Gold was one of the few investments not to lose money over the past year, but where does the gold price go from here?
While investments in shares, property, and commodities have all taken a bashing, gold prices are more or less where they were a year ago, in dollars, and up 37% in sterling. But where does the gold price go from here?
Finding the answer to that question is complicated by the fact that gold is a strange hybrid of commodity and currency, but let's start by looking at supply and demand.
Jewellery accounts for about two-thirds of the demand for physical gold and this market is rather price sensitive. India is the biggest customer, due to gold's cultural and religious significance, though demand for gold jewellery in the industrialised world has been falling steadily for the past fifteen years. Industrial uses make up another 13% of demand, and about a fifth is bought for investment, which includes bullion to back physical ETCs. Total annual demand is of the order of 3,700 tonnes.
On the supply side, gold mine production peaked at over 2,600 tonnes in 2001, and may have dipped below 2,400 tonnes last year. The drop was partly due to labour and energy problems in South Africa, which has seen output fall to levels not seen since the war … and I'm referring to the Boer War! Other supplies come from recycling scrap and selling national reserves. And for every tonne we dig up, less than a fifth of a tonne of new gold is discovered.
Clearly the metal is still in demand, but the trade in physical gold is tiny compared to the value of 'paper gold' contracts that are settled in cash, so it's this market that really determines the price. And like many other assets, gold has been sold off by investors 'de-leveraging' -- selling anything they can find in order to meet their repayment commitments.
That's the market in a nutshell, but where does that leave our decision-making?
First, the bull case:
- Increasing wealth in India, and in Asia generally, will drive demand for gold jewellery;
- Production has been falling despite increased prices, and new discoveries are relatively small;
- Gold is traditionally viewed as a hedge against inflation due to its scarcity. Through bailouts and other schemes, inflation is one tactic being tried to pull the world out of this recession as large volumes of cash enter the system and encourage us to spend now before things get more expensive. That's the theory, anyway, and in theory gold should thrive in that environment;
- Gold could do well in a deflationary environment. If printing money somehow fails to produce inflation, then the economy is really facing a catastrophe and there's nothing you can trust apart from gold;
- The economic crisis might cause increasing distrust of governments and their currencies, and perhaps fuel demand for gold. (Adding to this distrust is the current Banking Bill, currently working its way through parliament, which removes the requirement for the Bank of England to report weekly on its activities. So while we're free to debate the pros and cons of 'quantitative easing', it has been decided that it's better if we can't easily…, er…, quantify it. It's all grist to the mill of conspiracy theorists and a possible boost for gold);
- At $860, and having peaked at $1,033 last March, gold is still well below its inflation-adjusted peak of $2,297, reached in January 1980;
- Interest rates are low, so the opportunity cost of owning gold rather than cash in the bank is almost trivial;
- The forced selling that held prices back can't go on forever.
And now, the bears:
- The industrial uses for gold are insufficient to drive the price, so gold is only desirable or valuable if we think it should be. Gains depend on investment fashion;
- Demand for gold jewellery fell last year, and is sensitive to price;
- South African production issues may be resolved, in time;
- Gold didn't soar during October's market crash. Does that mean it's the wrong insurance for this type of crisis?
- Gold is a popular topic of discussion recently, and that may signal a peak;
- Gold might now be driven up or down by general demand for commodities, as it's a component of many broad commodity funds, and the prices of other metals may not be so resilient in a downturn.
Conclusion?
It is fiendishly difficult to call, and the experts have got this horribly wrong in the past. Remember that 56% of Britain's reserves, 395 tonnes, were sold between June 1999 and March 2002, perfectly catching the long-term trough in prices. When I consider how many of the country's top economists must have been involved in that decision, do I really think I can make a better one?
But I won't let that inconvenient fact prevent me from positing an opinion. For what it's worth, I believe we are facing inflation rather than deflation, and that would appear to favour gold.
I'm not concerned about a possible fall in the dollar, as this should be compensated for by a higher gold price; it's the sterling price that matters to UK-based investors. We can almost think of gold as a separate currency, and ignore the dollar.
I am worried that when gold had its chance to shine, it didn't, even though everything appeared to be in its favour. Everything except the forced selling, that is; this explanation sounds plausible, although I can't quantify it or guess how long it will last, but I'm sure it won't go on indefinitely. Physical ETCs have seen in influx of cash, and it would be interesting to see what effect that has on demand for bullion.
For what it's worth, I think the arguments support having some exposure to gold and I've invested accordingly.
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