The yellow metals has for millennia played a curious, semi-mythical role in human culture. In particular, times of economic anxiety have tended to trigger an almost primeval rush for gold as the ‘ultimate store of value,’ one of the few reliable hedges against chaos and uncertainty.
Having effectively served as the lynchpin of the postwar Bretton Woods system of exchange rates, gold has experienced extraordinary volatility during the past four decades. But the wild swings have concealed one consistent theme. Whenever economic and political anxiety has mounted, gold has gained favor. When investors have had confidence in the economic actions of governments, the role of the yellow metal has tended to become secondary.
In practice, after President Richard Nixon declared the end of the Bretton Woods era in 1971, gold has experienced two extraordinary bull runs. The first one took place in the 1970s – a decade marked by the oil crisis, rampant inflation, and global political tensions – and peaked in 1980 at a per ounce price of USD895, which in inflation-adjusted terms is still the all-time record and roughly double the current price.
The return to fiscal monetary orthodoxy, heralded by the elections of Margaret Thatcher and Ronald Reagan, soon restored investors’ faith in paper money and their governments’ economic strategy. The mood once again begun to swing in the opposite direction as a new century dawned. A cluster of risks – the dot.com bust, Y2K, 9/11, and the onset of the Afghanistan and Iraq wars – paved way to a period of growing macroeconomic instability.
In order to manage the risks, central banks aggressively cut interest rates, creating a negative interest rate environment in many economies. The era of fiscal consolidation in the US and elsewhere gave way to renewed deficit spending and fears of fiscal unsustainability. Investors looking for higher returns outside of low-risk assets began to generate bubbles in a large number of assets, most notably property, equities, and commodities. Suddenly, it seemed as if the old rules no longer applied and many more cautiously inclined investors began to seek safety in gold.
Even though aggressive stimulus spending and zero interest rates led to a sharp recovery in asset prices last year, questions are once again being asked about sustainability as the stimulus effect begins to wane and many of the structural problems remain largely unchanged. Even if newspaper headlines in recent weeks have been dominated by vows of fiscal consolidation, there is a high probability that, faced with renewed economic weakness, Western governments will once again seek to address the persistent structural pressures through countercyclical stimulus spending. In all probability, the only politically and economically (from the perspective of financial markets) acceptable and feasible way of doing this involves a major element of quantitative easing.
Given the high level of uncertainty facing the global economy, gold is unlikely to lose its safe-haven status any time soon. However, it remains highly sensitive to swings in investor sentiment, given the relatively small size of the market. The global stock of processed gold is estimated at some 160,000 metric tons. This is currently rising at an annual rate of some 2,500 tons, or roughly 1.56 per cent.
Some relief has recently been provided by the growing supply of scrap – effectively recycled – gold which now accounts for roughly one-third of the new supply. In spite of this, however, the supply of gold is failing to keep up with demand. Many of the traditionally dominant producer nations have been struggling to maintain their production levels and there are widespread concerns about a structural tightening in the gold market.
Even as the supply situation grows more challenging, the increasing popularity of gold investments is tightening the demand side as well. Moreover, while the general interest in the yellow metal has risen, it has also become easier to invest in. Products such as exchange traded funds (ETFs) have made is increasingly easy for individuals and institutions to invest in gold in liquid and flexible ways that do not necessitate storage costs. ETF gold holdings are estimated to have grown from less than 500 tons in 2005 to over 1,800 tons now. Also traditional jewelry demand is showing signs of becoming less price-sensitive as more and more consumers recognize that high prices may be here to stay.
Another important structural shift in the gold market has to do with the growing activism of central banks. Having been net sellers of gold for some two decades, at least at times seemingly in a deliberate bid to stabilize the price, they have once again re-entered the market as buyers with key emerging markets leading the way. India bought 200 tonnes from the IMF last year and gold now accounts for 6 per cent of its reserves, still far short of the 20 per cent recorded in 1994.
China’s gold reserves are estimated to have risen from 600 to 1,054 tons over the past five years. The World Gold Council recently stated that SAMA holds more than twice the amount of gold previously thought: 322.9 tons, or 2.8 per cent of its total reserves. By contrast, European central banks have begun to use their gold holdings to raise cash with the Bank for International Settlements. The BIS is reported to have accepted 346 tons of gold in exchange for foreign currency swaps during the financial year ending on 31 March.
Under the circumstances, a growing number of analysts have been adjusting their gold price projections up. There are widespread expectations of gold hitting USD1,500 an ounce this year and potentially rising further towards $2,000. Nonetheless, even though gold seems to be amidst a major upward cycle, there is a high probability of at least short-term corrections. The gold market tends to be highly seasonal and prices usually stall or soften in the summer. Moreover, perceived progress in stabilizing the global economy would probably reduce the investment demand for gold, at least temporarily.
Similarly, the current fears of inflation may prove premature in view of current inflationary expectations in key OECD markets. Many economies are dangerously close to deflation with their money supplies actually shrinking. Nonetheless, gold does appear to have established a much more central place in investor portfolios that used to be the case. While periods of economic stress tend to benefit it, it has proven increasingly resilient even at times of perceived normalization.
In the longer term, there are mounting expectations of an overhaul of the global financial system in ways that might once again give gold a more central place in it. Last year’s calls for commodity-based currencies by China, Russia, etc. serve as an important reminder of this.
Email the writer:
j.kotilaine@alrroya.com
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