Timing Gold’s Recovery

A mixed global economic outlook is currently hampering the price of gold, writes Mark McFarland, chief investment strategist, Emirates NBD Private Banking.

Gold is supposed to be a store of value but its price is down almost 20 per cent since the peak last autumn. The yellow metal has been trading in an ever-narrowing range that now lies between $1,700/oz and $1,550/oz. At the end of last year, it was assumed that gold would rise through the two thousand dollars per ounce barrier and potentially hit $2,500/ oz. What has happened?

To understand the dynamics of the gold market, we need to move away from simplistic views based on central bank activity. Physical gold is two things at the same time. It is a store of value when there is inflation and deflation.

It holds its value in real, inflation-adjusted, terms when other asset prices lose theirs. It is also a store of value when there is deflation or financial chaos. There is no one to default on payment once you have the bullion in your possession. Bonds can default because governments and companies fail to repay lenders. Corporates, which issue equity, can fail because of recession or bad management.

Physical gold doesn’t have a liability attached to it. It is the last asset standing. Being an asset with no interest, gold
tends to outperform when the yield on alternatives, such as longer term US government bonds, are negative and when the US dollar is falling in value. A negative real yield on US government bonds makes gold attractive because the asset that comes closest to it in terms of default potential is offering no real return.

Currently 10-year US government bonds offer an inflation-adjusted yield of between -0.5 per cent and -1 per cent.

At the moment, the consensus outlook for the global economy sees neither rapidly rising inflation nor deflation. The picture
is very mixed in developed countries and is clouded somewhat by the recent decline in energy prices. Also, the US dollar is
in demand due to concerns that euro-denominated assets aren’t secure.

For these reasons, gold has refused to move back towards the USD1,900/oz level last seen in September 2011. To some extent, the decline in gold price volatility represents the end of the period when markets reacted in horror to the prospect of euro-breakup.

For gold to move higher from now on, two events are now necessary. First, central banks need to move from using conventional monetary policy, where interest rates are adjusted, to unconventional policy where they buy bonds from government and flush the markets with cash. This will raise the prospect of a return of inflation and gold will return to its former role as a means of preserving wealth.

Second, to some extent the positioning of traders needs to become less biased towards higher prices. Many traders who hold contracts looking for prices to rise need to close those positions and allow the price to stabilise before entering fresh long positions. A clearing out of long positions will probably result in gold moving lower, before resuming a move higher.

Until that happens, it is likely that gold will continue to trade in a pattern with downshifts in prices accompanying an inevitable deteriorating in Europe’s growth outlook. Inevitably, the European Central Bank or all the G7 central banks will opt for aggressive quantitative easing as Europe’s banking sector problems deteriorate. This is the point at which gold will revive.

Timing is therefore everything, but from a private banking perspective gold should be held in a portfolio regardless of whether the price is rising or falling. The volatility of its price is less than that of financial assets and a portfolio that contains gold will therefore be less volatile than one that holds only a traditional mix of cash, bonds and equities.