The Rush to Gold and What it Means
Econominst Nasser Saidi PhD discusses the fluctuating fortunes of Gold and what the future is for the precious Yellow metal
Gold prices had been on the decline since rallying strongly after the financial crisis and peaking above the 1,800-mark in Y 2012. But after touching a 7-year low in early January 2016, it has been moving up, with the Bullion rising by 20% +this year.
Markets, including precious metals, have been volatile over the past year with investors reacting to a multiple risks.
These have included expectations of US Fed rate hikes, a slowdown in growth in emerging markets (the China growth and rebalancing effect), a weaker USD, monetary stimulus for Europe and Japan, the Brexit matter and geopolitical factors including uncertainty about the outcome of US Presidential elections.
The fascination with Gold throughout history has much to do with its near-unique physical properties. It is durable and storable, so is used as a store of value. It is shiny and malleable and hence used in jewelery. It is conductive and hence used in high-end electronics. It is resistant to oxidation, unlike Silver, and is relatively unknown.
These qualities have made it attractive as a store of value and medium of exchange through history.
Indeed, until August 1971 when then President Nixon ended the international convertibility of the USD into Gold, the international monetary system had been tied to Gold.
After that, fiat currencies aka paper money became the norm. But despite the breakdown of the Bretton Woods system (a monetary policy that tied currencies to bullion), Gold remains the main asset of central banks’ reserves, accounting for 75% of US and 57% of Euroarea international reserves.
Many individuals view Gold as a store of value which provides protection when other asset prices are diving. This gives rise to the ‘precautionary demand’ for bullion by central banks, fund managers and individual investors, as opposed to ‘use demand’ by various industries.
Because Gold offers no yield, the lower the actual or expected returns offered by alternative investments such as bonds, the more attractive it looks.
As with all assets and commodities, price fluctuations result from the interaction of the forces of supply and demand. Gold demand recorded a 21% increase Y-Y to 1,290 tonnes in Q-1 of Y 2016, making it the 2nd largest Quarter on record.
The increase was driven by huge inflows into ETFs (exchange-traded funds) 364 tonnes (over 300% Y-Y) driven by concerns about the shifting global economic and financial landscape. This followed 3 Q’s of uninterrupted outflows that led to a sharp decline in prices.
Gold-related ETFs are investment vehicles that account for about a 10% of global demand and are more convenient and less costly than holding physical Gold.
Buying by central banks in the developing world surged in the Q-4 of Y 2015 and remained strong with buyers purchasing 109 tonnes in Q-1 of Y 2016.
Over the long-term, the shift in the world’s economic geography and growing wealth of emerging economies implies a structural change in demand patterns. If prominent emerging markets like China and India increase their gold holdings to the average per capita or per GDP holdings of developed countries, the real price of the precious metal may rise even further from today’s elevated levels.
Indians and the Chinese are the world’s biggest consumers of Gold, buying almost 1,000 tonnes a year and together accounting for almost 50% of global demand for the metal.
Retail buying in these 2 biggest markets starts with the Hindu Diwali festival in late Autumn and ends with the Chinese New Year. On an annual basis, world consumption of newly Gold produced is about 50% in jewelery, 40% in financial investments, and 10% in industry.
Gold demand is much more volatile than supply, which can be newly mined or recycled Gold.
Total supply increased 5% to 1,135 tonnes in Q-1 of Y 2016 but the price of mining Gold fell in recent years due to lower energy costs and higher productivity.
All-in costs of producing an ounce of Gold (excluding exploration and future projects) have fallen some 34% since Y 2012, with the biggest producers increasing the amount of Gold in each tonne of ore by about a 33% last year. Not surprisingly, Bloomberg’s index of 14 major Bullion miners 2X’d this year after diving 76% in the previous 5 years.
Beyond the short-term, three facts emerge clearly from historical experience.
Gold prices tend to rise in conjunction with high-inflation episodes, in times of severe economic downturns and recessions threatening to trigger deflation in times of political and financial crises.
For investors, Gold represents a hedge, a financial safe haven during periods of high and volatile inflation and when the probability of extreme events is perceived to be unusually high.
From Y’s 1975 to 2015, the average real rate of price change for Gold in the United States was 2.8% per year and the standard deviation was 20.3%, whereas the real return on stocks was 8.2% and the standard deviation was 13.6%. Corrected for inflation, the evidence is that stocks outperformed Gold and Silver and were less volatile.
So why would investors want to hold any Gold?
The answer is that returns tend to be negatively correlated with returns on other assets such as stocks, bonds and treasury bills. In addition the empirical evidence is that the correlations of Gold’s real rate of price change with consumption and GDP growth rates are negligible: Gold can act as a hedge against real shocks.
The implication is that it can be useful in diversifying risk in a portfolio of assets. Gold investment acts as a hedge against current and expected future inflation and in periods of uncertainty, wars and market volatility.
For investors, Gold tends to have value mostly during times of great uncertainty, it keeps its value in relative terms as currencies have depreciated and bourses remain stagnant. And unlike other commodities such as Crude Oil, the price of Gold tends to be counter-cyclical, rising in response to negative stock market shocks.
Gold is seen as a safe-haven during bad times. In their paper The Effects of Economic News on Commodity Prices: Is Gold Just Another Commodity, Shaun K. Roache and Marco Rossi write: “Gold prices react to specific scheduled economic announcements in the United States and the Euroarea (such as indicators of activity or interest rate decisions) in a manner consistent with its traditional role as a safe-haven and store-of value.”
When markets are volatile, and investors are feeling fearful, risk-averse in investment parlance, Gold tends to outperform other assets.
Short and medium-term holders can take advantage of the lack of correlation of Gold to other assets to achieve better returns during times of trouble. Long-term holders can manage risk through an allocation to the precious metal, without necessarily sacrificing returns.
For central banks that hold and accumulate it as part of their reserves, returns maximization is not a priority as much as liquidity and safety of assets considerations. But, generally a portfolio with bullion has better risk-return outcomes than one without.
The bottom line is that be it an individual investor or a central bank, the argument is in favor of holding a diversified international portfolio. A portfolio with Gold in the mix would marginally improve the long-term risk adjusted returns and help portfolio returns during periods of high inflation, negative real interest rates, war and declining mining supply.
What is next?
Fed tightening will put bullion under pressure. Higher interest rates increase the opportunity cost of holding Zero-yield assets, meaning the money tied up in bullion could be earning a return if invested in bonds, stocks or other assets.
However, other risks may favor Gold.
Financial crisis legacy issues in advanced economies remain: banks face profitability challenges and weakness in the insurance sector are contributing to increasing systemic risk.
Emerging market economies are facing headwinds of slower growth, weaker commodity prices and tighter credit conditions amid more volatile portfolio flows. In times of slower growth and higher uncertainty, investors may also fear future inflation from monetization of government debt and the large increase in the monetary base in major countries as a result of massive QE (quantitative easing) central bank policies.
Gold may well benefit from greater financial market volatility and risk aversion resulting from the rising economic, financial and political risks.
By Nasser Saidi, PhD is founder and president of Nasser Saidi Associates and former chief economist at Dubai International Financial Centre
Paul Ebeling, Editor