hedge against inflation.

Destabilisation as support withdrawn

The prospect for expansionary monetary policy to have unintended consequences increases the longer the policy is in place. ECB purchases under PEPP could distort asset prices (Chart 5). Any sign of a slowdown in these asset purchases could lead to a correction in asset prices, destabilising the recovery that the central bank has been trying to support.

Higher inflation could also force policymakers to increase interest rates from their current ultra-low levels sooner than expected, while higher borrowing costs could stunt the economic recovery by making debt more costly to obtain and service, both at a private and public sector level.

Sustainability of higher indebtedness

Unprecedented levels of spending have been unleashed as governments across Europe have looked to support their economies through the pandemic. Government deficits have ballooned as a result – euro area sovereign debt to GDP now exceeds 100% (Chart 6). And this excessive indebtedness is not just a potential concern at the sovereign level; corporate debt levels in Europe have grown too.

While borrowing costs remain low – allowing some nations to re-adjust the maturity profiles of their debt – these burdens have been manageable. But a rise in interest rates, especially at a faster rate than expected, could curtail spending and investment, putting the economic recovery at risk. In this scenario investors may look to diversifiers, such as gold, to help them weather any further uncertainty.

Spread of Delta and potential new variants

The COVID Delta variant represents an added threat to economic recovery and the return to a more ‘normal’ environment. While the rate of vaccinations across Europe has significantly improved after a slow start – 67% of adults have now received two doses of the vaccine – the number of fully vaccinated people varies significantly between European Union (EU) countries.²⁰ Cases have been rising in several member states, casting a cloud over the recent upswing in economic indicators. And while lockdown measures and travel restrictions have begun to ease across the region, concern around the Delta variant and potential new variants creates significant uncertainty.

Despite the region’s nascent economic recovery, European investors will need to ensure they have adequate risk management in place. Gold’s investment characteristics make it well-suited to help investors guard against many of these risks. Not only is it a proven long-term hedge against inflation and currency debasement, but it is also a high-quality, liquid asset that performs well in times of crisis (Chart 7)

Outlook for European gold investment demand

An increase in interest rates will certainly be a headwind for gold investment as it raises the opportunity cost of holding a non-yielding asset. Our analysis has also shown that gold’s sensitivity to changes in interest rates rises when the risk of inflation is front of mind, as it has been in recent months (Chart 8).

A higher opportunity cost could encourage more tactical investors in gold ETPs to unwind their positions. However, our expectation is that the strategic element of European gold ETP holdings will remain in place due to the continued transition risks for the region. A survey of 137 European institutional investors found that just under 25% had an allocation to gold. Of those, 41% planned to increase their gold holdings over the next three years.²² Since the end of 2003 there appear to be no instances of significant declines in European gold ETP holdings during periods of monetary tightening, although it should be noted that examples are limited.

Bar and coin demand, on the other hand, may prove to be ‘stickier’. Historically, the overall level of disinvestment in Europe is comparatively low, demonstrating that European investors are less likely to sell their gold after a crisis event. Following the GFC, for example, annual European bar and coin demand remained at multiples of the levels seen before the crisis (Chart 1). And the findings of our consumer research support this. In Germany – the third largest bar and coin market in 2020 – investors have said they tend to view gold as a long term investment offering security and wealth protection.

Questions remain on whether inflation will necessitate a shift towards tighter monetary policy and the likely timing of any changes. We believe, though, that the ECB’s cautious approach means that any increase in interest rates is likely to be incremental and gradual so that support is not withdrawn prematurely. The monetary policy environment in Europe therefore looks set to remain supportive for gold investment over the medium term, even if tightening is signalled at upcoming policy meetings.

And this is relevant not just for European investors; the region’s gold investment market is sizeable enough to significantly impact the global gold market.