| Summary: The gold price slumped heavily in April last year as exchange-traded funds sold out of the precious metal, spooking many retail investors to do the same. But gold demand actually surged last year, and the selling pressure has stabilised. But gold investors still should tread carefully. |
| Key take-out: An agreement by Europe’s central banks this week to co-ordinate their gold transactions, ongoing interest from central banks elsewhere, and the turnaround in ETF selling pressure should calm anyone’s concerns about a sustained slump in the gold price. |
| Key beneficiaries: General investors. Category: Commodities. |
Earlier this week the major central banks of Europe, including the European Central Bank and the Swiss National Bank, signed the fourth central bank gold agreement.
The aim of the agreement is to bring clarity with respect to their gold holdings and to prevent any disruptions to the market. Not an unimportant event given that the ECB, plus the other major European banks who are signatories to the agreement, collectively hold about 37% of the world’s official gold holdings and one-fifth of all the gold ever mined. In the agreement the banks specified that:
- Gold would remain an important element of global monetary reserves;
- The signatories would continue to coordinate their gold transactions so as to avoid market disturbances;
- That the signatories do not have any current plans to sell significant amounts of gold.
That last point is probably the most important as it’s a clear change from their last agreement in 2009. Back then, the banks agreed to cap sales at 400 tonnes per year. They didn’t get anywhere near that of course, selling only about 200 tonnes over the last five years – but still the flexibility was there.
The importance of the shift becomes apparent when you look at the broader market dynamics. Looking back over the last decade or so, European central banks had been net sellers of gold and indeed this led to an official net selling position for many years until 2010. The argument at the time was that there were more productive uses for central bank reserves than gold – which earned no return. Moreover, many European governments already held a high proportion of their reserves in gold and the aim was to diversify.
That being the case, if European central banks are now telling the market that they plan no significant sales over the next five years, what does that say about the official perception of gold? Gold still doesn’t earn any return and, the fact is, many signatories to this latest agreement still hold a very high proportion of their reserves in gold.
Central banks are clearly key to the market, and this change in European perceptions of gold as a reserve comes at a time of significant Asian central bank buying. Asian central banks have been diversifying into gold for some years and this process is clearly not over – especially as many central banks hold comparatively low gold holdings as a percentage of total reserves (see chart 2) – and it’s not just Asia. Brazil doubled its holding of gold in 2012, a year in which total central bank buying was its highest in around half a century.
Central bank buying has come down since then, as too have prices, although central banks still bought a lot of gold last year. The process only seems to have accelerated into the first quarter of 2014. This strong interest gold is understandable and the reasons are well known. All the major economies are debasing their currencies on an unprecedented scale. As discussed in past articles, this hasn’t led to consumer price inflation just yet – although asset price inflation is extraordinary. In that environment, gold remains attractive for nations as:
- A hedge against the central banks yet again making a mess of policy;
- A store of wealth;
- A currency hedge;
- An inflation hedge.
They are all the traditional reasons, and they haven’t changed. I’m not suggesting that we’re going to see central banks in Asia and elsewhere make a sudden and dramatic shift into gold out of foreign exchange. They haven’t done it yet, and they’re not likely too. It would be too destabilising.
Instead, I think they will continue, given the current stances of monetary policy in the US, Europe, Japan and Britain, to lift their holdings of gold gradually. This is what they’ve been doing since the GFC. Yet we don’t need to see a sudden and dramatic change. Asian countries tend to hold a very high level of reserves – $7 trillion (most in foreign currency). Total gold demand in 2013 was a mere $185 billion (just under 3% of total reserves). Just on the math, you only need to see very small changes in reserve policy for there to be a huge impact in gold demand.
So if all of the above is true, why has the gold price slumped 30% since reaching a high in October 2012? Many reasons have been offered – some too simplistic to really be a reason at all (i.e. gold was a bubble and so correction was due). In addition to the bubble, other possible explanations for this sudden drop in investor interest include the fact that QE was ending, Europe is improving etc.
What we do know is that there was no real change in the supply/demand dynamics. Gold remains rare. Moreover, actual real demand – from central banks, for jewellery and for use in industry – surged by 14.5% in 2013 as the price slumped 30%. It is interesting to note the surge didn’t seem to arrest the slump. No, the fall was due entirely to a sudden drop in investor demand – namely through exchange-traded funds.
By and large, the fall remains an unexplained event – especially because 40% of the decline in the gold price occurred in about one week! The fact is, there is no shortage of investors who think the Fed drove prices lower in order to fight off rising inflation expectations, protect the value of the US dollar, and generally deflect accusations of incompetence. I haven’t seen any data to support that, but the sudden and unexplained price move did raise eyebrows. And the fact remains that governments have been very active in keeping a cap on other commodity prices – especially oil.
Whatever the cause for the slump ETF selling appears to have stabilised now, with no sales into the March quarter of 2014 – the first time in about a year.
This is critical, because ETF sales ‘added’ about 880 tonnes of gold to the market last year – 20% of the total market. Take that out, and there is some serious upside pressure just there, especially with central bank buying remaining strong and physical demand otherwise robust. That last point, of course, means that the ETF selling pressure we saw last year is unlikely to return. Or if it does, it is unlikely to be sustained. It can’t last forever, as it would be irrational for investors to sell off gold like they did through 2013 while real demand is surging.
Obviously, these are very bullish signals for gold. Yet I think it’s far too dangerous for investors to load up on gold with some bullish bet in mind. Given the experience of 2013, which remains largely unexplained, retail investors need to be very careful.
Instead, I think the key message we should take is that we should not be afraid to hold gold. The actions of Europe’s central banks, ongoing interest from central banks elsewhere and the turnaround in ETF selling pressure, should calm anyone’s concerns about a sustained slump.
Gold is a scarce resource, it has intrinsic value and, at the end of the day, it is a great insurance policy should policymakers stuff things up again – which is a very high probability. Will the gold price surge if that happens again? History suggests it will.
With that in mind, there are a number of ETFs available on the ASX for investors to get into – such as BetaShares’ currency hedged gold bullion ETF (QAU), ETF securities (GOLD) or Perth Mint Gold (PMGOLD).
