Gold Fell Below $1,200: What Led To The Plunge?

Gold prices dropped below the psychological level of $1,200 this week, owing to a stronger dollar, solid momentum in the U.S. manufacturing sector, expectations of higher interest rates in the United States and escalating global trade tensions. The yellow metal has fallen about 8 percent so far this year, primarily weighed down by the U.S. dollar's strength against both developed and emerging market currencies, especially, weakening of the Chinese yuan and Turkish lira.

A Rising Dollar Spells Doom for Gold Prices

The public comment period on the U.S. proposal to impose tariffs on $200 billion or more on Chinese imports is draws to a close on Thursday. Once the deadline is past, the United States could impose tariffs on roughly half of the Chinese goods entering the country, making it the most impactful round of tariffs so far.

Heightened concerns owing to an escalating trade conflict between the world's two largest economies are resulting in investors dumping emerging market currencies and seeking safe haven in dollar. It also got an extra boost from economic data that showed manufacturing growing at its fastest pace in 14 years.

The dollar index, which measures the greenback against a basket of currencies, was up 0.12 percent to 95.56 on Tuesday. Notably, a stronger dollar makes dollar-priced gold costlier for non-U.S. investors.

ISM Manufacturing Index At A 14-Year High

Per the Institute for Supply Management's latest report, manufacturing index advanced to 61.3 percent in August, up from July's 58.1 percent and ahead of the consensus mark of 57.2 percent It also marked its highest level since May 2004, when it clocked in at 61.4.

The manufacturing index shows business conditions in sector and is considered a significant indicator of the overall economic condition in the United States. A reading above 50 is seen as a sign of economic growth. The August PMI indicates growth for the 112th consecutive month in the overall economy and the 24th straight month of growth in the manufacturing sector.

The New Orders Index was at 65.1 percent in August, up from July's reading of 60.2 percent. New orders have witnessed growth for 32 consecutive months. Further, the index has been at or above 60 percent for the 16th straight month. Moreover, ISM's Production Index registered 63.3% percent in August, up from 58.5 percent reported for July, indicating growth in production for the 24th consecutive month.

The manufacturing sector's labor market also observed strong momentum growth in August. The Employment Index increased to 58.5 perent, up from the previous reading of 56.5 percent.

Rate Hike Expectations Triggered: Negative For Gold

Another factor that is working against gold is the prospect of the Fed hiking interest rates this September. A strengthening economy gives the Federal Reserve reason to raise interest rates.

Higher U.S. rates dent the appeal of gold as it does not offer much interest. Consequently, an interest rate hike, which is likely at the Fed's upcoming meeting this month, is likely to weigh further on gold.

Gold Hasn't Totally Lost Its Sheen, Yet

Despite these headwinds, there are other factors that might support gold's performance in 2018.

Production Expected to Rise in 2018: A number of new mines entered production in late 2017, which is likely to support mine production till 2018.

India, China To Help Sustain Demand: Major gold markets, India and China, will continue to be growth drivers. Further, the back half of the year is seasonally strong in India due to the festive and wedding season buying. The Indian government also announced measures to bolster rural incomes, including higher minimum support prices and an increase agricultural credit. This along with normal monsoon bodes well the rural sector which is an important consumer for the gold industry. Moreover, the United States continues to be a strong market driven by economic growth, improving employment levels and growth in consumer confidence.

Lower Costs for miners: Over the past few years, gold miners have cut costs, checked capital expenditures, improved recovery efficiency within existing mines, paid down debt, eliminated non-core assets and focused on their highest ore-grade assets. These endeavors have helped lower the all-in sustaining costs for miners. Consequently, most gold mining stocks could be profitable even if spot gold prices were significantly lower.

Valuation is Inexpensive: The Zacks Mining – Gold Industry has underperformed both the S&P 500 and its own sector year-to-date. The industry has declined 23 percent.

However, the valuation appears cheap now. One might get a good sense of the industry's relative valuation by looking at its Enterprise Value to Earnings before Interest Depreciation and Amortization (EV/EBITDA). This valuation is a good measure for the industry's given its complicated and capital-intensive nature.

The industry currently has a trailing 12-month EV/EBITDA ratio of 6.8, which looks inexpensive when compared with the market at large, as the trailing 12-month EV/EBITDA ratio for the S&P 500 is 11.9.

A comparison of the group's EV/EBITDA ratio with that of its broader sector ensures that the group is trading at a decent discount. The Zacks Basic Material Sector's trailing 12-month EV/EBITDA ratio of 8.03 is way above the Zacks Mining – Gold Industry's EV/EBITDA ratio of 6.8.

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