This content is from: Portfolio

The Increasingly Changeable Case for Gold

Bullion may no longer be primarily an inflation hedge, but that makes its direction more unpredictable.

  • David Turner

Many of the most cherished hopes of gold bugs have come true in the past few months — but not, alas, the only one that matters to them in the end: a sharp rise in the price to bring it back into record-breaking territory.

The Comex front-month futures contract for gold peaked just shy of $1,800 an ounce in early October before dropping again, defying bulls’ hopes that it would rise above the 2011 peak of $1,912. In Monday’s New York lunchtime trading it was $1,730. Should its flat recent performance make institutional investors wary of its luster in the future?

The run of favorable news for gold bugs began in August when Mario Draghi, president of the European Central Bank (ECB), stoked inflationary fears by outlining his outright monetary transactions program to buy the sovereign bonds of troubled member states where necessary. Federal Reserve chairman Ben Bernanke’s September announcement of a third round of quantitative easing (QE3) — an injection of another $40 billion into the economy each month — added inflationary pressure to the U.S. economy.

The reelection of Barack Obama as U.S. president on November 6 provided further impetus for gold, by increasing the chances that Bernanke can continue with ultra-loose monetary policy for longer. Mitt Romney, the Republican challenger and a monetary-policy hawk in comparison with Obama, was set to replace Bernanke with an inflation hawk after the chairman’s term in office expired in January 2014.

These three factors boosted gold — but not as much as bulls had hoped, given past surges in the price in response to signs that inflation might dilute the real value of the dollar and the euro.

One argument for gold’s rather muted rally is that while potentially inflationary news from the developed world was boosting the yellow metal, the fundamentals for gold were poor in China. Last year the Middle Kingdom was judged to have altered the market forever by overtaking India to become the world’s largest consumer of gold. However, demand from China fell at its fastest year-over-year rate since 2003 in the third quarter, hit by a retreat in inflationary fears: Chinese consumer price inflation dropped to only 1.9 percent in September, down from a high of 6.5 percent in 2011.

Nevertheless, it is likely that inflation fears will stalk China again before long, since the country’s economic slowdown is proving short-lived.

Worrisome for gold nonetheless is a growing sense that, like a teenager with an identity crisis, its behavior is becoming unpredictable.

Historically, the metal has risen partly in response to inflationary fears, because of its 4,000-year-old pedigree as a store of value. However, it has also risen during times of risk aversion in capital markets — those times when institutional investors have a powerful sense of impending catastrophe, even if the nature of the catastrophe is not necessarily inflationary. The explanation for gold’s rise during crises of every shape and hue is as circular as a gold ring, but none the less powerful for that: investors buy gold in the assurance that it will rise during a crisis, and it rises because investors always buy gold during a crisis.

A problem for gold is that this circular argument has recently broken down.

The looming U.S. fiscal cliff — the tax increases and spending cuts due to come into effect in January unless politicians strike a deal — has the same timbre as other fiscal crises in other major economies which have boosted gold purchases in the past (though the effect of going over the cliff would be deflationary). However, Edel Tully, precious metals strategist at UBS in London, notes: “The expectation of political posturing surrounding the fiscal cliff is not [yet] providing the ingredient for the next rush of buying.” Tully argues that some of this correlation stems from “gold’s still positive correlation with risk.” She concludes, “Quite clearly gold hasn’t separated itself enough from the risk crowd.”

This view is supported by statistical research from HSBC, which shows that gold has been moderately positively correlated with risk-on assets over the past 20 weeks.

Nomura remains bullish about gold — forecasting a price of $2,100 at the end of next year, because of loose monetary policy. However, it notes: “We acknowledge that gold’s correlation to risk can be variable.” It is, in other words, not reliable a risk-off asset at the moment.

Many analysts credit the new link between gold and risk-on assets to the increasingly cross-asset nature of investment. Macro funds are buying the full gamut of different assets, including equities and commodities. At moments of market panic when most asset prices are falling, they find themselves forced to meet funding needs by selling classic risk-off investments such as gold on the same days as classic risk-on investments such as equities. Partly because of this trend, in terms of short-term, day-to-day trading, gold’s safe-haven status has become tenuous indeed.

But although gold’s recent daily unpredictability counts against it, it may yet be saved by the long-term unpredictability of global financial systems.

The low inflation that prevailed in developed economies for much of the 1990s and 2000s appeared to sound the death knell for gold. Much of the price stability can be credited to the relative independence given to central banks, which remained largely free from government pressure to cut rates to meet political ends.

Over the coming years, however, the temptation among governments to interfere in central banks’ operations in order to encourage higher inflation may become irresistible, as they try to inflate away their high debts.

It may not even require much government interference before central banks start pursuing more inflationary policies. Announcing QE3 in September, Bernanke said he would continue pumping money into the economy until the labor market improved. Many analysts think the “neutral” unemployment rate in the U.S. — the rate below which inflation starts to build up because of skills shortages — has risen in recent years. If true, that means the inflationary price tag for improving the labor market will be higher than before — a promising scenario for gold, at least in the traditional sense.