Gold has produced impressive gains over recent years, with the ascent in prices undeterred by the ebb and flow of other financial markets as demand swelled from both the bullish and bearish sides of the investor spectrum. The evolution of the global recovery increasingly looks likely to cap the rally going forward. Our analysis points to price declines in the second half of 2011, with the proliferation of gold ETFs threatening to make any drop especially violent. We expect gold to trade below $1320 per troy ounce by the end of the year.
Gold Rally has Been Driven Exclusively by Investment Demand
Why has gold proven so strong? Demand from investors.
Gold stands apart from other commodities in that its spectacular advance has depended exclusively on its allure as an investment rather than for any other purpose. Indeed, looking at the recent trends in physical supply and demand, gold prices should be falling. According to GFMS Limited – a leading precious metals consultancy – gold supply hit a record high last year while fabrication demand for jewelry and electronics has been trending lower since peaking in 1997. And yet, gold prices set an all-time high just shy of $1600/oz in early May.
Source: Bloomberg
Why have investors become so keen to own the yellow metal? Through the 2008 credit crisis and recession as well as in its aftermath, financial markets have been ruled by broad-based swings in investor sentiment. The leading asset classes separated into two distinct and opposing camps: one associated with optimism in a recovery from the turmoil (so-called “risky assets”, referencing traders’ confidence in accepting risk in return for greater returns), the other with pessimism (“safety” or “safe-haven” assets). When investors were optimistic, “risky” assets such as stocks and the Australian dollar would rise, while “safety” assets such as US Treasury bonds and the US Dollar would fall. When investors became fearful, the opposite tended to happen. Meanwhile, gold charted its own course, pushing higher regardless of the markets’ mood. This resilience reflected the prevalence of “extreme” optimistic and pessimistic (“bullish” and “bearish”, respectively) views on the state of the global economy, both of which saw gold as an attractive store of value within their respective outlooks.
For the extreme optimists (“bulls”), the central fear was inflation. In their scenario, global growth would snap back quickly and central banks would not be able to mop up the flood of cheap money they had created through record-low interest rates and quantitative easing during the crisis. This would cause prices to soar on a global scale, debauching paper currencies and making a hard asset store of value like gold a very attractive alternative. When “risky” assets did well, these investors bought gold as protection against inflation.
Meanwhile, the extreme pessimists (“bears”) didn’t believe that the mounds of fiscal and monetary stimulus that governments and central banks had undertaken would amount to more than a temporary reprieve from economic decline. They saw these efforts as being akin to putting a band-aid on a broken arm, and held that the recovery would fail as soon as policymakers withdrew their support. When “safety” assets did well, these extreme bears were buying gold as a tangible store of value alternative to “paper” assets like stocks and most currencies, which they expected would crash anew…
The Bulls and Bears Both Got It Wrong
Sizing up the current macroeconomic landscape, the extreme bulls and bears in the above scenarios are both proving increasingly wrong in their assessment of how the recovery did and will progress. On one hand, all of the major engines of global growth appear to be slowing. At its most recent monetary policy meeting, the Federal Reserve said the US recovery had been disappointingly slow and slashed their growth forecasts for the remainder of 2011. In China, recent data from HSBC showed that expansion in the manufacturing sector in June registered at the slowest pace since February 2009, having deteriorated for four consecutive months. An analogous gauge tracking manufacturing- and service-sector growth in the Euro Zone for the same period yielded the weakest reading in 32 months.
Despite this weakness, backslide into full recession seems as unlikely as a robust burst of strength. In its latest World Economic Outlook released in April, the International Monetary Fund (IMF) argued that risk of a “double dip” recession had receded. The IMF forecast that the global economy would grow at a pace of about 4.5 percent in 2011 and 2012, which is only a bit lower than the 5 percent recorded in 2010. Political leaders in the world’s top economies appear to be of the same mind as the IMF. The reversal of fiscal stimulus programs put in place during the crisis and the shrinking of budget deficits are now a major policy objective for governments across the globe.
Likewise, central banks have started to scale back their stimulus measures. Looking at the world’s top three economies, this has been most acutely evident in China, where policymakers have aggressively raised a range of interest rates and bank reserve requirements in order to slow the economy amidst fears of overheating. At the same time, the European Central Bank has issued its first interest hike since the crisis ended, and is widely expected to do so twice more over the next 12 months. Finally, the Federal Reserve – the most sluggish of the bunch – has pledged to end the second round of quantitative easing (“QE2”) in June and has so far dismissed the need to provide any more such programs. In fact, some members of the US central bank’s FOMC rate-setting committee are now aggressively arguing for an increase in interest rates this year.
Does Owning Gold Still Make Sense?
On balance, this means the “extreme” scenarios at the bullish and bearish ends of the spectrum that had driven gold higher are both unlikely. The more probable path of recovery looks to be a long, hard slog over the coming years, rather than runaway growth and inflation or catastrophic collapse. With neither the bulls’ nor bears’ extreme scenarios proving accurate, the logic behind owning gold seems suspect.
Indeed, gaping budget deficits and tightening monetary policies point to rising interest rates and bond yields. Governments will need to issue more debt to cover their budget shortfalls in the short term until they can cut their budgets down to size. This will cause an increase in the supply of outstanding bonds, which will pressure bond prices lower as investors demand to be paid a higher return to buy them, pushing up yields and boosting borrowing costs across the board. Interest rates will also need to rise as central banks increase their benchmark policy rates. With bond yields rising and becoming more compelling, gold – which yields nothing – becomes increasingly unattractive by comparison.
Meanwhile, sluggish growth is likely to be reflected in downward revisions to investors’ expectations of corporate earnings. This threatens to weigh on stock prices and encourage a familiar dynamic whereby traders cash out a portion of their equities holdings and move that capital toward the safety and liquidity of the US Dollar, pushing it higher. Gold is priced in terms of the greenback on global markets, so the US currency’s appreciation amounts to de-facto downward pressure on the metal’s prices.
Gold ETF Popularity to Amplify Coming Selloff
The patterns behind investment demand and its interaction with the spot price suggest that the headwinds now facing the gold rally are likely to produce a price drop that is particularly rapid and abrupt. Exchange-traded funds (ETFs) have become a very popular vehicle for gold exposure. ETF’s are easy to use compared to physically buying bullion. While ETFs make buying gold comparatively easier, they make selling gold easier as well. This suggests that the ultimate reversal looming on the horizon will be far more violent today than would otherwise be the case, as many investors (many of them first-time gold investors) “rush to the exits” and sell the ETF’s with a simple click of a mouse.
Source: GFMS Limited, Bloomberg
Conclusion
Gold’s rally in recent years has been impressive, breaking to new high after new high. The advance has been largely driven by demand from investors, as supply has increased while physical demand has fallen. Some investors feared sharp growth and runaway inflation. Others believed in economic collapse. It increasingly appears that the global economy will chart a course somewhere in between, seeing a modest recovery and subdued inflation. In light of these trends, and barring a sudden dramatic shift in economic circumstances, such as a strong oil spike or major sovereign default, we favor a drop in gold prices over the coming six months. In looking at the prevalence of investors and the ease of use of gold ETF’s, we also expect that any significant sell-off will be particularly strong and violent. We expect to see spot gold trading below $1320 by the end of the year.
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