Commodity Focus: Gold
Gold - a shiny, naturally scarce metal, which is highly valued by society, and has been traded for millennia. Its main use is in jewellery – in fact, jewellery accounted for roughly 50 per cent (usually higher) of total gold demand in 2019. However, it is also used in technology and investment. Geographically, overall demand is mostly consolidated between China and India (28 per cent and 23 per cent last year respectively; over 50 per cent of consumption combined). To elaborate, Europe and the Americas (USA, Canada, Mexico, and Brazil) consumed 14.4 per cent altogether, down from 21.4 per cent in 2010. Most of the gold, as well as its industrial value, lies in the jewellery sector in Asia (between India and China). Supply side (tonnes) - around 73 per cent of gold comes from mine production, the rest being from recycled gold, and some from producer hedging. Around a quarter is used in investments, with nine per cent being traded in increasingly popular ETFs (Exchange Traded Funds).
ETFs offer investors exposure to a basket of tradable companies via shares. Simply put, ETFs offer investors a return from a basket of shares (or other assets) that matches the return of a benchmarked asset. ETFs are said to track their benchmark (e.g. tracking the FTSE 100 or the price of gold) meaning a five per cent return on the FTSE 100 should be matched by a 5 per cent return on an ETF tracking the FTSE 100. More will be covered on ETFs in a future article dedicated to them, but for now, know that gold ETFs are extremely popular. Gold ETFs can be physically backed (hold physical gold), purely derivative, or a mixture of both – the biggest gold ETFs are physically backed.
Gold can be used as a hedging instrument, an investment vehicle, and sometimes as collateral in financial contracts. The interest in gold took off after the 1970s, when the gold standard was completely abandoned (after becoming disused since 1930 – the price of gold dropped 65 per cent until 1970 to $240 per troy ounce ($1,599 in 2019 adjusted for inflation)). From 1970, the price of gold became free floating, and since then, it has oscillated between $400 and $2200.
Rally to the Safe-Havens
India and China’s recent economic contractions have greatly deprived the jewellery sector of business (down a further 46 per cent annually in H1 2019 from 2018). Additionally, since 2010, total gold supply has increased by roughly 12 per cent, with a 28 per cent increase in production, but demand for gold has increased by only around 5 per cent. Taking only this into consideration, one would expect the price of gold to have fallen. Nevertheless, the price of gold has skyrocketed to recent record highs. Why has the price of gold increased in the last months?
Although gold is regularly bought for portfolio diversification, the recent price rally is a result of purchasing gold as a safe-haven asset. Gold is considered a safe-haven asset because of its natural scarcity and consistent industrial demand, contributing to its high intrinsic value. Consequently, gold maintains value better than most other assets, so during times of economic contraction and uncertainty, investors (mainly financial institutions) increase their (proportion of) gold holdings, hoping that the precious metal will sustain returns that outweigh depreciating stock returns. Given the macroeconomic conditions we are currently faced with, the investment demand for gold, particularly in gold ETFs, has recently seen record inflows as agents attempt to reduce their losses from other markets.
Gold is bought more when the price is low/falling and less when the price is high/increasing – it is liquidated in times of need. The low demand level in 2010 was due to the investment in gold (during the financial crisis) prior to that time driving the price up. Shortly after 2010, institutions recouped losses and funded expenditure through gold sales, which drove the price down. I calculated some correlations below (between demand and prices) that support this logic (2010 to 2020).
As aforementioned, this price increase is due to Gold ETF inflows, justified by the historic performance of gold during recessive economic climates. My calculations found that investments have strong positive correlation with price changes, ETFs having a disproportionately higher correlation. This supports the notion that investment demand is the main driver of the gold price. Analysing the ETF flow chart, you can see positive ETF flows match price increases in gold with negative flows reducing the price.
Has Demand for Gold Gone Too Far?
Let’s break it down once more – investors buy gold in tough times expecting to hedge against inflation and curency depreciations, and to reduce the erosion of profits and wealth caused by recessions - a behaviour that has been observed in the past. Covid-19 has increased uncertainty and decreased future economic expectations greatly – we are likely going to be faced with a recession, hence investors are quick to invest in gold. As a result, demand has increased and the price has been forced upwards. The gold price hit a record high of $2,070 last week, which is a standout price rally unseen in the past 40 years. More investors are jumping on the bandwagon, and following the trend. However, is this price rise sustainable?
Nowadays, the financial markets have really opened up, expanding to allow more retail investing, with passive investments surging. A concern in the stock markets is that passive inflows are algorithmycially reallocated to few blue chip assets that ultimately carry the weight of very large indices (thousands of other stocks). This increases systematic risk exposure by having fewer big players denominating the overall market performance. As passive investment fuels into the same handful of assets, without fundamental justification, index price rises become second nature and inefficient, posing a greater risk for losses when market pricing becomes efficient. Perhaps the same risk applies for gold with passive investments disporportionately driving the price up to harder levels to maintain.
What is clear is that the price increase is leading to greater investment demand, which ultimately creates a self-fulfilling loop driving the price up. Does the historical performance of gold in times of crisis truly warrant its current rise and lofty forecasts of $2600 - $3000 in the next twelve months?
In my opinion: no - but I wouldn’t be surprised if it did continue to rise. However, staying up there is a different question. The diagram below illustrates how ETF demand has helped to prevent the fall in gold price, but the purchasing of gold is being fuelled from previous gains and debt – this fuel is driving the price up but is being depleted - companies will have to refuel soon and this will likely be through gold sales, capturing the investment gains and ensuing a small glut and price drop.
Gold ETFs hold lots of physical gold and trade some shares. The majority of their value is simply based on how much gold is in their vaults. Gold is certainly being utilised heavily right now as a safe-haven asset but, as in previous safe-haven rallies, they are short-lived with divestment coming quicker than the initial investment.
Gold right now is being bought for one simple reason – other people are also buying gold. It is not being driven by fundamentals - suggesting gold’s rally is unsustainable - once enough gains are made, and institutions close out their holdings for profit, the rally will reverse. Having said this, in the short-term, the price of gold will continue to increase as institutions restructure their portfolio away from riskier stocks during the economic downturn and look towards safer options. However, with an economic recovery expected soon (post vaccination - expected late this year), the bullish sentiment in gold will reverse as negative ETF demand (sale/shorting of gold) increases. In the long-term, it is more uncertain as gold’s price and demand will depend on the rate of recovery of the jewellery and technology sectors.
Some people, like Dominic Frisby suggest “the fundamentals for gold don’t need spelling out. There’s social unrest. Negative real interest rates. A looming Cold War with China. Economic depression. But above all, money is being printed like there’s no tomorrow.” These provide some reasons for increasing safe-haven investment demand over the next few years; in my opinion, they are proxies to the fundamentals, not actual fundamentals, but they're sensible observations.
In conclusion, the price rally should be short lived (less than two years) following expected low real interest rates, low USD valuation, and inflation (resulting from fiscal stimulus). With the economic recovery looming, the longer-term sees gold prices returning to around above pre-covid19 levels. The very long-term is always unprecedented so there is never certainty, however gold will likely continue increasing in price, especially with the economic growth of India and China contributing to higher gold demand, as well as demand growth picking up the Middle East.