All that Glitters

The traditional view of gold is that it is the ultimate store of value and that the sharp rise in gold price over the past decade was caused by easy monetary policy in the developed world and the resulting fall in the value of so-called hard currencies. In other words, the gold price was thought to be positively correlated to inflation, especially US inflation.

Chart 1 below shows that changes in US inflation explain gold price movements to some extent, particularly prior to 2000. Throughout the 70s, 80s, and 90s, changes in the gold price could to some degree be explained by changes in the US inflation rate.

However, this relationship breaks down post 2000, a period during which the gold price increased 20% pa from under US$300/oz. in 2002 to around US$1,700 currently, while core US inflation remained in a relatively narrow band, averaging 1.9% during the same period, close to the 2% Federal Reserve target.

Chart 1: Annual change in gold price (LHS) vs U.S. core inflation rate (RHS)

Source: Investec Wealth & Investment, I-Net Bridge

Reasons for buying gold

However, aside from the inflationary implications of easy monetary policy, low interest rates provide another incentive to hold gold.

Given that direct gold (and other commodity) investment pays no income, investors receiving a high interest rate have little incentive to switch into gold. The opposite is true when interest rates are low and especially so if negative real interest rates prevail, such as in the present environment of widespread central bank reflationary policies. Investors are far more willing to forgo a negative real income return in order to hold gold.

A third reason investors might seek the relative ‘safety’ of gold is to diversify their source of return. Much has been written in the academic literature of the benefits of holding alternative assets, including gold and other commodities, in a diversified portfolio in order to achieve more consistent returns on capital over time without necessarily sacrificing their level of return. As we will see, the evidence supports the former of these arguments for higher gold prices rather than the latter.

Chart 2 shows how the sources of demand for gold have changed over the period 2002 to 2011.

Chart 2: Gold Demand Trends by Source, excl. Central Banks, 2002-2011 (tonnes)

Source: Investec Wealth & Investment, Thompson Reuters GFMS, World Gold Council

Trends in the purchase of gold

The primary trends that can be observed are:

Jewellery purchases are still the major demand source, but are an ever-declining % of aggregate demand, down from 79% in 2002 to 48% in 2011.
Investment in the form of gold bars and coins is the fastest growing segment of the market, with 37% share in 2011 and likely the main contributing factor to higher prices in recent years.
Although gold ETFs initially grew rapidly from a zero base in 2002, they are more recently seeing lower levels of interest and now account for less than 5% of total demand. So much for the diversification strategy argument.
Technology demand has been relatively flat during the period and remains a small share of overall demand.

Who is buying?

So, if investment in gold bars and coins is behind recent gold price increases then who has been buying?

Well, European consumers, for one, have gone from being perennial net sellers of gold bars and coins until 2007 to buying a net 374 tonnes in 2011.

However, the answer lies more in emerging Asia as this where the real action – or rather demand – is taking place.

Gold demand over the past 10 years has increasingly come from emerging Asian countries, with India, China and Vietnam showing the biggest gains. In fact, in 2011 emerging Asian gold demand reached a new high as a proportion of total gold demand at 48%. While India’s cultural attachment to gold has long been understood, what has been less evident is the growing importance of China and the shift in purchasing mix from jewellery to investment within the region.

Chart 3 shows emerging Asia’s increasing demand for gold bars and coins, with Chinese investment demand, in particular, starting to explode from a near zero base in 2002 soon after the deregulation of their gold market.

Chart 3: Emerging Asian Consumer’s Share of Gold Investment Demand, excl. Central Banks, 2002-2011

Source: Investec Wealth & Investment, Thompson Reuters GFMS, World Gold Council

Why Asians prefer Gold

That the gold price is being driven by emerging Asian consumers should not be all that surprising given a familiar economic backdrop in the major markets in the region: that of negative real interest rates. Governments have been regulating deposit rates, effectively forcing negative real rates on consumers in order to stimulate fixed investment.

 In addition to this, the incentive to buy gold has been further fuelled because of capital controls that restrict outward investment. Chinese and Indian citizens have few alternatives in which to invest their savings, especially given equity markets that lack depth and sufficient regulatory oversight. Poor recent returns and numerous accounting scandals in these equity markets have further discouraged investment. Of the remaining alternatives, gold and platinum jewelry, gold bars and coins and real estate have become the most popular. One only has to look at luxury goods sales growth in the region or data from the platinum industry, where Chinese jewellery demand is now the largest single demand segment at 20% of the market to find confirmation of these trends.

According to GMO, “coupled with this ‘financial repression’, savings in emerging markets rose dramatically in both relative and absolute terms between 2000 and 2010. In 2000, emerging markets accounted for roughly 25% of global GDP. By 2010 this figure reached 40%. Domestic savings rates in China rose from a 41% average in the 90s to 47% in the 2000s while India’s savings rate rose from 23% to 29%. Consequently, combined gross savings in China and India increased from $557 billion in 2000 to $3.4 trillion in 2010.” Given this explosion of money available to invest and a dearth of suitable alternatives described above it is no wonder the price of these investments have soared.

The final piece in the Chinese demand puzzle is the currency.

Chart 5 below shows that since the currency’s US$ peg was relaxed in 2005 it has appreciated by roughly 24% against that currency. Simply put, relative to the majority of other global investors the price of gold has not appreciated to the same extent.

Chart 5: Chinese CNY vs US$

Source: Investec Wealth & Investment, I-Net Bridge

The point we would emphasize is that emerging Asian consumers as the marginal buyer of gold is entirely consistent with the fundamental laws of economics, in this case the supply of and demand for suitable investment vehicles.

How long will the Bull Run last?

Given the powerful tailwinds driving the gold price, one would be forgiven for thinking the outlook for gold to be overwhelmingly positive.

However, before we extrapolate current demand into the future it would be prudent to consider alternative scenarios. For one, slowing economic growth in Asia and or the relaxation of capital controls in the region, allowing savings to find a home abroad and in a broader range of assets, could reduce demand for the precious metal. In China specifically, policies aimed at rebalancing the economy and encouraging greater levels of consumption may lower savings rates and also reduce demand.

With gold prices now consolidating well below the highs of a year ago, signs of moderating Asian demand are clearly evident, at least partially due to both the depreciation in the Indian rupee and the resulting record prices in that country as well as a slowing economy in China.

Whether these more recent trends are sustainable is debatable. While central banks have been quick to accelerate purchases during this period of price consolidation, one demand source that continues to remain surprisingly untapped is that of developed world investment in the form of gold ETFs. These listed funds have the potential to absorb much higher demand for the metal, particularly if institutional investors take advantage of negative real rates to increase holdings to diversify their source of return and protect capital in the event of higher inflation.

Arthur Clayton is primarily responsible for the management of the SA Wealth & Investment unit’s range of Retirement Funds and Balanced portfolios. He sits on the Investment Committee responsible for the investment process within this business. Previously, Arthur worked in stock broking and portfolio management at Sasfin and in wealth management in private partnership. He is a CFA charter holder and member of the Investment Analysts Society of SA.

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