All that glitters is not Gold. Unless of course you are referring to GDX, GLD or other similar ETFs! Gold and Gold ETFs have had a phenomenal run since the last couple of years. Through this article, let us look at some of the key factors that can explain gold price performance.
Firstly, you have to look at Gold in its historical context. While from an application perspective it has fairly limited real use cases, historically Gold has been treated as Money for centuries together and regarded as “Store of Value”. In contrast and by comparison, the true fiat currency world has been in play just the last 55 years or so, post abandonment of the Bretton Woods system. That “store of value” belief has remained deep rooted and is not going away.
When I evaluate Gold as an investment asset class, I primarily narrow down my focus to 4 main factors – the direction of real interest rates, demand for physical gold, relative strength or weakness in the US dollar and state of the equity markets.
Real Interest Rates: Gold price movement can be largely explained by its extremely strong negative correlation to real interest rates (See Graph below). US monetary policy is expected to be accommodative for a long period of time from now. While there are significant risks of deflation, there are also significant inflationary pressures from factors like the unprecedented large fiscal measures taken by almost every country (whether they can afford it or not from a budget financing viewpoint!), supply side constraints and international trade tensions and related re-shoring activities. On the other hand it is worth noting that even if the deflationary pressures start building further, the Fed and the US government seems ready to “Do whatever it takes” which will keep real interest rates low for the foreseeable future. On a separate note, whether this unprecedented US fiscal spend will result in an unsustainable US debt level and result in paradigm shift in the global financial system is anybody’s guess and topic of discussion for another day.
Relative Dollar Strength / Weakness: After the initial flight to safety in late March 2020, there was a continued weakness in the US Dollar attributable to multiple factors including, loose monetary policy and also a general view that the world seemed to be doing better than the US in dealing with the virus situation. A weak dollar augurs well for Gold since it makes buying Gold more affordable. (See graph below. Alternatively look at DXY on Bloomberg for the below period). Interestingly a major risk event in the Rest of the World, geopolitical escalation in the Middle East, usually results in dollar appreciation – mostly on account of flight-to-safety. As an example – if one looks at the August 2011 to August 2012 period, real interest rates were declining and yet Gold price scaled back from an all-time high of around $1,900 to approx. $1,550. The dollar was in a broad based strengthening phase given the severe public debt crisis in Europe.
Physical Demand: Just like any other commodity, physical demand for gold also plays a large role in the determination of its price. Around 50% of demand for physical gold comes from Jewellery consumption and Central Banks constitute another 11% (Source World Gold Council). Again, a weaker US dollar makes it relatively more affordable for consumers in India and China, which are the 2 biggest countries of consumer demand for physical gold. Once again, adding shine to its investment value and store of value proposition, is the deep rooted cultural significance and resulting attractiveness for Gold purchases in India. India imports approx. 750-800 tonnes of Gold every year. Admittedly compared to China, the Indian economy is probably going to be hit harder and that will reduce consumption demand. Central Banks have been increasing their share of gold reserves in the past decade. Currently Central Banks and supra-national organizations are said to hold approximately 34,000 tonnes as Reserve Assets. Demand from the Central Banks has expanded rapidly since the Great Recession of 2009, especially large scale purchases by Central Banks of Emerging Market and Developing Economies. The long term rationale seems quite simple – heightened geopolitical and economic risks including the prominence of China as a competing power to a hitherto unipolar world and resulting risks to the dollar, unprecedented debt binge by the supposed leading economies of the world and resulting uncertainty in the world economic order and monetary financial system. This trend seems unlikely to reverse. According to official reports China’s official gold reserves are said to total approx. 1900 tonnes, almost triple pre-2008.
State of the Equity Markets: Lastly, the state (or the outlook) of the equity markets play a strong role in the direction and quantum of gold price change. While the world is awash with liquidity, at the end of the day all asset classes have to compete for investor wallet share. As equity starts performing better (which typically happens when risk levels off), investors start to rebalance portfolios and tend to rotate out of gold and into equities. For instance, looking back at the post Financial Crisis period, it was really post 2013 that a secular equity rally took hold and continued up till 2017-18. During this period gold generally underperformed.
To recap, Real interest rates, Relative dollar strength or weakness, retail demand and central bank demand and finally the state of the equity markets are the key determinants of Gold price performance. There is a definite role that Gold plays in strategic asset allocation and a well diversified portfolio. Each of the above factors need to be monitored constantly to though, to do tactical allocation shifts in and out of Gold.
Happy investing!
