The great retracement. After more than a decade of riding the escalator of growth gold is now taking an express lift down. Panic took hold last week and the reaction was swift and severe. By Monday, the yellow metal shed almost US$220/oz, dropping below US$1,400/oz for the first time in two years. It was the steepest percentage fall since 1980 and the biggest two-day dollar price drop ever.

How it happened: Based on various news reports and financial blogs, a huge sell orders started flowing into the market by mid-Friday morning, pushing gold futures down US$35/oz in a matter of minutes. By late Friday afternoon, gold was barely clinging to US$1,480. By Monday it already fell by about 14% from last Thursday and almost 30% from its peak in August 2011 at US$1,888/oz, which puts gold in “official” bear market territory. However, the correction is just the beginning.

Where is it heading? On the technical chart perspective, gold could tread water between US$1,350 - US$1,450/oz in the short term. It rebounded to around US$1,379/oz by Wednesday after it fell to a two-year low of US$1,335/oz on Monday. Based on where gold had consolidated immediately before and after the 2008 financial crisis prior its three-year push toward near US$2,000/oz-level, the next support level is between US$1,000 - US$1,100/oz. The crash of the bullion that started last Friday was even cleverly dubbed the “Golden Swan” a misnomer to the “Black Swan” whereby more often than not provides a lifetime buying opportunity for contrarian investors. Given the physical shortage of gold, the sell off may not last long. However, judging by the frenetic two-day selling and a moderate rebound that followed, the downtrend may be around for a while.

Why now? Though there are many theories and possibly genuine reasons behind it the truth is, the market is still puzzled by the sharp correction. This makes it more indomitable for gold to continue its downtrend. Most commonly cited are fears of beleaguered members of euro zone might be forced to sell gold to raise emergency funding, slowing growth in China, further improvement in the U.S. economy, global deflation setting in, aggressive devaluation of the yen, exchange-traded funds liquidation and mysterious hedge funds blowing up from margin calls.

What triggered the sharp correction: General improvement in global risk appetite and the combination of factors given above may have collectively influenced the underlying reason for the crash as gold is seen overvalued. Alternatively, as viewed by gold supporters, the crash was solely attributed to losses of paper gold market as there is actually a shortage of physical gold. Coupled with short selling and advance announcement made by Goldman Sachs in early April that hedge funds and institutional investors would be selling their gold positions, it added fuel to the fire. The brutal selling was in reaction to the fall of a major support area near the US$1,530-1,550/oz-level. This was the level that investors enthusiastically resumed buying every time gold dipped since reaching its peak 2011. Apparently, when this critical support level broke investors panic and sellers took control.

Fear of hyperinflation subsides? Gold is often viewed as a safe store of value when prices are rising. The attraction in gold is largely driven by distrust in the global financial system and its minders: fear hyperinflation in the future - a by-product of quantitative easing (money printing) by central banks. But signs of slowing growth in China, central banks selling gold reserves as well as rising optimism that a U.S. recovery will curb the need for stimulus or quantitative easing suggest that inflationary fears is starting to subside. China’s GDP growth moderated to 7.7% in 1Q13 from 7.9% in the 4Q12. The growth number was higher than the official target for 2013 but much weaker than the 8% most economists were expecting. Another factor that could weaken China’s economy and raised doubts about the health of the global economy include slowing industrial production – slowed to 8.9% in March against economists’ forecasts for a 10% rise. A weak Chinese economy could mean reduced demand for major commodities including crude oil, industrial metals as well as food. This in turn would result in subdued inflationary pressures.

The return of the dollar. It is arguable that gold has no fundamentals in the financial sense: it produces neither cash flows nor issue dividends. With only an intrinsic value, it is only worth what others are willing to pay for it. As fear of inflation seems to be diminishing and after a 13-year run, perhaps it is time for the safe-haven crowd to switch to other assets like bonds and high-yielding stocks. This could herald the return of the U.S. dollar or at least delay the slow-motion process of devaluation. The correlation between gold price and the U.S dollar is relatively high: a negative correlation of 0.63 when compared with the U.S. dollar index. If gold prices decline, it’s almost two out of three probability that the greenback would appreciate. Conversely, against major commodities especially crude oil, gold has a high positive correlation of 0.85. True enough, U.S. crude oil is down nearly 7% since last week, to below US$90/barrel. Even silver dropped more than 10% and aluminium touched 42-month low. This explains why when gold falls the dollar appreciates. At the same time it bodes well for global inflation as all commodities deflate relative to this benchmark.

Better prospects ahead? A stronger greenback may be good for the global economy, at least in the short to medium term as it provides the U.S. economic recovery with an added booster: stronger purchasing power to U.S. consumers and businesses. But it also means the U.S. is once again saddled with its exorbitant privilege and that would slow its recovery in the long term. Nonetheless, as American conservative economist and commentator Larry Kudlow once said, the last time there was a large and sustained decline in the price of gold – in the early 1980s – it was setting the stage for a multi-year economic and equity boom. As the current economic climate is different, Kudlow’s view should be taken with some caution as the global economy and the financial markets is still in the process of healing. However, assuming that we subscribe to the fact that U.S. equity and gold should be negatively correlated, then this is a positive sign for the economy and market.

Impact on the Malaysian economy. A stronger dollar in the short to medium term as well as further improvement in the U.S. economy is expected to boost purchase of Malaysia’s exports and increase FDI flow. In 2012, Malaysia shipped 8.6% of its total exports direct to the U.S. With regards to FDI, total manufacturing investments approved have dwindled substantially last year to just RM295.8m from RM2.5b. With a firmer growth recovery and possibly stronger dollar, U.S. firms may likely increase investments this year. This would further support our view of a stronger economic growth in the 2H13. On the back of improvement in external demand and investments, we project Malaysia’s GDP to expand to 6.0% in the 2H13 from 4.6% in the 1H13. For the whole of 2013, our GDP forecast is 5.3%.

Flows and ringgit outlook. With the expectation of a dollar comeback, the safe-haven crowd would likely gravitate back to U.S. capital markets. This may put the brakes on foreign fund flows into Malaysia in the next six months or so and possibly ease the pressure that has been building up in the bond market over the years. As it is, foreign holdings in debt securities have recently reached record high of RM229b in February (It has eased to RM218.3b in March) with a share of nearly 45% of total Government issued debt. Meanwhile, continued competitive devaluation and quantitative easing by major central banks has resulted in some of its excess liquidity spilling into Malaysia’s shores. With the expectation of positive returns from carry trade as well as capital gain, the torrent of foreign capital inflows has constantly added pressure on the ringgit to appreciate. Since Malaysia’s economic growth is largely dependent on exports, occasional intervention by Bank Negara has kept the ringgit within a competitive band. Since the beginning of the year, the USD/MYR exchange rate has been swinging between 3.02 and 3.13 thanks to both external and domestic factors. With the shift of investments back to U.S. denominated assets along with the uncertainty in the global economy, we expect the ringgit to remain volatile and trade in the range of 3.03 and 3.15 in the next three to six months. On the expectation that the economy is to improve in the 2H13, there is still room for the ringgit to appreciate in tandem with better economic prospects in the region. Hence, our year-end target stays at 2.97.

Source: Kenanga