Behind the significant fluctuations in gold, where is the next stop for cyclical investing?

In the last week of March, the gold market saw an unusual drop.

On March 23, domestic gold prices fell below the 1,000 yuan per gram mark. By market close that afternoon, the Shanghai Gold main contract fell 8.62%, closing at 940 yuan per gram. International gold prices dropped sharply and successively lost multiple key levels. Spot gold fell a total of 10.52% last week, marking the largest single-week decline since March 1983.

The mainstream explanations for this round of gold selloff point to the Fed’s latest remarks. On March 19, the Fed announced it would keep the target range for the federal funds rate unchanged at 3.5% to 3.75%, in line with broad market expectations. This was the second consecutive time this year that the Fed chose to “hold steady” in its rate decision. Fed Chair Jerome Powell said that higher energy prices will raise overall inflation in the short term, but it is still too early to judge the scope and duration of how the Middle East situation will affect the U.S. economy.

Market participants interpreted this as a “hawkish pause”—with rising oil prices pushing inflation up, rate-cut expectations cooling further, U.S. Treasury yields and the U.S. dollar index rising in tandem, and thus gold coming under pressure. But Eastspring’s equity investments department fund manager Gao Xiang offered a different view. He told reporters, “We remain long-term optimistic about gold. The current decline has shown signs of slowing.”

Gao Xiang’s view on gold stems from his understanding of the macro framework. “For gold, we mainly follow a three-factor framework. In the short term, we look at risk-off sentiment; in the medium term, actual interest rates; and in the long term, U.S. dollar credit. After 2022, falling U.S. dollar credit dominated gold’s long-term performance. Central bank gold purchases became the main logic behind gold’s rise. Gold prices even at one point moved away from the actual interest-rate framework, but we believe the question of whether the actual interest-rate framework has failed depends on differences in the time horizon people are looking at. Falling U.S. dollar credit remains the big trend for gold in a long-cycle dimension, but in the medium term, the analytical framework for actual interest rates is still valid.” He said.

Put simply, nominal interest rates minus inflation expectations equals actual interest rates. If actual interest rates fall, gold rises; if actual interest rates rise, gold falls. He further broke down what makes up nominal interest rates: “Nominal interest rates include short-end rates and expectations for economic growth. The short-end rates are controlled by the Fed. Everyone believes that inflation expectations rising led the Fed’s stance to shift from rate cuts to rate hikes. The huge transition from rate cuts to rate hikes ultimately drove actual interest rates up significantly, thereby suppressing gold.”

Gao Xiang believes, “In the short term, the market is trading the Fed’s change in stance, and due to various liquidity reasons, the market has sold off gold. But when you look at a longer horizon, this is actually a relatively good time to add to gold positions, because the underlying logic has not changed. Actual interest rates = nominal interest rates − inflation expectations. When inflation expectations rise, policy interest rates move up. But inflation expectations should rise faster than policy interest rates because inflation expectations are the cause, while policy interest rates are the result.”

Based on his reasoning, actual interest rates should decline over the medium-term horizon. In summary, in the short term, the market hasn’t “got it wrong”—it is just trading today’s policy reaction. Looking to the medium term, the market may revert back to the underlying framework. This path of “holding up inflation with nominal interest rates” may be hard to sustain. From historical experience, such situations typically lead to two outcomes: when the economy can’t withstand high interest rates → enters a recession → nominal interest rates come under pressure and move down → actual interest rates fall → gold benefits; or inflation truly gets out of control → the increase in nominal interest rates falls short of inflation → actual interest rates turn negative → gold rallies sharply. No matter which path it ultimately takes, it usually points to a fall in actual interest rates and a rise in gold. The current situation can be understood as a distorted行情 in which the market is experiencing a period of “the Fed forcing it through” until it reaches this final direction.

Gao Xiang and his team reviewed two oil crises from the 1970s. “During the second oil crisis, oil rose from $20 per barrel to $40 per barrel, doubling. But gold prices rose from $500 per ounce to a peak around $800 per ounce—roughly still moving upward along with oil prices. If we look at that period on a six-month horizon back then, gold was rising along with CPI expectations and the expectations for oil to rise.” That is also why he and his team remain long-term optimistic about gold.

After the Russia-Ukraine conflict broke out in February 2022, gold prices surged within half a month. But since the outbreak of the Iran-U.S. conflict (U.S.-Iran conflict) and related conflicts, oil and the U.S. dollar have surged while gold has fallen consecutively. Qiu Rui, Senior Deputy Director of Research and Development at Orient Securities? (Dongfang Jincheng), analyzed that gold prices are falling mainly because “the interest-rate logic is significantly suppressing the safe-haven logic.” Gu Fengda, Chief Analyst at Guotai Futures, believed the main reason is that the market’s trading main line has shifted. He also said that the core contradiction in the current market has moved from “geopolitical safe-haven” to “inflation expectations versus monetary policy game.” These views represent relatively mainstream judgments in today’s market.

Gao Xiang conceded that “this round of pullback control is indeed facing considerable challenges. At market cycle peaks, it often corresponds to when people are most optimistic about industry trends. People think gold will rise even higher, and taking safe-haven actions at that level really requires mastering one’s mindset.”

