The world gold market has undergone a fundamental shift over the past
year. This year marks its official end of a 20 year bull run.
The last two times the gold market fundamentally shifted were when vast
gold deposits were discovered in South America in the 16th century
leading to a sharp drop in gold prices, and when Richard Nixon announced the
abolition of the Gold Standard in 1973 as a response to the USA running out of
enough gold supply to back all the USD it was printing.
Here is the problem – the supply of gold depends on what can be mined
whereas if we use gold to back the economy it needs to bear some relation to
the world’s economic needs. Thomson Reuters GFMS produces an annual gold survey
with their latest suggesting there is 171,300 tonnes of gold. All this gold
would be valued at around US$950 billion totally. We won’t run out of gold
anytime soon. Estimates suggest there are 52,000 tonnes of minable gold still
in the ground and more is likely to be discovered.
This suggests that the gold price will continue its downward trend. It
had been on a bull run from 2011, rising from US$260 to a peak of US$1,920 in
September 2011. Since then it has steadily shed more than 30% of its value by
falling to US$1,230 currently. The gold price is still well above its price if
adjusted for inflation of circa US$900. With no shortage of gold supply in the
near future, we would expect the gold price to converge with its price adjusted
for inflation. This is a view shared by some notable funds, such as PIMCO,
Third Point (run by Daniel Loeb) and Baupost Group (run by Seth Klarman), who have
continually cut their gold ETF holdings.
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| John Paulson up to his eyes in Gold |
That is not to say that the gold price won’t, in the long term, revert
back to its typical use as a hedge for inflation. The solution for governments
troubleshooting most economic problems is to print more money, the corollary of
which is inflation. There has always been a strong link between inflation and
gold, which no doubt will bring the gold price up over the long term. One of
the world’s highest-profile gold proponents is hedge fund Paulson & Co,
which made billions correctly predicting the 2009 US housing crash. They have
accumulated large quantities of the metal since 2009 and have retained their
faith despite the 30% price drop over the past year, backed by the assertion
that inflation will raise gold demand.
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The one x factor that may shift the current demand and supply dynamics
for gold is one of its relatively new uses. Until now, gold has never gone away
but has always been recycled. 12% of the world’s current gold production is
being used in the technology industry where it is used in such small quantities
in each individual product that it may no longer be economical to recycle it. If
this percentage should rise, beware the ramifications for long-term gold
prices.
In the extreme short term, gold prices are highly sensitive to
expectations of US Federal Reserve tapering. Any reduction in Federal Reserve
bond purchases will sharply decrease gold. However, with Janet Yellen taking
over from Ben Bernanke as head of the US Federal Reserve, she is likely to err
on the side of inflation as she has a penchant for supporting the Federal
Reserve stimulus plans, which will provide some short-time support for gold
prices. On the other hand, easing geopolitical tensions in the Middle-East have
caused demand for gold as a safe haven to decline. Meanwhile, the S&P 500
index’s 30% increase this year has incentivized investors hunting for yield to
switch from other asset classes into shares. There is also debate as to whether
investment demand is determining short-term gold prices or whether physical
demand for jewellery, coins and bars particularly from China, India and the
ASEAN nations is driving gold prices.
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