Golden wonder

Market commentators were as surprised as they were delighted to see the gold price hit $1,387 last month. But is the surge simply the result of fear in a financial crisis, and are the optimists justified in looking for further gains? Tomas Hirst reports.

“Developing markets have been buying gold for the last decade but the big change now is that Europe is not selling anymore,” says Raw. “The key thing is not that developing markets have fallen in love with gold but that they’ve fallen out of love with other ­currencies.”

With the Federal Reserve set to undertake as much as $600 billion (£237 billion) of additional quantitative easing, many central banks with high exposure to the dollar have taken the opportunity to reduce the possible risk. In July, South Korea gave a strong hint that it would buy gold for the first time in 11 years.

An official from the Bank of Korea was quoted as saying that the bank had “closely watched central banks in other nations and trends in the global gold market” in formulating its plan to manage the country’s foreign exchange reserves, the sixth largest reserve pool in the world.

”It seems likely that central banks will remain large net buyers of gold for the foreseeable future”

Although to an extent the statement is anecdotal, the possibility of a major economy reversing its stance on gold would surely be supportive to the value of the commodity. It is, at the very least, an example that highlights the general tone of uncertainty in global markets towards further monetary easing and the growing wariness of central banks towards one another.

Central banks, however, are not the only demand-side pressure that the gold market has been receiving over the past decade. Having only shifted from the supply to the demand side of the equation in the past couple of years, they were hardly in a position to be supportive to gold prices earlier in the new millennium.

At the start of last decade, jewellery made up about 80% of total demand for gold. Last year investment demand matched jewellery demand at about 35-40% of the market, illustrating the extent to which it is seizing the position of jewellery as the key driver of spot prices.

Much of this rise has been attributed to the advent of Exchange Traded Funds (ETFs), which have allowed investors to gain exposure to the physical commodity without having to take delivery of it. In effect it has allowed those outside the high-net-worth bracket to buy and sell gold much as though they would any other asset.

GFMS figures suggest that net world investment in gold almost doubled in 2009 to more than 1,900 tonnes, with an approximate value of $60 billion. ETFs showed a 617-tonne increase between December 31, 2008 and December 31, 2009, as retail investment surged to more than 400 tonnes from less than 50 tonnes in 2007.

Raw says that physically backed ETFs can have influence over the spot price as they remove supply from the market. Given the pace of growth in demand for these products, the price moves could be sizeable.

While there can be little doubt about the increasing scale of the market, the extent to which these types of products have an impact on long-term prices has been brought into question.

Joshua Crumb, an analyst at Goldman Sachs investment bank, produced a report last month suggesting that any impression ETFs make on the spot price of a commodity is likely to be short-lived.

“Ultimately, we don’t believe that these products will impact the market beyond the short term,” he wrote. “Specifically, even if an ETF were to buy sufficient material to drive a market into shortage, it would then shift the forward curve into backwardation and there would be an arbitrage to sell the storage-paying ETF and buy lower- priced futures, thus releasing the material right back into the market to ease the shortage. We believe such a product would have to assume a large degree of irrational investor bias to ultimately disrupt the market and create significant ’new demand’.”

Given the attacks on the Efficient-market Hypothesis in recent years, behavioural economists might suggest that factoring irrational behaviour into an investment model is fundamental to its success.

Furthermore, in current market conditions there is also an argument that gold ETFs are not being used as strategic short-term investments but as part of a broader portfolio diversifi­cation push. Daniel Wills, a senior analyst at ETF Securities, says that while the physical holdings in his firm’s products have not had a strong correlation to the spot price, this does not ­necessarily mean that investments of this type are short-term in nature.

“While the trend for both spot prices and gold ETF/ETC holdings has been up, holding accumulation has not necessarily been closely associated with spot price movements,” he says. “This suggests a significant uptake from long- term strategic investors over an extended period, possibly mirroring the broader move towards investors looking at alternative asset classes such as commodities for portfolio diversification.”

