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Gold or Not to Gold – Part 1

Updated: Dec 6, 2019


Gold or Not to Gold – Part 1

Gold has been investors’ favorite hedging instruments. Investors usually allocate 2%-10% of their portfolio in gold or gold linked instruments, depending upon their portfolio distribution[i]. Gold is generally believed to be an inflation hedge, as it cannot be ‘printed’ unlike money circulating in the market. And yet, while we had noticeable inflation over past four years, gold has lost its luster by more than a third. There is a fear that it will further drop as Fed hikes interest rates.

And that would make an investor wonder- to Gold or Not to Gold?

To get the answer, we need to look at the fundamental and technical analysis in gold – How the supply and demand in gold market is, who the key players are, where the price is coming from and where it could go.

Let’s first look at what has been driving prices of gold over past four to five years. After financial crisis in 2008, worldwide markets had been butchered, job losses and unemployment rates were high and investors’faith in economy was very low. Real estate went spinning down, shattering investors’ belief that real estate assets always appreciate over time. Not surprisingly, shaken and burnt investors took refuge in gold. As a result, gold prices shot up from below $1000/ozin 2008 to $1900/oz in early 2011.

However over past four years we have seen gradual decline in gold prices (in US$). Low inflation and increased job market in the US pushed unemployment down, and that reflected in the stock market. From late 2011, US equity market resumed its rally and soon broke all-time high. As Euro and Japanese Yen continue to weaken due to loose monetary policies from respective central banks, US$ gains strength. Stronger US$ also means reduced US trade deficit- as it costs less to import to the USA. Gold is inversely correlated with US $ index as well as trade balance, and gets weakened by strengthening dollar[ii]. The real interest rate (interest rates adjusted for inflation) that were close to -4.0% in 2011 have been rising since[iii], and are expected to go higher with Fed increasing interest rates during 2016.

Fig. 1: Gold prices and US Real Interest Rate

Fig. 2: Gold prices and US Trade Deficit

As far as the global demand and supply goes – we see a few interesting facts. While the demand for gold and gold backed securities has been steady over past few quarters. That includes gold demand for jewelry, investment in bars/coins, investment through ETFs and similar securities, gold usage in technology and holding by institutions and central banks. There has been significant increase in gold buying from China and India, and they together constitute more than half of global demand in Jewelry, Bar and Coin investments. Following chart shows global demand trend across different categories.

Fig. 3: Global gold demand trend by category

On the supply side, the total supply – which mainly consists of mining output and recycled gold – is more or less flat. Gold mine production has been increasing steadily, and is bringing fresh supply to the market. It may have possibly contributed to drop in gold prices over past few quarters.

Fig. 4: Gold mining output

All these fundamental factors have eased investors’ risk appetite, and they have moved to other asset classes giving higher returns (e.g. equities, emerging markets, real estate). They explain why prices have gone up and now are coming down. The question is – what next? Where would the gold price be going in near and long term future?

While we saw that the gold mining output was increasing, it is expected to flatten out in 2015[iv], and possibly fall thereafter. While the prices of gold have fallen significantly, the costs are likely to increase as high yielding ore is extracted from the mines first[v]. As a result, the key gold mining companies are less inclined to invest into new gold fields, and a new gold field would take 10 years or more to bring its supply into market. This is a good news for gold investors from long term perspective.

There are other signs why demand for gold may increase. Some of that is technical, other is fundamental. We shall discuss that in the next part.

References

[i] World Gold Council (www.gold.org)

[ii]US trade deficit down, takes gold down with it (http://marketrealist.com/2015/02/us-trade-deficit-takes-gld/)

[iii]What rising US real interest rates mean for gold investors (http://marketrealist.com/2015/02/rising-us-real-interest-rates-mean-gold-investors/)

[iv] World Gold Council – Demand Outlook Q1 2015

[v]If gold mine production slows, could GLD investors benefit? (http://marketrealist.com/2015/02/gold-mine-production-slows-gld-investors-benefit/)

#GOLD