Gold - First Among Equals
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Gold prices, which began rising at the beginning of this millennium, have not turned around since then. Even after 12 years, the prices of gold only seem to be rising in what can best be described as a unidirectional move to the top. From an average of USD 271/troy ounce during 2000, the price of gold is currently at USD 1725/troy ounce – an average rise of 18.3 per cent per annum since 2000. What this means is that gold has well performed its primary task of beating inflation. Besides this, it has also managed to surpass the returns provided by various other asset classes including equity, which returned 15 per cent during the same period. There are very few instances in history where gold has consistently outperformed other asset classes over such a long time.
In fact, a look at gold prices over a period of time suggests that they have remained stable for most part of history. For example, the price set by Isaac Newton (English physicist, mathematician and astronomer, best known for the falling apple and the law of gravitation) in 1717, as master of the UK Mint, remained almost same for the next 200 years. Even after that, the prices of gold did not fluctuate much till 1973, when the Bretton Woods system of fixed exchange rates collapsed and gold prices were determined by market forces. In 1990s too, the prices of gold either remained stable or went up.
Therefore, the current surge in the price of gold poses a very natural and logical question. When will the law of averages catch up, and how long will the current bull run of gold sustain? More so, is this the right time to invest in or buy gold?
To find out answers to these questions, we need to first understand why gold, despite being a commodity, displays characteristics different from other commodities, and hence, how the factors that determine its prices are not just the simple economic principles of demand and supply.
A Unique Commodity
One of the factors that single out gold from other commodities is that unlike other commodities, gold does not perish or degrade over time. This gives it a unique property of being a very long-term store of value. Gold mined today is interchangeable with gold mined at any time ever over thousands of years.
Another unique feature of gold that makes it less price elastic is its supply. The supply of gold has been relatively fixed for quite some time now. Unlike other commodities, there is a very negligible possibility of increasing the supply of gold to manage prices.
Another important attribute of gold is its relatively less prominent use for industrial purposes as compared to other commodities including precious metals like silver and platinum.
Moreover, with a steep increase in the price of gold, only around two per cent of gold demand in 2010 came from industrial uses and the balance of the demand arose from jewelery and for investment. As a result, gold prices has often exhibited a very low or even negative correlation with economic cycles and with other financial assets (See table: Correlation of Annual Returns Since 1972).
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Golden Rule Of Price
Owing to these unique characteristics, price of gold is dependent on factors that are more macro-economic in nature.
Fiat Currencies Vs Gold: Due to different institutional settings in the past, gold is mostly priced in terms of the US dollar. Hence, the external value of the US dollar has had a significant influence on gold prices, at least in the short term. According to a study conducted by the International Monetary Fund (IMF) in 2008, it is estimated that about 40-50 per cent of the move in gold prices since 2002 has been dollar-related (See Graph: USD Index Vs Gold Prices). A one per cent change in the effective external value of the dollar led to more than one per cent change in the price of gold.
How far is this hypothesis true? To validate this, we extended the same study to cover a period stretching from way back in 1971 till 2012. A regression analysis of the average yearly prices of gold and the average yearly move in the USD index (which measures the external value of dollar against a basket of currencies) suggests that though the link has weakened, a quarter of the movement in gold prices is still solidly determined by the movement in the USD.
The reason for such a relation is that despite gold being a commodity, it is not really a commodity at all. It is actually a medium of exchange, and one that is officially recognised and widely held by most of the world’s larger central banks as a component of reserves along with other fiat currencies, majorly the USD.
It is estimated that the total gold reserves held by central banks form almost 15-18 per cent of the total stock of gold (as at the end of March 31, 2012). Therefore, at times when the USD loses its value, the central banks increase their exposure to gold as an alternative store of value, driving up the prices of the yellow metal. This is best exemplified in the actions of some of the central banks over the last one year. The total holdings in gold had increased to 55.1 metric tonnes during the first four months of 2012 alone when the value of USD index was down by three per cent, pushing up prices of the metal by 3.3 per cent during the same period.
In view of the current actions of the major central banks, it is obvious that gold is likely to appreciate more ahead from here. The US Fed remains highly accommodative on the monetary policy front. On 13th September, 2012, the Fed announced QE3, which involved the extension of ‘Operation Twist’ and the introduction of new buying to the order of USD 40 billion/month of mortgage-backed securities. Even the ECB’s plan to alleviate the finances of Europe’s peripheral nations with potentially unlimited bond purchases is going to weaken the fiat currencies and make gold stronger.
