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Gold loses its luster, signs of a comeback are hard to find
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“GOLD gets dug out of the ground in Africa, or someplace; then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
That was Warren Buffett in 1998, when gold averaged about US$300 an ounce. By 2011, gold had surged six-fold to a record US$1,900, driven by investors spooked by a likely “meltdown” scenario following the 2008 financial crisis. Gold’s 40 percent plunge since that peak has partly borne out Buffett’s warnings. Outside of an Armageddon scenario, gold has much less value.
This truism was brought home once again recently. As global equity markets corrected, volatility surged in China, and amid Fed-related uncertainty, the euro, Japanese yen and Swiss franc gained against the US dollar as investors adopted risk-aversion stances. But gold barely rebounded.
So are gold prices likely to fall further? We believe so. Investors still holding gold should use the recent rebound to reduce exposure further.
As we build the case against gold, it may be salient to first look at the reasons why investors typically hold gold. Other than as insurance against catastrophic events, gold is seen as a hedge against inflation. Also, a weaker US dollar is usually bullish for gold as a store of alternative value. Then there is the perennial bid for gold from jewelry buyers, primarily in China and India.
Most of these reasons have fallen by the wayside as the global economy emerged from its worst crisis since the Great Depression of the 1930s. Supportive monetary and fiscal policies worldwide have won the day, all but pushing the “Armageddon” scenario to the background. For sure, there are lingering concerns about the long-term effects of the unprecedented stimuli introduced by the world’s most powerful central banks. But investors are no longer willing to pay an extremely high premium — via higher gold prices — for such insurance.
Meanwhile, inflation is unlikely to return significantly any time soon, given excess global production capacity and the plunge in oil and other commodity prices. In any case, the relationship between gold and inflation holds only over several decades, whereas the shorter-term relationship is less clear-cut.
The US dollar is unlikely to come to gold’s rescue either. The greenback’s supposed long-term decline was a bugbear for investors for a major part of the past decade, until the US dollar started strengthening in earnest in 2014. Since falling to a record low in 2008, the US dollar has climbed almost 40 percent against the world’s other major currencies. A stronger US dollar makes gold, which is internationally priced in dollar, expensive for major buyers in Asia. Thus, the US dollar’s rebound has mirrored gold’s decline in recent years. Indeed, the US dollar is likely to strengthen further, as the US Federal Reserve prepares to raise interest rates, perhaps as early as this year.
Gold demand has remained largely stable in the past decade, barring a brief spike in Indian jewelry demand in 2013. But jewelry demand accounts for only half of the total demand for gold. Investors are the main short-to-medium term drivers of gold prices, and investors have been dumping their gold holdings in recent years. The amount of gold held at exchange-traded funds used by investors to speculate on gold has plunged more than 40 percent since peaking in December 2012.
Investors have every reason to sell — gold provides no income, unlike bonds and stocks. Continued outperformance of equities and bonds since the crisis has raised the opportunity cost of holding gold. Meanwhile, output from gold mines has continued to surge, especially since the 2008 financial crisis, even as jewelry demand remains stable and investment demand plummets.
Given these trends, we believe gold prices have further to fall.
The key question then becomes ascertaining how far can prices drop. For one, median production costs for gold fall in the range of US$700 to US$800 an ounce. Another way to measure gold is by valuing its inflation-adjusted price over a long period. Gold has averaged around US$700 an ounce in inflation-adjusted terms since the early 1950s.
These measures suggest gold could fall another 20 percent. Most other estimates of “fair value” relative to other asset classes price gold well below US$1,000. This is also corroborated by chart patterns that suggest a gradual decline toward US$1,000 by year’s end, tracking the trend-channel followed since 2013. A breach of the lower end of this channel could see an acceleration of the downtrend. A rate hike by the US Federal Reserve could well be the trigger, as higher US rates boost the dollar and make zero-yielding gold less attractive.
Before the next leg of the downtrend comes to pass and gold turns full circle moving toward its long-term averages — bearing out Buffett’s prophecy — investors would be well advised to cut their holdings of the yellow metal.
Manpreet Gill is head of fixed-income, currency and commodities strategy at Standard Chartered’s Wealth Management unit
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