All this in spite of its limited practical applications in the production of goods, setting aside its use in arts and jewellery. Its value is derived from the fact that others find it valuable.
To a great extent, the higher price reflects gold as a store of wealth and offering investment potential at a time of currency debasement and economic uncertainty. A key driver for the hyperbolic gold price over the past decade has been lower real interest rates – in other words, the difference between nominal interest rates and inflation. The negative relationship between the price of gold and real interest rates relates to the opportunity cost of holding gold (lower real interest rates minimise the cost of holding the commodity).
While inflation has been relatively low over the past decade, real interest rates fell sharply in early 2000 as a result of an easing in monetary conditions, most notably from the US Federal Reserve. Latterly, as a result of non-conventional monetary policy measures to deal with the financial crisis, inflation fear has picked up among some investors.
It should be noted that overall inflation expectation from both the bond markets and consumer surveys point to price increases remaining under control in the near term. The liquidity provision by central banks has not so far fed through to the credit markets. Economic and policy uncertainties are causing households and businesses to hold back significantly on spending and hiring.
As we move through the lengthy process of deleveraging and global rebalancing, a key requirement for the next stage of the recovery is the return of private sector confidence, or what John Maynard Keynes termed “animal spirits”. Nonetheless, the price of gold is affected by the expectations for interest rates and inflation among some market participants.
A small fortune
The real interest rate expectation is further compounded by the comparatively small investable market. The amount of above-ground stocks was 171,300 tonnes at the end of 2011, according to the World Gold Council. Jewellery accounts for 50% of this total followed by investment at 19%, the official sector (central banks) at 17%, technology at 12% and unaccounted at 2%. If we take the investment sector alone, this equated to $1.7trn at the end of last year.
This, however, is a small proportion of the overall global capital market – the equity market capitalisation alone amounts to approximately $37.5trn and this excludes the sizeable bond market as well as other asset classes. As the investable gold market is comparatively small, it can thus be affected by changes in investor sentiment on the outlook for both inflation and interest rates.
Losing its shine
Jewellery has consistently accounted for half of the demand for gold. Since 2010, jewellery represented 45% of demand followed by investment at 37%, technology (electronics, other industrials and dentistry) at 11% and the official sector at 7%.
The demand for jewellery was impacted by the recent financial crisis, most notably in the US. It has been recovering in India and Asia since then while China has seen continuous consumption. India, Greater China (China, Hong Kong and Taiwan), the US and Turkey accounted for two-thirds of the global consumer demand in the 12 months ending June 2012.
Overall, jewellery demand has ranged from 400 to 600 tonnes per quarter since the second quarter of 2009. On the supply side, gold production has fluctuated between 1,000 and 1,200 tonnes per quarter over the past several years.
Gold is seen by some investors as providing partial portfolio diversification. A study by the World Gold Council highlighted that gold mitigated the potential portfolio loss during periods of market turbulence over the past 25 years.
The risk, however, is a downward shift in investor sentiment towards gold owing to an increase in real interest rate expectation, as a result of an improvement in the global economy or a fall in inflationary expectations. Given the fairly static supply and comparatively small investable market, the price of gold may be particularly sensitive to a shift either way.
Any easing in financial and economic uncertainty will also reduce the appeal of gold as a store of wealth. A change in sentiment could be further undermined by a fairly constant level of gold stock, for example despite a fall in demand, supply remains comparatively high. Similarly, a strengthening of the dollar against other currencies could be negative for the price of gold given it is normally expressed in dollars.
In summary, the real price of gold is above its long-term historical average though below its ’80s high. The risks are a shift in investor expectation for real interest rates and a strengthening in the dollar. However, the low real interest-rate environment, inflationary fear among investors and relatively stable and diversified demands are supportive for the price of gold in the near term.
Global macroeconomic and political concerns mean that gold could continue to provide some diversification benefit to an investment portfolio.