The minting of fiat currencies gives rise to another important and key driver of gold prices – inflation.
Gold, Inflation & Interest Rates: The real interest rate, which is essentially a byproduct of nominal interest rate and inflation, remains one of the most important factors that dominates the price of gold. The price and demand for gold moves inversely to the real interest rate. Higher the real interest rate, lower the demand for gold and lower the real interest rate, higher is the demand for gold.
This is best exemplified by the steep rise in the price of gold that happened during the 1970s, when gold prices increased an average 23.8 per cent per annum. Gold that was trading at average of USD 36/ounce in 1970 increased to USD 306/ounce by the end of 1979. Although a partial increase in the prices of gold was also to do with some geopolitical developments (the Iranian revolution and the Soviet invasion of Afghanistan), the role of higher inflation and lower real interest rates that was in existence at that time cannot be undermined. The real interest rates were either negative or remained near to one during that period. The average real interest rate in USA in the 1970s comes out to around 1.7 per cent. Such a low real interest rate was more due to a higher inflation of around eight per cent that prevailed at that time.
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The reasons for such an inverse relationship between gold and interest rates is that gold as an asset class neither fetches you any dividend nor do you get a coupon rate paid for holding it. Therefore, the opportunity cost of holding gold increases with a rise in real interest rates and decreases with a fall in the rates. During a period of lower real interest rate or negative real interest rate, it makes sense to invest in gold, as historically it has been seen that the prices of gold move northwards in such a scenario.
Moreover, the long run purchasing power of gold has remained stable. According to a study conducted by the World Gold Council (WGC), if we adjust different institutional settings (such as the Gold Standard, the Bretton Woods system and the free floating price for gold since 1971) and the migration of gold from use as an everyday currency to an investment vehicle, the long run purchasing power of gold has remained remarkably stable over time. In the 1830s, the price of gold in terms of the value of the USD in 2010 was around USD 450/troy ounce. The price of gold in real terms has remained much the same even in 2005, which is more than a century and a half later. The current rise in gold prices since 2008 can be partially attributed to a similar phenomenon of the real interest rates being very low.
In contrast, the early 1980s saw substantially positive real rates as a result of a concerted attempt by the global central banks to squeeze out inflationary pressures. It is probably no coincidence that in the wake of the radical rate hikes by central banks during this period, gold prices declined from their 1980 peak levels, with some funds getting diverted into other assets like cash and government bonds. From the average of USD 615/troy ounce in 1980 the start of 1980, gold prices plunged to USD 271/troy ounce over the 21 years that followed. This marked a decline of four per cent per annum during the period.
This discussion makes it clear that during times of higher real interest rate, gold as an asset class tends to under-perform other assets whereas in the case of lower real interest rates gold is likely to give you truly golden returns. The current scenario, where interest rates are at a multi-
year low, supports higher gold prices, and this is likely to continue for some more time.
Exchange Rate: Another Twist For Indian Investors Since gold prices are expressed in dollar terms, Indian investors have to keep an eye on the movement of the Indian Rupee (INR) against the US dollar. There are times when the international prices of gold have fallen, but due to a weakening of the rupee the prices of gold in INR terms have either remained stable or increased during the same period.
For example, when gold prices dropped from the high of USD 1920/troy ounce made in the month of September 2011 to USD 1574/troy ounce by May 2012, they didn’t comedown in the Indian market. On the contrary, the price of gold in INR terms increased by three percent during the same period. The reason for this is a sharp depreciation in the INR against the USD during the same period. Going forward, we believe that the INR will appreciate from here on, and hence, the current surge in the gold prices will be partially negated.
Conclusion
Golden Run To Continue Currently, gold prices stand well above their post-1971 real-term average. However, historical experience says that it will be naïve to assume that the prices will reverse anytime soon.
To get a better idea of this and take a broader perspective, one should compare the purchasing power of consumers in the G7 countries to assess how many ounces of gold are equivalent to the per capita income there. A study by Deutsche Bank says that since 1970, a G7 consumer has been able to buy an average 69 ounces of gold per year. If gold prices average USD 1550/troy ounce this year (2011), then the income in G7 countries is currently equivalent to 26 ounces. Bringing the purchasing power of G7 incomes relative to gold down to the levels that prevailed at the beginning of 1980s would require gold prices to rise to USD 2410/troy ounce.
Thus it is evident that besides the loose monetary policy, a weakening dollar, lower interest rates, there are several other factors that point towards a sustained golden run for the gold prices.