These 4 key factors could indicate what's next for gold.
The surge in the gold has encouraged substantial debate as to the future direction of prices. I think there are four main drivers behind the gold price at the moment...
1. Emerging markets
In my opinion, this is the single strongest bullish argument in favour of higher gold prices. It relates to emerging market growth and the expansion of the middle classes in China and India.
Both countries have populations disposed towards holding gold and their discretionary spending power is increasing. In addition, as their financial markets are less developed, they also see gold as more of a mainstream investment option.
Gold is also seen as a hedge against currency risk, following the financial crisis in Asia in the late 1990s. Both countries run large budget surpluses and have substantial investments in US Treasuries. Gold gives them diversification from this, too.
Here is some data from the World Gold Council, looking at jewellery and net retail & investment demand.
| | 4 quarters
to Q1 2009
$bn | 4 quarters
to Q1 2010
$bn |
|---|
| India | 17,432 | 24,739 |
| Of total | 21.2% | 28.4% |
| China | 11,974 | 15,651 |
| Of total | 14.6% | 18% |
| Total | 82,294 | 87,121 |
2. ETFs
There has been a lot of demand for gold from the Exchange Traded Fund (ETF) industry. Turning to figures from the World Gold Council again...
| | 2005
$bn | 2006
$bn | 2007
$bn | 2008
$bn | 2009
$bn | Q1
2010
$bn |
|---|
| Jewellery | 38.7 | 44.4 | 53.8 | 61.3 | 55.6 | 16.8 |
| Industrial | 6.2 | 9.0 | 10.3 | 12.2 | 11.3 | 3.7 |
| Net retail | 5.6 | 8.1 | 9.7 | 24.2 | 22.1 | 6.5 |
| ETF | 3.0 | 5.1 | 5.7 | 9.0 | 18.5 | 0.1 |
| Of total | 5.6% | 7.7% | 7.2% | 8.4% | 17.2% | 0.4% |
| Total | 53.5 | 66.6 | 79.5 | 106.7 | 107.5 | 27.1 |
Around three quarters of the ETF figure for 2009 fell in the first quarter of that year and demand has declined significantly since then, as the figures for the first quarter of 2010 illustrate. Despite this, the price of gold still managed to rise over this period.
The growth and increased sophistication of the ETF market over the last several years has been important. ETFs are seen as new revenue generators for investment banks, although many have been structuring them with derivative instruments rather than physical gold. This should trigger alarm bells as sharp falls in the gold price could cause liquidity problems.
Furthermore, the increasing use of derivatives could mean physical demand growth is lower than investment exposure growth. This will be a concern at the margin, because most of the gold physically held by ETFs is held on a matched basis. The largest single fund, State Street's SPDR Gold Trust, holds between 80-90% of the ETF total and matches physical gold with investor buys/sells. However, the knock-on effects of a liquidity problem with derivatives in gold ETFs should not be dismissed lightly.
3. The risk factor
Putting China & India aside, it is worth considering global investors. They have been favouring gold, as a movement towards risk aversion from other asset classes. You could argue the growth in the ETF market in recent years is evidence of this.
Gold is seen as offering diversification from increasingly correlated asset classes and volatile currencies, whereas traditionally it has been used as an inflation hedge.
4. The feedback factor
In 'The Alchemy of Finance' George Soros said asset classes can have self-sustaining feedback loops. In other words, prices rises attract more investors causing further price rises and so on. At some point there is a point of inflexion. The feedback loop stops and violent price falls can follow.
I think this could be happening with gold. It's long bull run has resulted in many converts. This encourages ETF sales and issuance. But investors could become less risk averse, asset allocators could move away from gold, or retail demand could dry up due to buyer fatigue.
Where next?
If you believe the feedback loop theory is correct, then the next question is whether the point of inflexion has been reached yet. I reckon that the answer to that is unclear.
Slowing ETF demand suggests it may have, but the global economy is certainly not out of the woods yet. But if the economy continues its slow recovery for the next 6-12 months, gold could have substantial downside.
More from Lee Samaha:
Lee does not hold a position in gold... yet.
