The financial crisis of the late noughties continues to define global financial markets; from the supranational policies of G20, national intervention and global trade flows to debt restructuring, corporate insolvency and unemployment levels. This most recent of recessions is the worst post-war contraction on record. In the US, real GDP began contracting in the third quarter of 2008, and by early 2009 was falling at an annualised pace not seen since the 1950s. In 2009, the UK economy suffered its first annual contraction in GDP since 1991.
Globally, wealth has been eroded on a frightening scale. Worldwide, share markets lost an estimated $14trn during 2008 and, over the same period, private wealth was reduced by 20 percent. With the OECD also reporting that the value of pension funds in the developed world had plummeted by similar amount, both institutional and private investors were hit hard and left reeling. Now, as we venture forth into a new decade, all eyes are on potential recovery but, even with slowing job losses and rallying stock markets, there is still a pervading and persistent sense of uncertainty as to how secure and sustainable that recovery might be.
The recounting of these tales of woe is, of course, now commonplace, with book shelves rapidly filling with new explanations and exposés of where it all went wrong. But hindsight must also teach us something and its lessons must be enduring. Recent events may have been unprecedented for well over a generation, but that certainly does not make them unique. There is a pressing need not only to rebuild asset values but also to rebuild confidence; we must learn from the recent past and make plans to stabilise our collective and individual futures.
One of very few beacons of stability and growth over the last few years has been an age-old but, until fairly recently, much-neglected asset – that is, gold. As fund managers and investment strategists scrabbled to identify a means by which they might halt the accelerating slide of their assets, the gold price remained relatively unperturbed and, indeed, prospered. At the time of writing, the gold price has risen 67 percent from its value three years previous. But this is no flash in the pan or even, as is so often assumed, merely a reflection of tactical safe haven buying; the price has been steadily rising since the turn of the millennium. And even with the recent bounce in equity markets and sporadic signs of life in the dollar, the gold price remains robust.
Gold’s ascendancy and exceptional performance during recent crisis conditions have attracted a corresponding growth in attention both from financial media and from headline commentators. This has now led to a deluge of articles speculating on the supposed fragility of gold’s position and the possibility that its price appreciation is ultimately, and imminently, unsustainable. The proposition being advanced by some parties is that gold represents a bubble that may soon burst. Unfortunately, such discussions frequently fail to examine the complex and diverse factors that shape the gold market. It may, therefore, be worthwhile to spend a little time examining some of the arguments that have been presented in support of the gold bubble theory and to what degree they correspond to research and experience.
Recent anxiety about both the health of the US dollar and the consequences of US monetary policy have also led some observers to focus on the fact that low US interest rates enable investors around the globe to borrow dollars for next to nothing and invest them elsewhere at higher rates, thus profiting from the spread. Known as the dollar carry trade, this is often cited as the keenest downward pressure on the value of the dollar. Several high profile economists have speculated on what might happen when this carry trade unwinds or collapses and the dollar snaps back. They suggest that this will trigger a wide scale asset ‘bust’; that the ‘bubble’ in higher yield, riskier assets, further inflated by the recent waves of liquidity, will burst. Recent investment in commodities, particularly gold, and the economies of faster-growing emerging markets will, it is argued, consequently suffer.
Proponents of the gold bubble argument also frequently make assertions as to gold’s lack of utility or ‘intrinsic value’ and suggest that its fundamentals are unclear or uncertain. Many also point to broader short term economic prospects, particularly deflationary pressures, as probably not being favourable to gold.
But in proposing that these factors may create a gold price bubble, protagonists are overestimating the shift to commodities, failing to understand the diverse nature of the gold market and underestimating the breadth of gold’s price drivers and investors’ motivations. Gold is many things to many people – luxury good, commodity and monetary asset – and its price is driven by a much broader range of factors than those which influence other assets, and even other commodities.
