Gold shines when everything else falls apart. So goes an old adage. True, the glitter is back. A combination of falling stock markets, unrest in the Middle East, spiking oil prices and a slump in the value of the US dollar, seemed to have added to the sharp rise in gold prices. With the alternative investment opportunities deteriorating, gold enjoys good patronage among masses.
The sharp advance in gold price owes to a number of factors. A weakening US dollar helped boost the metal as it is denominated in US dollars. Therefore, when dollar weakens gold becomes more affordable to countries like India and China, which leads to increased demand for the precious metal and higher gold prices. Market analysts opine that it is poised to rise in a sustained manner in 2011 and the next, and possibly for a longer period.
Although physical off-take was reduced in the industrial sector in the recent past, activity in the investment market took gold prices higher as investors looked forward to mitigate their risk. In some countries such as India there has been very strong purchasing by both the mainstreet (in the form of coins and bars) as well as by the professional investors and speculators. Similar trends can be seen in parts of Europe, the Middle East and North America. The professional investor has been drawn to the gold market for a number of reasons:
Concerns about the equity markets and lingering doubts about the global recovery; Japan's disaster; and the fact that the dollar, the yen and initially also the euro will all be under pressure. All these have combined to generate a desire on the part of the investors to hold an asset class that would diversify the risk. And, gold has been one of the favored beneficiaries.
The Gold Dynamics
Like any other commodity, gold reacts to the basic demand-supply equation, but tends to be more volatile in situations like war and social unrest. It is an incredible market. It is so cyclical that it is sometimes uncanny. The present rally is no exception. On the demand front, each year, gold is close to 50% higher than mine supply worldwide and it has been this way for many years. This is a long-term chronic problem that is not going away overnight. In short, it is a limited market. There is less than an ounce of gold above the ground per person on the face of the earth and most of this is not available to the market. In a small market, it does not take many new buyers entering the market at one time to push prices to extreme levels very quickly.
Glitters all the Way?
As an era of economic uncertainty extends this year, investors are likely to preserve wealth rather than look for quick returns. Gold has come to be an asset of last resort. In countries like India, the yellow metal continues to be a primary means for savings. There are strong cultural preferences for gold as a store of value and symbol of wealth. Though in the recent decades its ‘safe haven’ image lost ground to the US dollar, the recent weakening of the US dollar and a troubled global environment, investors have been buying gold largely because it is the only alternative for its traditional value.
There were periodic rallies, but for most part of the past five years, gold was traded at prices below $1000 an ounce and today cross $1500 mark. Gold will always have a historic intrinsic value. In case of a global meltdown, people will trade as they did many hundreds of years ago, opines a gold analyst. After years gold has made a strong comeback as a safe investment in times of international tension. “Gold has always been an important check and balance on the way in which a government uses its finances. I cannot gainsay Greenspan, former Federal Reserve Governor, who has referred to it as the ultimate form of money,” says Rhona O’Connell, Market Analyst, World Gold Council, US.
However, in the present rally for gold, the fear is that the force behind the current investment-driven gold move, attributed to the fear of rising oil prices, has dashed hopes of a global economic recovery. Other worrisome factors are Middle East unrest, continuing European nation’s defaults rocking fragile international banking stability, fear that mines will not be able to extract the required gold to cover their positions, and they thus have to buy gold in the open market.
Historical Perspective
In general, gold has proved to be an excellent hedge against high inflation. While gold has historically outpaced other investment categories during periods of high inflation, history shows that gold can increase in value in periods of low inflation also. This is exactly what happened from June 1982 to February 1983, when the price of gold increased 74% in just nine months, despite the fact that inflation was moderate. What prompted the price of gold to rise? The answer is weakness in the US dollar. History repeated itself from February 1985 to November 1987 when gold increased in value by 78% in just 21 months, again due to a falling dollar. Finally, from March 1993 through June 1993, the price of gold increased by 24.8% not due to high inflation, but due to currency turmoil in Europe.
If one considers the gold prices from a historical perspective, it is nothing more than a ‘normalizing process’. From January 1982 to January 1998, gold prices usually traded in the range of $300 to $400 an ounce. Since then, gold prices have usually traded in the $250 to $300 range. If history repeats itself, the present trend simply signifies the start of a more normal trading range where gold prices are locked into a range of $300-350. Says, Rhona O’Connell “There is undoubtedly a ‘war premium’ in the gold price at present. This is partly because the dollar is under some pressure for economic reasons and partly because of the high degree of uncertainty whether there will be a war and how drawn out and/or effective it will be. Financial markets dislike uncertainty above all else and this is one of the features that is keeping gold prices high.”
However, Dr. Stephen G Cecchetti, Professor of Economics, Ohio State University, US, disagrees that gold prices are doing well in a climate of war and uncertainty because of the absence of other investment avenues, thereby helping gold to retain its glory. He opines, “I am secure in my belief that gold is a poor investment in the 21st century. Analysts who believe otherwise are not analyzing the available alternatives properly; forces that are completely unrelated to economic fundamentals drive the gold market, he further adds. In contrast, David Wyss, chief economist, Standard & Poor’s, US, feels, “The absence of good alternative investments is clearly a factor. That is reflected in the low holding cost currently.
With the fed funds rate at 1.25% and Japanese deposit rates at zero, there is little cost to holding gold. The social unrest adds another purpose. Still, flight capital is increasingly going into money markets, since they can be spent more quickly than gold coins. The weak stock market is helping to push gold higher, since stocks are clearly not a safe alternative for preservation of wealth.”
Whatever the reasons are, most gold analysts are of the view that the driving forces behind the present moves will continue to push prices higher in the coming days.
Gold – A Pillar of Stability?
In general, gold has assumed a pillar of stability in good times as well as bad. Defensively, it has a natural stabilizer. However, Dr. Stephen G Cecchetti disagrees with the above premise. He articulates, “The world economy has exhibited remarkable stability in the face of the shocks it has withstood. And, while the financial systems of some countries have experienced instability, this is largely a consequence of poor regulation and poor government policy. Gold has nothing to do with this. Gold has more to do with theology than with economics and finance. It is mystical.”
In short gold is tangible, portable and anonymous. “Gold jewelry, in much of the world, is seen as a store of value as well as an adornment. In addition, gold in the international market is denominated in US dollars, although obviously in individual countries it is traded in the local currency. As a consequence of these and other features, gold has very little correlation with other asset classes. It has, also, in the main, a much lower volatility than other assets, and because it has ‘adornment’ and some industrial uses also it means that demand for gold can be a function of economic growth in the same way that it is for other metals,” observes Rhona O’Connell. Consequently, if economies are slowing and it means that ‘professional’ investors start looking at gold as a hedge against a downturn in the equity markets, so some day-to-day purchasers of gold for jewelry or electronics may have withdrawn from the market, he further adds. This is one of the factors, which gives it, in general, as lower volatility than many other asset classes.
However, David Wyss is of the view that calling gold a pillar of stability is a bit strange. When and if the economies improve, interest rates rise, and the war fears calm, gold prices will fall back. Until then, gold is expected to remain strong.
To conclude, there is no doubt that the ongoing unrest in the Middle East, feeble US economic recovery, sovereign debt problems in the peripheral European nations have prompted investors to anticipate a further increase in the international prices of gold.
N Janardhan Rao, Lead Economist
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