Gao Xiang believes that, from a big-picture macro cycle perspective, demand is still affected by multiple factors such as the macro environment, geopolitics, and industry trends, making it highly uncertain. Meanwhile, supply has relatively stronger certainty and can be deepened gradually through research. Therefore, supply remains the most important variable in current investing. “If a commodity has clear supply constraints, we will pay relatively high attention.”

He believes that the ultimate impact of supply constraints is reflected in two aspects: “First, it provides a safety margin for the commodity price. Second, when there is a gap between supply and demand, it can provide enough room for price increases.”

“Supply constraints are reflected when demand surges: if the supply growth rate is clearly slower than the demand growth rate, then the commodity price can keep rising until the gap disappears.” Gao Xiang explained.

In addition, at the level of stock selection, Gao Xiang shared two key observation points for cyclical products.

For cyclical products that keep falling, consider a company’s reset cost. He used mining companies as an example: “Reset cost is the mines that the company owns. We will consider: if we put these mines into the primary market and buy them, how much would that be worth? Compared with the current market value, is it overvalued or undervalued?” In 2023, during the copper price downturn, Gao Xiang used reset cost to measure the company’s safety margin rather than relying simply on valuation and other factors.

For cyclical products that keep rising, focus on the company’s future volume growth and the certainty of that growth. He mentioned an experience researching a specific gold stock. “The company’s future volume growth is still quite strong and sustained. Because through on-site research, we found that the volume of its future mines will remain in a continuous growth state.”

Beyond gold, electrolytic aluminum is another key area Gao Xiang has been focusing on recently. His assessment of electrolytic aluminum is also based on supply constraints.

“The most important resource attribute of electrolytic aluminum is not the mine, but electricity. Domestic electrolytic aluminum production capacity has a ceiling of about 45 million tons, and overseas wants to expand, but the global power shortage problem is very obvious.” Gao Xiang explained.

In a recent research report, China International Capital Corporation (CICC) pointed out that if the Iran-U.S. conflict lasts relatively longer, the impact on the Middle East aluminum industry chain and the global aluminum supply chain may increase. The Middle East region’s electrolytic aluminum production capacity, accounting for 9% globally, faces the risk of power supply interruptions. The region’s dependence on external sources for alumina is 68%. In addition, GF Futures also added that as Middle East conflict intensifies, Qatar Aluminum announced a 40% production cut, Bahrain Aluminum announced a 19% reduction, and on top of that, a Mozambique aluminum plant has shifted to maintenance shutdown; the total supply contraction has already exceeded one million tons. If the Strait of Hormuz blockade continues, it is expected that at least 0.5 million tons of production capacity in the Middle East will still face the risk of passive production cuts.

According to related research data cited by Eastspring Fund, by 2030 the electricity consumption of global data centers is expected to be comparable to the electricity consumption of the electrolytic aluminum industry. Whether this trend is accurate still needs time to verify, but at least it provides a new perspective for observing supply constraints—electricity.

“The issue of a global power shortage is very important, and right now electricity itself is also being squeezed by new demand such as AI power-compute infrastructure. So building electrolytic aluminum plants overseas is comparatively difficult. The bottleneck is electricity. Therefore, in a global power-shortage context, electrolytic aluminum is also an industry with very strong supply constraints.” Gao Xiang said.

Chemicals is another direction Gao Xiang has been focusing on recently. After the chemical industry went through four years of a “cyclical winter,” it is becoming an area that some fund managers are paying attention to. CEB? China? (China?) (Industrial?—listed entity) (China? Securities) said that expansion in this round for the chemical industry is nearing its end, and measures like “anti-overcompetition” (反内卷) may catalyze a recovery in the industry’s earnings trough.

Gao Xiang’s layout in chemicals also follows the supply framework, but he believes chemicals and non-ferrous metals have fundamental differences. Supply in non-ferrous metals is “rigid.” Once a gap appears, it takes years to fill. Meanwhile, supply in chemicals is “fragile.” When demand recovers, supply can be released quickly. But because it has already fallen enough, the upside explosive power when chemical product prices rise is stronger.

“Different from non-ferrous metals, the investment logic for chemicals is that the supply duration is different.” He gave an example: copper mines take about 8–10 years to extract. The duration mismatch is very long. But when demand for chemicals improves, supply may be released in as little as half a year.

This difference in duration determines the differences in investment strategy. “Non-ferrous metals have already risen for three years, but chemicals haven’t. Yet chemicals could possibly finish rising within a year, precisely because its supply duration is different.” Gao Xiang therefore also believes, “Now should be an important time point to focus on chemicals.”

Applied to specific investments, Gao Xiang currently, within the cyclical sector, is more focused on investment opportunities related to chemical products, especially oil-related assets within them. In addition, he is also watching sub-sectors such as potash fertilizers and refrigerants.

For individual investors, Gao Xiang advises, “For a cyclical style, when it rises you need to consider whether to reduce holdings. When it falls, reassess whether there is an opportunity to buy. If individual investors find it hard to grasp the timing, dollar-cost averaging may be a more稳妥方式.”

In his view, the investment logic differences across different assets are huge. “For technology-type assets, the investment logic is different—it may place more emphasis on the continuity of industry trends, and the higher it goes, the stronger the sense of potential upside space may be. The characteristics of cyclical products mean they can’t keep rising one-directionally like some growth tracks; stage-by-stage fluctuations are normal.”