The prospects for gold

This article, more technical than most of my pieces, discusses the factors driving the gold price. It was first published in this month’s issue of IPE magazine.

Gold probably evokes more passions than any other natural resource or even perhaps any asset class at all. For some it should be seen as more-or-less like any other commodity. From this perspective it can be understood by straightforward reference to the laws of supply and demand. But others argue that gold’s special status as a store of value means it must be considered differently from other investments.

This distinction often overlaps with a fierce disagreement between different schools of economics on the importance of gold. Some fiscal hawks view gold as real money in a world where rampant inflation could render the value of paper or ‘fiat’ money illusory. Others, particularly Keynesians, see such doom-laden ‘goldbuggery’ as absurd.

It is not necessary for practical types like investors to take sides in this debate – but it is worth considering why gold so often polarises people into different camps, as it can yield insights into the commodity’s peculiar features. From there investors can decide whether or not to hold gold in their portfolios and, if so, whether it should be held primarily for return or hedging purposes. Gold can even provide a useful signalling mechanism for those who do not invest in it at all.

The heated differences over gold are at least partly rooted in the special status that governments have often accorded to it. Various countries have at different times pegged their currencies to the value of the precious metal. For instance, when Germany first became a unified nation in 1871 it went on the gold standard. Most other European nations followed its example shortly afterwards and the US joined in 1900. The gold standard ceased to operate in practice during World War I before falling apart completely in the early 1930s. A modified gold standard came into existence again in 1944, under the Bretton Woods Agreement, before collapsing in the early 1970s.

Not that the special role of gold is entirely a thing of the past. Central banks still maintain significant gold reserves with their levels rising in recent years. The US, France, Germany and Italy have over 60% of their reserves in the precious metal according to the World Gold Council, a lobbying organisation for the gold industry. When in mid-April the Central Bank of Cyprus announced plans to sell part of its gold reserves the global price fell sharply shortly afterwards. Although Cyprus’s proposed debt sell-off was relatively small there were fears that other indebted countries might follow suit.

Some countries, such as Iran and Turkey, are promoting an internal monetisation of gold. In Turkey it is possible to deposit gold and withdraw cash or borrow against it. Such actions are partly designed as anti-inflationary measures.

In other countries, most notably India, the public’s distrust of the authorities helps feed its appetite for gold. People hold on to gold jewellery and other forms of physical gold as a way of evading taxes or other forms of financial scrutiny by government. Under such circumstances it is not surprising that Palaniappan Chidambaram, the country’s finance minister, used his February 2013 budget speech to condemn India’s “passion for gold” while announcing measures designed to lure households away from the precious metal.

Another aspect of gold’s special global role relates to its physical properties and the difficulty of its extraction. There is a huge stock of gold relative to the amount of new gold mined each year. Production from mines is running at about 2,700 tonnes per year compared with total above ground stocks of about 174,000 tonnes. The latter figure would only be enough to create a cube of pure gold that measured 20 metres in each direction. In effect the vast majority of gold is recycled rather than created afresh.

It is this restricted supply of gold which helps explain the vociferous arguments between many fiscal hawks and Keynesians on the subject. The attraction of the gold standard to conservatives is precisely that it restricts the amount of money that can be created. From this perspective it limits the ability of governments to debase their currencies or stoke-up inflation.

This effect is compounded because gold has few uses besides its role as money or its decorative function as jewellery. About half of global demand comes from jewellery with 36% in investor demand (including physical gold and exchange-traded funds) and about 4% in net central bank purchases.

Gold does have some uses in dentistry and electronics but unlike with other precious metals its industrial applications are minimal. Technology has only accounted for about 11% of gold demand in recent years. Palladium and platinum, in contrast, have many industrial uses including in catalytic converters in cars. Even silver, which in the past has also been used as a reserve asset, is much more heavily used in practical applications than gold.

That is why investors such as Troy Gayeski, a partner and senior portfolio manager at SkyBridge Capital, like to point out that, “Unlike other metals or commodities, there is no terminal demand driven by economic growth.”

It is also probably why people generally feel that gold does well in times of extreme turbulence while faring badly during periods of smooth growth. High inflation and currency debasement can both favour gold, as can a deflationary environment.

Andrew Milligan, the head of global strategy at Standard Life Investments, says: “I find it useful to think of a ‘smile’ or curve, whereby there is demand for gold when there is a major risk of deflation or inflation but when prices rise slowly then there is little reason to hold gold.”

But that just raises a further question: how can we tell when prices are likely to either rise or fall dramatically?

The answer is not straightforward. Gold rose strongly from 2002 to 2011 without either hyperinflation taking off or the economy collapsing into a deflationary spiral. However, closer inspection shows there was a heavy emphasis on avoiding deflation over much of that period. The stock market crash early in the decade raised deflation fears, as did the crisis of 2007-08.

In addition, Leigh Skene, an associate economist at Lombard Street Research, points out in the middle period there was anxiety over inflation taking off. “Inflation was low, but it more than doubled from late 2003 to 2007 and real interest rates on long-term bonds were falling, both positive for gold,” he says. “However, I think the most important factor was a strongly inflationary psychology due to the soaring house prices.”

CrossBorder Capital, a specialist investment advisory firm, has developed a framework for identifying inflationary and deflationary risks by monitoring global capital flows. Managing director Michael Howell argues that an excessive build up of debt in the public sector tends to be inflationary whereas a surfeit of debt in the private sector tends to be deflationary. He points to Germany in the 1920s and Britain in the 1970s as prime examples of burgeoning public debt leading to rampant inflation. The US in the 1930s and Japan in the 1990s provide exemplars of surging private debt coinciding with deflation.

From this perspective he argues that a declining rate of monetary expansion helps explain why the gold price has tailed off in the last two years. Although the scale of the present round of quantitative easing (QE) in the US sounds large, at $85bn (€64.1bn) per month, its growth rate has fallen considerably.

Private sector liquidity growth has experienced contrasting fortunes recently. In the US it has expanded strongly with signs of economic recovery, while Japanese companies have benefited from the advent of the ‘Abenomics’ stimulus programme. Emerging economies have suffered unusually weak private sector liquidity growth as a result of China’s economic slowdown and the adverse competitive impact of the weaker yen.

Taking all these factors into account Howell concludes that gold is likely to stay within a trading range in 2014, with limited upside potential.

This does not preclude the possibility of high inflation or even hyperinflation over the longer term. The legacy of high public sector debt from the last recession could mean that any future attempts at QE could have damaging consequences. “If you look at the long-run trends and extrapolate it’s not fanciful to say the gold price could get to $3,000 per ounce,” says Howell.

Milligan agrees that high inflation, while not an immediate prospect, could become a threat later. “It is certainly the case that QE policies could eventually backfire, and governments could be forced to create inflation in order to bring fiscal burdens under control.”

At present this may seem academic as mainstream investors tend to avoid gold. Dennis van Ek, a principal and actuary at Mercer, says: “We see gold completely off the radar from regular investment managers.”

In many countries this is for local regulatory reasons. Germany, for instance, bars pension funds from holding physical gold. Other nations have similar bans or use other measures, such as the imposition of VAT, to discourage such holdings. In many other cases investors have presumably either chosen not to invest in it or simply feel they lack the necessary expertise to do so.

However, if the likes of Howell and Milligan are right there could be a reasonable case for holding gold in the medium and longer term. Although there are other tangible assets that can be used as a hedge, such as property, gold comes into its own when economic fears become pronounced