To paraphrase the Sherlock Holmes yarn, Silver Blaze:
“(Mr Holmes) is there any other point to which you would wish to draw my attention?
“Yes, the curious incident of gold in 2012-13.
“Gold did nothing in 2012-13 (except go down).
“That was the curious incident.”
Between the collapse of Lehman Brothers and September 2011, as governments debased their currencies to prevent deflation and great crises repeatedly threatened the stability of the global financial system, the gold price almost tripled, producing an annual compound rate of return of 37 per cent.
It then flatlined for 12 months and since last October has fallen 20 per cent.
Most curiously, gold has not responded to either the Cyprus crisis or the Japanese decision to crank up its money-printing machine. Many are now calling it a bear market – the bursting of the gold bubble.
Well, a 20 per cent drop is at least a pretty fancy correction, if not a bear market, and there is some reason for thinking that it has further to go.
Why has gold not responded to the debasement of fiat money, and therefore likely future inflation, of the past 18 months, as well as the clear evidence that Europe is not out of the woods, crisis-wise?
For the usual reason: the market priced in more than was ever likely to happen. According to researchers at Societe Generale, the current gold price implies US inflation of 45 per cent per annum for the next five years (using 1968 as the starting point).
In those terms – looking at gold strictly as an inflation hedge – what happened between 2008 and 2011 was similar to what happened to internet stocks between 1996 and the end of 1999. Put simply, more was assumed in the price than was possible.
Gold is more than an inflation hedge, of course. It’s a complex asset with the characteristics of a monetary instrument, owing to its long history as money, and a commodity susceptible to simple supply and demand, because of its use as jewellery.
Supply of gold has been fairly stable for a century and big supply shocks in response to the price seem difficult to the point of impossible. It seems to take about eight years for supply to respond to a price move, and a relatively modest increase in supply is forecast for this year.
India and China are the biggest buyers of gold, especially after the market was deregulated about 15 years ago, and demand was a big part of the gold bull market up to 2011. Even though investment demand in China has fallen because capital controls have been eased, allowing a wider range of assets for Chinese investors, it’s clear that Chinese and Indian demand has been an important buffer for the gold price.
But the key to the marginal price of gold remains its role as a safe haven monetary asset.
Over the past few years it seems to have picked up a double whammy, benefitting as a perceived hedge against both inflation and deflation – rising when central bank quantitative easing threatened to cause inflation and rising again when a financial crisis threatened to produce depression and deflation.
Now that “double whammy” is working in reverse. Concerns about a eurozone shock have eased, for better or worse, and it’s clear the US economy at least is turning around, in part due to the advent of cheap energy.
This last point is very important. The last great gold bull market was in the 1970s after the oil supply shock of 1972 led to very high inflation. In fact, as it did in the 2000s, the gold price ran well ahead of inflation, and when the full extent of inflation that was being discounted in the gold did not materialize, the gold price crashed.
This time there is another energy supply shock – the other way. OPEC has been sidelined by colossal reserves of shale gas and oil that are now exploitable through fracking and horizontal drilling technology.
The doubling of the gold price since 2008 has occurred despite the US CPI staying below 4 per cent and inflation expectations, as measured by the yield on inflation-adjusted bonds, still staying within 2-3 per cent.
Despite that the gold price was, and still is, discounting a huge rise in the inflation rate over the next five years – 45 per cent according to SocGen economists.
It’s likely that inflation will increase – in fact it seems to be the earnest desire of policy makers everywhere that it does – but not that much.
Gold just got carried away.