The poor recent performance of gold has resulted in claims that it is now a 'broken' investment vehicle. Broken as a commodity, an alternative currency and even as a portfolio diversifier. (This article focuses on physical gold itself, not gold stocks, which is a more complex story for another article).
Major correction was due
Given the 25% fall this year to a recent low of USD1179, it’s hard not to have some sympathy with this view. However, when one considers that gold rose in US dollar terms every year for 11 years to 2012 and outperformed every major asset class over that period, a major correction should be expected. But should investors be writing gold off at this point?
In my view there have been two key drivers for why investors have recently come to see physical gold as ‘broken’. How these drivers play out in coming months should be the major determinants of the future path of gold prices.
Firstly, there was a massive influx of ‘new’ gold investors after the GFC and leading up to 2011, which helped to produce a USD500 spike in that year to a September peak of over USD1900. Gold bullion Exchange Traded Funds (ETF) grew strongly and major investment banks became chief cheerleaders during this phase, predicting prices well over USD2000 - driven by ‘fear’ related to major macro risks, such as the possible collapse in the Euro.
Confounding these new investors, gold prices have since fallen more than 35% from the peak as some of these specific macroeconomic risks have subsided, and downward momentum in the gold price has accelerated. It is irrelevant to these investors that gold is up almost five times in nominal terms since its 2001 low. For them gold has failed and many are now abandoning it (often by selling their ETF holdings) and in doing so are contributing to the fall, spurred on by the newly bearish views of the major investment banks. Meanwhile trend followers everywhere have jumped on the ‘short gold’ bandwagon. Within two years, the consensus seems to have changed from predicting prices will move well above USD2000 to now heading to USD1000 and below.
Secondly, despite extraordinary levels of monetary policy accommodation leading to record low real and nominal interest rates, ongoing expansion in central bank balance sheets and the potential for this to translate into broad money growth and eventually inflation, gold failed to benefit from these developments through this two year period. Part of this disappointment could relate to some ‘front loading’ of these developments in the 2011 gold price surge. However, I suspect a more important factor is that many investors have been attracted to a range of other beneficiaries of accommodative central bank policies - with resulting strong performance from these areas reinforcing this confidence. This includes high yielding equities, REITs, listed infrastructure, corporate and high yield debt. If these areas can benefit from easy money and also pay a reasonable yield why would I need gold, the thinking goes.
What is needed for renewed support of physical gold?
If one accepts the above thesis as to why gold is now seen as ‘broken’, the question becomes what would have to alter for this view to change and gold to regain some much-lacking investor support?
Firstly, we need to reach a point where the majority of the ‘new’ gold investors from 2009-2011, both retail and institutional, have abandoned their gold investments. Only then is gold likely to be held in much stronger hands and better placed to perform. Many of these newer, weak-handed investors probably should never have invested in the first place - buying for short term, fickle reasons into an accelerating uptrend that was increasingly vulnerable to a major reversal. The evidence suggests we are well down this path as investor revulsion to poor performance has driven gold bullion ETF redemptions of more than 500 million tonnes so far in 2013. In addition, small and large speculators have dramatically decreased long positions and moved to record gross short positions in Comex gold futures. Investor sentiment towards gold has never been lower. Historically, when pessimism becomes this extreme and futures participants are positioned short, a significant rally is likely. In contrast, physical buyers of gold, who tend to take a much longer term view, have been aggressively buying into recent weakness. Much of this buying has come from China and India, while central banks remain net buyers.
Secondly, we need to see the other asset classes that have benefited from extremely loose monetary policy cease to perform well or for there to be growing scepticism that they will perform well in the future. Only then is gold likely to stand out as a major long-term beneficiary of the current unique monetary environment.
Until recently, strong market rallies in many mainstream asset areas have fed investors complacency and justified their avoidance of gold. However, the more recent volatility in late May and June across many financial markets could mark the beginning of a new phase. At the very least this recent volatility across many ‘yield’ asset areas is demonstrating to investors how elevated valuations have become and how dependent they are on easy money. Perhaps more worrying is the lack of evidence that this easy money is actually spurring economic growth and earnings, another essential pillar for the valuation support of some of these asset classes. One must also note however, that at least to this point, gold too has suffered badly in this recent market volatility although this could change quite quickly.
Much of the discussion driving this most recent gold weakness has focused on possible tapering of Quantitative Easing (QE) in the US. However, even if QE ceases by mid-2014, (something quite questionable given the fragile nature of the US and global economic recovery) short term interest rates are likely to remain at very low levels compared to history for a number of years yet. Further, neither QE nor high inflation was necessary for gold to rise almost 250% between 2001 and 2007 so those arguing that cessation of QE alone (but with little shrinkage of bloated central bank balance sheets) and the current absence of high inflation will cause gold prices to fall further have little historical support for this position. Having said this, it is likely that current monetary and fiscal policies will result in higher inflation in a number of countries at some point in the future - although the last decade clearly shows that such inflation does not need to be current or imminent for gold prices to rise strongly.
Traditional financial asset investors likely to miss any gold rally
Those who have recently abandoned or written gold off as ‘broken’ may yet come to regret this view. Indeed this could occur at a time when - and partly because – many other investments are performing poorly. In the midst of its last secular bull market in the 1970s, gold fell 45% over 18 months between the end of 1974 and mid 1976 (at a time when sharemarkets did well) before rising over 800% over the following four years (as many sharemarkets struggled, particularly in real terms).
History may not repeat but given the aggressive short positioning of many participants and the extreme pessimism inbuilt into prices, the rally in gold when the current weakness ends could be quite dramatic. However, given the painful experience of the last two years and the perception of physical gold as ‘broken’, few traditional financial asset investors are likely to participate.
Dominic McCormick is Chief Investment Officer and Executive Director at Select Asset Management.