Suki Cooper

By Suki Cooper
Executive Director, Precious Metals Research, Standard Chartered Bank

Gold’s quickstep with $1000 in 2008 was not a chance meeting. The first steps in this dance were taken several years ago, with the introduction of new avenues to gain exposure like ETFs, bringing the metal back into vogue with investors. Last year, gold not only breached the all-time nominal high set in January 1980, but also set a record annual average high. Investment demand is still taking the lead in 2009. This article examines some of the tunes to which gold investment dances, and which is most likely to put on the moves in 2009.

During March 2008, not only were exogenous factors neatly aligned, but the metal’s own fundamentals had become favourable. Mine supply has disappointed for a number of years, despite prices reaching record highs. The European central banks’ Gold Agreement has been a successful tool for the European banks to dispose of gold holdings without causing market instability yet providing market confidence. Indeed, subdued sales in recent months added to the bullish sentiment. Despite the higher prices, growth in recycling has not been sufficient to offset the decline elsewhere. Gold scrap accounts for about 30% of total supply, leaving most of the supply inelastic. Jewellery consumption still makes up the bulk of the end use of gold and tends to provide a floor to prices: when prices encounter a downward trajectory, physical buying returns to the market.

One of the key dynamics that has been crucial in the change of fortune for gold has been the swing in producer strategy from hedging to de-hedging. The additional ‘demand’ created through restructuring and position buybacks has been significant. The global hedge-book peaked at over 3000 tonnes at the start of the decade; the latest data from the Fortis/VM Group report estimates the global hedge book fell to 512 tonnes as at Q3 08 – less than a fifth of that peak. Investment demand has been the one flow that has shown tremendous growth, partly due to the new channels of investment that make holding gold easier and partly due to the external environment that has provided investors with a plethora of motives to hold gold.

Investors in search of a safe haven have rapidly increased their exposure towards gold. Fears of a recession, uncertainties regarding the credit markets, Fed rate cuts, a falling dollar, as well as inflationary concerns are some of the factors that helped gold to conquer $1000/oz and cause shortages of physical gold worldwide.

Looking at four factors – dollar hedge, inflation hedge, recession hedge and equity market hedge – from a simple return point of view shows that some of them are purely theoretical, not all are equally important, and indeed those that drive prices sometimes switch places in the driving seat.

Dollar Hedge

Most commodities are priced in US dollars, so it is not surprising that a negative relationship exists between commodity prices and the value of the dollar. Gold’s legacy as a monetary asset, with key consumption being outside of the US, helps it to rank top in terms of the strength of its relationship with the dollar over the past ten years.

To the casual observer, a weakening dollar would certainly appear to be broadly supportive of an uptrend in gold prices, but the converse does not necessarily hold true. Taking selected isolated periods of significant change in the EUR/USD shows during periods of dollar weakness (Figure 1), gold prices do tend to benefit. For example, between February 2006 and April 2008, the EUR strengthened by 32% against the USD and gold prices rose 64%. Gold prices rose more than the dollar weakened. As the table shows, this is not always the case: gold prices do not always appreciate by a set magnitude of dollar decline. Conversely, between October 1998 and October 2000, the EUR fell 29% against the USD, while gold prices fell 9%. Notably between August 1992 and February 1994 where the EUR weakened against the USD by 20%, gold prices still rose some 11%. Although a weakening dollar is supportive of higher gold prices, it is not essential; furthermore, a strong dollar does not necessarily prevent gold prices from appreciating. It is a strong relationship that is often traded but not one that will unquestionably cause an equal and opposite reaction. The correlation between the USD and gold prices is currently firmly in positive territory, but history shows this relationship tends to weaken during periods of dollar strength, and the relationship becomes stronger during periods of dollar weakness.

Back in March 2008, when gold prices breached the $1000 level, the USD had hit record lows against most major currencies. In turn, our expectation for the USD to weaken against the EUR on a 12-month basis bodes well for gold.

Inflation Hedge

Gold is sometimes bought as a hedge against inflation, but it is far from a perfect or dynamic hedge and may need to be held for longer periods to be effective. As illustrated in Figure 3, inflation and gold prices have broadly moved together but gold has been far more volatile: while US CPI has moved between zero and 16% since 1971, gold prices have fluctuated between minus 50% and 200%.

In the past ten years, since the launch of the TIPS (Treasury Inflation Protected Securities) data, TIPS offer a better inflation hedge because they have provided a continuous positive return. Gold, on the other hand, underperformed inflation for the first six years, but then overshot the US CPI index over the last four years (Figure 4). It follows that inflation hedging is not the driving factor in gold investment demand.

Recession Hedge

Gold’s performance during recessionary periods is inconsistent as it is in inflationary periods. Figure 5 highlights recessionary periods in the US after the gold price was freely floated. Assuming gold is bought at the start of a recessionary period and held until the end of the recession, the return varies significantly and there is no clear pattern.

The impact of recessions on gold demand also varies. Jewellery demand is not just a function of income, it is also dependent on other factors such as price levels and price volatility. Industrial demand is too small a proportion of overall demand to function as a major depressant. Investment buying, whether through small bars and coins or more recently through ETFs, has generally risen and, in turn distorted overall demand.

Although periods of rising interest rates have yielded far better returns for commodity index investors than periods characterised by monetary policy easing, gold’s performance appears to be little affected from fluctuations in economic growth. There is not a strong consistent pattern of gold price behaviour during recessionary periods (see Figure 5).