During the financial crisis most traded commodities and diversified commodity baskets lost between six percent and 63 percent; the price of oil dropped 56 percent. Around the same time (the two years leading to June 2009), gold rose by 42 percent. Gold has remained relatively insulated from the forces that have dragged down other asset classes.
This is nothing new; gold has consistently shown itself to be less vulnerable to the economic cycles and prevailing market sentiment that affect most other assets. Its low correlation with the vast bulk of financial instruments can be proved to hold across time, markets and countries.
It can be argued that much of the bubble debate is indicative of a fairly common feature of commentary in the financial media; that is, relatively short term speculation on immediate fluctuations which often obscure longer term trends. For example, while recently there have undoubtedly been significant inflows from more tactical traders into gold investment products, there has also been a reawakening of the retail gold investment market in the developed world – a source of demand that has been relatively dormant for decades, but which typically represents ‘sticky’, long-term money.
In reality, the gold price has been building steadily for nine consecutive years, underpinned by a range of market developments and growing demand from diverse sources. For example, the last decade has seen the development and rapid growth of the gold ETF market, deregulation in several key consumer countries, the introduction of design-led jewellery in China, the development of gold-backed savings products in the Far East, renewed private investor interest in the US and Western Europe, a growing acknowledgement of gold’s unique diversifying properties by institutional investors, a geographical broadening of the production base, a marked reduction in Central Bank sales, and a growing number of official sector purchasers. The current trading range should not be regarded as a spike, but the result of a fairly measured rise, supported by favourable and robust market fundamentals. Gold’s relatively stable rise is also reflected in its relatively low volatility, something frequently misunderstood or misrepresented. Gold is typically far less volatile than other commodities and comparable to most blue-chip stock indices.
The lack of clarity in many discussions regarding gold market fundamentals is perhaps not surprising given the range of price drivers, both in terms of supply and demand, but it can cause an exaggerated perception as to gold’s potential vulnerability. For example, while investor flows have, for some years, provided a key means of support, recently reinforced by Western market interest during the course of the credit crisis, the larger portion of gold’s traditional demand base comes from jewellery (averaging 63 percent of total demand over the last five years), mostly from emergent economies such as India, China, and the Middle East. This geographical diversity provides much needed balance to the market and reduces the volatility in the gold price. During periods when investment demand may be relatively flat, possibly reflected by a sideways movement in the price, this stability may stimulate buying activity in the local gold jewellery markets in India and the Far East.
Returning to discussions of the dollar carry trade, it would seem a little short-sighted if considerations as to the fate of the dollar and possible consequences for gold do not acknowledge the bigger picture; the volume of greenbacks in circulation, the size of the US budget deficit – according to recent projections running over 10 percent – and US gross national debt, currently estimated at 86 percent of GDP.
Of course, the dollar is not the only currency currently faltering and while some commentators have suggested deflation should be our most pressing concern, the issue of long term currency depreciation and, ultimately, the ravages of inflation cannot be dispelled for long, particularly as we ponder the impact of quantitative easing measures and ‘emergency’ liquidity pumped into the system to stem the threat of protracted, deeper recession.
Empirical studies show that gold is a leading indicator of a rise in the velocity of money and a consequent increase in inflation pressures. The gold price can be seen to have a positive correlation with global money supply growth, whether in expansionary or recessionary periods.
Regardless of whether the economic recovery gathers momentum or stumbles in 2010, it can be argued that much of the talk of a gold market ‘bubble’ is based on relatively superficial and short term views of the gold market. Furthermore, this debate neglects gold’s key benefit to long-term investors and that is its role as an ‘insurance’ asset that can be proven to enhance and protect portfolios. Gold’s relative stability and diverse drivers ensure that it does not exhibit the boom and bust characteristics so evident in most other asset classes over the last decade and can therefore be relied upon to preserve wealth and provide a secure foundation for pursuit of broader recovery.
Marcus Grubb is MD of Investment at the World Gold Council
