DESPITE widespread economic uncertainties, gold prices performed in a disappointing manner in the past nine months. Gold prices have slumped more than US$300 a troy ounce after hitting a record US$1,921 in early September 2011. In the last three months, the price has averaged around US$1,600, slightly above the level at the start of this year.

Since the beginning of the world's current economic problems, the four major central banks have printed around US$9 trillion, which is almost equivalent to the total nominal value of gold ever mined. Unlike fiat money, stocks of gold can neither be increased nor decreased at the will of governments and central banks. Rather, supply is dictated primarily by mining output.

Despite its long-standing pedigree as a safe haven, gold has noticeably failed to rally in the recent period of economic turmoil. So what are the factors undermining the rally in gold prices?

Gold used to be bullish in risk environments. However, this traditional bullish effect has been neutralized for most part in recent months. During periods of heightened eurozone concerns, resulting risk aversion sentiment led to equity market sell-offs, triggering margin calls that were then translated to sell-offs of gold as investors raised cash to cover the calls. In addition, as the euro weakened, the corresponding strengthening of the US dollar further weighed down gold prices.

Both bullish and bearish mechanisms are now at play in the risk environment to neutralize each other, establishing gold as a unique commodity with "risk-on, risk-off" neutrality. In addition to being risk-neutral, the price of gold remains largely driven by its own fundamentals. The eurozone sovereign debt crisis, highly accommodative monetary policies in the US and profligate fiscal policies designed to combat weak economic growth contributed to a long-running rally in the gold prices.

As the market tends to focus on these macroeconomic and geopolitical events, it is easy to overlook the "micro" factors. They may be slow to change and may not be immediately obvious to investors. However, they have the potential to exert powerful long-term influences on gold prices.

Let's first have a look at gold from the "macro" perspective. Regardless of gold's behavior as either a safe-haven or a risk-neutral commodity, the "macro" case for gold looks compelling in both scenarios.

Highly accommodative monetary policies are traditionally supportive of bullion. Hence, recent weak US economic data, which enhanced the possibility for additional monetary easing, may buoy gold prices. Economic uncertainties, geopolitical tensions and the uncertainties of the US November elections are all theoretically bullish for gold prices.

Currency markets

In addition to the above factors, the direction of the currency markets also affects the prices of gold. As a surrogate currency, gold is sensitive to movements in foreign-exchange markets. The inverse correlation between gold and the US dollar is among the most stable and enduring of relationships.

With the eurozone crisis, brewing US public debt and fiscal problems are consequently being overshadowed. However, as we move closer to the US presidential and congressional elections later this year, the market focus will likely change and soon shift onto US government finances and political discord. In that scenario, the US may be presented with a choice of austerity versus more debt as it finds itself struggling to cope with the so-called "fiscal cliff."

While "macro" factors dominantly point to a rally in gold prices, the "micro" supply-and-demand side is working against the bull.

Gold production has been rising in response to the high prices and investments made earlier in the mining cycle. Despite the rising costs of gold extraction, the vast bulk of producers still have significant financial incentives to increase production at current price levels. Output has risen from 2,550 tons in 2005 to 2,818 tons in 2011.

Recycled scrap gold has risen from 886 tons in 2005 to 1,661 tons in 2011. It plays a key role in curbing gold prices. High gold prices, as denominated in Indian rupee terms, also triggered a boom in Indian gold recycling.

From the demand perspective, consumption has been disappointing this year. Jewelry is the largest component of the demand side and is arguably the most important determinant of gold prices. Gold jewelry accounted for barely 45 percent of the gold demand in 2011, down from 75 percent back in 2005. This is primarily the result of high unemployment levels in the developed countries, crimped disposable incomes, rising food prices and economic uncertainties.

India is a particularly important market for physical bullion, with the Indian demand traditionally accounting for 30 percent of world demand. However, as the rupee has weakened significantly against the US dollar, high gold prices in Indian terms have curbed jewelry demand.

According to the Bombay Bullion Association, Indian gold imports may fall to only 550 tons this year from 960 tons last year. The Indian government welcomes it because of the negative impact gold imports have on the balance of trade. The government has imposed import duties and taxes on bullion, which also adversely affected gold consumption.

Central banks' purchases

Despite the continuing decline in consumption demand, the growing physical supply of gold will likely be absorbed by the increased purchases by central banks. After nearly two decades as substantial sellers of gold, central banks swung to being net buyers in 2010, when they purchased a net 77 tons. The pace of central bank gold purchases has accelerated sharply since then.

Going forward, since jewelry demand is already at historic lows, sales trends are unlikely to deteriorate any further. However, it is the "macro" side of the gold equation where we expect changes to occur.

With the uncertainties associated with the US problems, the November elections and further monetary easing, gold may rally later this year. It's also starting to become clear that there is a desire to diversify away from US dollar- and euro-denominated assets. Although gold has not yet been the first choice for investors, we believe that bullion will soon gain more attractiveness.

Shanghai Daily has condensed the article.