I last blogged on gold in April (see “Golden Rules Gone”), suggesting that the means that had been used to justify continued gains had gone. In other words, gold appeared like the proverbial cartoon character, running in thin air beyond the cliff edge, waiting for gravity to take over. The question to ask now is whether we’ve hit the ground.
Even though gold had the worst quarter for over 80 years, it’s hard to argue that we’re going to see much of a recovery in the second half of the year. For starters, dollar bears are hard to find and with fairly good reason, given the likely divergent policy trends between the US and the other major currencies. This makes it that much harder for dollar based commodities to push higher as they become more expensive in non-dollar terms. Having said that, it certainly doesn’t make it impossible, given the greater volatility in the gold price compared to most major currencies.
Secondly, investment demand for gold has ballooned in recent years. According to the World Gold Council, investment demand has expanded 435% over the past 5 years in value terms (up to 2012). In other words, this has outpaced the gain in price by nearly a factor of five. But what has this been predicated on? Of course, it’s pretty difficult to determine exactly the driving forces behind this, but a fair proportion has been driven by the belief that central bank asset purchases would ultimately be inflationary. With this having proven to be false (strictly, it could have well prevented deflation, rather than stoked inflation), gold has flipped, plummeting even when the pace of central bank balance sheet expansion has increased (largely owing to Japan).
Even more so than was the case back in April, the investment rationale for gold has weakened. In a world of near zero or negative inflation adjusted returns and ample liquidity, there was seen to be little to lose in investing in gold, especially with plenty of stories about monetary debasement from continued central bank money printing. With bond yields rising and inflation remaining low, then the opportunity cost of holding a non-yielding asset has increased substantially. Furthermore, the Fed is subtly signalling a slowing of the pace of bond purchases at a time when inflation expectations are well contained and actually falling on the Fed’s preferred measure, which again provides a bullish dollar against which gold will struggle to outperform.
Underlying this though has been continued strong demand from India and China. Whilst the west has been investing, these nations have been leading the increase in demand for physical gold, jewellery still accounting for nearly 50% of global gold demand. Within this, India and China have accounted for half of the demand over the past 5 years, so far outstripping their 10% share of global output. There are strong cultural reasons why this is the case, but for China especially the case for continuing this pace of purchases has weakened, especially given the latest credit concerns which are likely to remain an underlying problem for China in the coming months.
So what does this mean for the gold price? It’s pretty much impossible to expect the losses of the past 6 months to be regained and the policy/economic backdrop are not likely to provide much support. At the same time, there is every reason to suggest that what we are seeing is the bursting of the gold bubble. The lack of income flow to support a sustainable model of valuation allows for some fairly off the wall reasons for justifying ever higher future prices and mis-guided views about its merit in portfolios. Gold has served to remind us that underlying every bubble is a fundamental, yet fairly simple, inability to properly account for risk. For the remainder of the year, a start to Fed tapering, combined with a stronger dollar, could easily push gold to levels last seen in late 2009.