”Gold’s greatest store of value is that it sits outside the influence of politicians and monetary policymakers alike”

Even these notes of caution have failed to dampen the enthusiasm of the gold bugs. They will often point to 1980 when the price peaked at $850 an ounce – or about $2,250 in inflation-adjusted terms – as evidence that the current price could still be far from its ceiling.

Of course, the statistics ignore the fact that the 1980 peak came as a direct consequence of a period of high ­inflation caused by strong oil prices, Soviet intervention in Afghanistan and the impact of the Iranian revolution, which prompted investors to move wholesale into the metal. It also preceded a sharp drop in value, with gold sliding from $850 to $260 an ounce over the next two decades.

That is not to make a case for a similar scenario this time, only to point out the inappropriateness of the comparison. As suggested above, there are a number of technical as well as macroeconomic and political factors that have contributed to the present rally.

So what could stall the seemingly inexorable rise of gold to new record highs? There is some irony from an investment perspective that a global recovery with strongly trending equity markets and robust economic growth could derail the performance of an asset. But this has invariably proved to be the case with gold as the properties of the metal as a safe haven become outweighed by the prospects of greater gains elsewhere.

Though there are few brave enough to state with any confidence when an economic turnaround may take place, the underlying assumption across markets is that whether it takes months or years a robust recovery will take hold. Given their record in such a situation, gold prices could be seen as vulnerable, particularly from a sudden retreat in ETF commodity investment.

More significantly, there is the more tangible threat of monetary easing causing an inflation spike either through feeding into broad money supply or being imported via higher commodity prices from developing economies. Interestingly, despite frequent claims that gold is a hedge against inflation, historical data shows that during periods of high inflation gold has performed relatively poorly.

“Gold actually doesn’t do well when you’re in an inflationary environment as long as the market believes that it is controlled inflation,” says Raw. “Where it outperforms is during per­iods of uncertainty.”

If there were a pick-up in inflation, history suggests that commodities such as crude oil would benefit while gold suffers. This is because oil has a direct exposure to the domestic market, whereas gold is not consumed in the same way – it is used as a store of value rather than a raw material.

So we are dragged back to the words of Morgan. Is gold the only real store of value in an uncertain world?

The answer all depends upon a general appreciation of the fiat economy, and indeed of the gold standard. The supposed advantage of the gold standard was that it was a method of ensuring long-term price stability, a guard against hyperinflation and economic mismanagement. If money supply was linked to gold holdings, aggressively expanding the amount of currency in circulation would have been unthinkable.

In practice, the fact that gold production has failed to increase for almost a decade would have almost assured a prolonged period of deflation or economic stagnation. As Ben Bernanke, the chairman of the Federal Reserve and scholar of the Great Depression, would no doubt acknowledge, it was only after America abandoned the gold standard in 1933 that the country managed to drag itself out of its economic slump.

Gold, then, is not in truth “money” in any meaningful sense but a rare and tradable commodity that is seen as detached from the whim of any one government’s policies. Its greatest store of value is that it sits outside the influence of politicians and monetary policymakers alike, and so is more difficult to manipulate than national currencies and buffered against policy mis-steps.

The resurgent interest from central banks might suggest that the dominance of the dollar that has endured since the Bretton Woods agreement to regulate international monetary policy was signed in 1944 may be starting to wane. If the gold price drives upwards during per­iods of uncertainty, its fuel is the breakdown of trust in international markets. This may be a lasting legacy of the financial crisis and could hasten the rise of competitors to the dollar for global reserve currency ­status, but at present this appears hypothetical.

If the debate, however, is whether there is a further leg-up for gold from its current level, the fact that technical factors on both the supply and demand sides of the equation seem supportive should be a cause for optimism. How far and at what pace this will go is contingent on a huge number of factors that could each derail the rally over the medium to long term.

As a diversification tool, therefore, gold has proved its worth during difficult market conditions, but investors should perhaps be cautious over making large strategic bets on the asset class. The gold bugs may be singing loudest but fear can prove a difficult theme to play.