Metals Commentary: Pullback in gold a buying opportunity, Macquarie says

Since the 2007 global financial crisis, March has been the worst month for the gold price with average declines of 1.6%. But David Doyle, a Toronto-based strategist and economist at Macquarie Capital Markets, believes the recent pullback is a buying opportunity and argues that the factors behind the price decline could in fact become “tailwinds” in the months ahead.

Doyle predicts gold prices will rise this year and average US$1,800 per oz. after reaching a peak of US$2,250 per oz., and recommends being overweight on both gold and gold equities. Improving sentiment over the coming months, along with “ongoing elevated unemployment in the U.S., further easing from the Fed and potential sovereign debt concerns” will act as catalysts to push the gold price higher, he determines.

Doyle also maintains that valuations “appear to be stabilizing at compelling levels and stocks should benefit from a potential rebound in the gold price,” adding that his top pick is Barrick Gold. “We see gold reaching a peak of about US$2,250 per oz. by year-end [down from a previous target of US$2,500 per oz.],” he writes in a note to clients.

“This represents a gain of about 18% from the 2011 peak and is close to the average yearly increase in the peak annual price over the 2007–2010 period. This price target is based on our view that a similar macro environment should prevail in 2012, and that there will continue to be negative real short rates in the U.S.”

Among the factors that suggest a potential rebound in gold is in store is the “excess capacity in the U.S. labour market,” which in his view is “an underappreciated policy consideration.” While he acknowledges there has been a recent pick-up in U.S. labour market activity, he argues that “three months of strong gains are hardly enough to make a substantial dent in the unemployment problem.”

The number of jobs in the U.S. remains about 5.3 million below its pre-recession peak, he says, “and on average, following recessions the Fed has only tightened policy when the number of jobs exceeds the prior peak by 2%.”

He calculates that “to reach that level would require an additional 8.1 million jobs — or 250,000 of jobs growth every month through the end of 2015.”

He also points to the labour participation rate, which he says has dropped from more than 67% in 2000 and 66% in 2007, to 63.9% today. While some of that can be chalked up to demographics and a drop in the number of people that are able and willing to work, his analysis suggests a bigger part of the problem is cyclical. “In our view, a more relevant measure adjusts the unemployment rate for cyclical changes in labour force participation [but not structural],” he reasons. “Using this measure we find that the ‘actual’ unemployment rate is about 10.7%, well above the Fed’s long-run estimate of structural unemployment of about 5.5%.”

The unemployment level is one reason why Doyle believes the Fed will leave short rates at zero through the fourth quarter of 2015. He also believes that the recent rise in the 10-year yield is unlikely to continue. “The rise in the 10-year yield from below 2% in late February to about 2.3% has likely also been a contributing factor to recent weakness in the gold price,” he writes. “We see limited potential for further significant increases in the months ahead, as this would be tantamount to unintended monetary tightening and act as a drag on growth.”

As far as sovereign risk is concerned, while the perception of risk is lower given the recent resolution of the Greek crisis, Doyle believes that the sentiment will be “short-lived,” and that “this theme is likely to shape the macroeconomic landscape for several years, providing further long-term support for the gold price.” This will not only be true of countries like Spain, Portugal and Ireland in Europe, he says, but also of the U.S. and Japan, two countries he says are projected to run deficits near their all-time highs in 2012.

“While quantitative easing programs have helped keep their long-term bond yields at very low levels, it’s likely that, at some point in the years ahead, bond market participants start factoring in a sovereign risk premium,” he contends. “In the meantime, we expect central bankers to continue expanding their balance sheets, providing catalysts to drive the gold price higher.”