Plenty of shine awaits the yellow metal

Gold remains out of favor with Western investors focused on the prospect of tighter US monetary policy and further dollar strength. But we see scope for a decent recovery in the price of the precious metal over the next year or two, with a target of $1,400 an ounce for the end of 2016.

The recent performance of gold has not been as poor as many of the headlines suggest. It is true, of course, that the current price of about $1,200 per ounce is well below the record high of $1,900 seen briefly in 2011. But the bulk of the fall from that peak was completed by mid-2013. Since then, the price of gold has mostly fluctuated within a range of $1,200 to $1,400.

Looking ahead, the main downside risk for the gold price is that the US Federal Reserve may tighten its monetary policy more aggressively than generally anticipated. We (Capital Economics) forecast the US central bank to start raising interest rates in the first half of next year and perhaps as early as March, which would be much sooner than most experts expect. Other things being equal, higher interest rates should strengthen the dollar, undermine the demand for protection against inflation, and increase the opportunity cost of holding an asset that pays no income - all potential negatives for gold.

Nonetheless, we do not expect these headwinds to be the whole story. For a start, US interest rates are likely to remain relatively low by historical standards. The peak in the next interest rate cycle could be less than 4 percent, a level which previously might have been thought of as a floor for rates. This is unlikely to be a game-changer for the demand for gold.

What's more, a lot of bad news is already reflected in gold prices. Indeed, given the unfavorable market conditions this year, gold has actually held up remarkably well. After all, the US dollar has already appreciated sharply against other currencies, and the Fed has concluded its asset buying under quantitative easing. The collapse in oil prices has dampened fears of inflation. And while global interest rates and bond yields have remained low, the relative appeal of gold has been reduced by the surge in equity prices in major markets, including new highs in the US. Despite all these negatives, the price of gold has repeatedly found strong support at, or slightly below, the $1,200 level.

A number of factors have helped prop up the market. The Bank of Japan has announced additional monetary easing and the European Central Bank is likely to follow. Gold demand has also benefited from geopolitical shocks, notably the crisis in Ukraine, which have underlined its appeal as a safe haven. Central banks have remained net buyers, especially in emerging economies.

On the supply side, industry sources suggest prices have already fallen to levels which are not far above the cost of mining new gold. Admittedly, mining costs could themselves fall because of lower energy prices and efficiency savings, and weak demand could mean that supply is still ample even if some production is cut. But the downside for the gold price from current levels is surely now limited.

As for the upside, there are several positives. Demand from households in emerging economies is likely to strengthen as incomes increase. Gold's safe-haven status could lead to a revival of interest from Western investors in the event of a renewed escalation of the crisis in the eurozone, fresh geopolitical shocks, or any nervousness in equity and bond markets prompted by the Fed's tightening moves.

In the meantime, central banks are set to remain net purchasers. We continue to expect the bulk of official buying to come from developing countries, but would not completely dismiss the prospect of new purchases by the European Central Bank as part of a large-scale programme of QE.

Overall, it seems reasonable to expect gold to retest the upper end of its post-2013 trading range at some point in the next year or two. A rebound to $1,400 would represent a sizeable 17 percent gain from current levels at a time when the valuations of many other assets, notably developed market equities and bonds, are looking increasingly stretched.

The author is head of commodities research at Capital Economics, a London-based independent macroeconomics research company.