Gold has no utility, Warren Buffett famously pointed out in 1998 – at a time when gold traded at around USD300 an ounce.
By 2011, the price of gold had surged six-fold to reach a record USD1,900, driven by investor fears of a ‘meltdown’ scenario following the 2008 financial crisis.
Gold’s 40 per cent plunge since that peak has partly borne out Buffett’s point. Outside of an Armageddon scenario, gold has much less value.
Investors still holding gold may want to consider using the recent rebound to reduce exposure further
This truism was brought home once again last month: while global equity markets corrected, volatility surged on China- and Fed-related uncertainty, and the euro, yen and Swiss franc gained against the US dollar amidst risk aversion among investors, gold barely rebounded.
So are gold prices likely to fall further? We believe so. Investors still holding gold may want to consider using the recent rebound to reduce exposure further.
Fewer reasons for holding gold
As we build the case against, it may be salient to look first at the reasons why investors typically hold gold. Other than as an insurance against catastrophic events, gold is seen as a hedge against inflation. Also, a weaker US dollar is usually bullish for gold as a store of alternative value. Then there is the perennial bid for gold from jewellery buyers, primarily in the major Asian economies of China and India.
Most of these reasons have fallen by the wayside as the global economy has emerged from its worst crisis since the Great Depression of the 1930s.
Supportive monetary and fiscal policies worldwide have won the day, all but pushing the Armageddon scenario to the background. For sure, there are lingering concerns about the long-term effects of the unprecedented stimuli introduced by the world’s most powerful central banks. But investors are no longer willing to pay an extremely high premium (in the form of higher gold prices) for such insurance.
The US dollar is unlikely to come to gold’s rescue
Meanwhile, inflation is unlikely to return significantly any time soon given the excess global production capacities and the plunge in oil and other commodity prices. In any case, the relationship between gold and inflation holds only over several decades, whereas the shorter-term relationship is less clear-cut.
The US dollar is unlikely to come to gold’s rescue. The dollar’s supposed long-term decline was a bugbear for investors for a major part of the past decade until it started strengthening in earnest in 2014.
Since falling to a record low in 2008, the dollar has climbed almost 40 per cent against the world’s other major currencies. A stronger dollar makes gold (which is priced in dollar) expensive for major buyers in Asia. Thus, the dollar’s rebound has mirrored gold’s decline in recent years. And the dollar is likely to strengthen further, as the US Federal Reserve prepares to raise interest rates, perhaps as early as this year.
Investors drive gold prices
Demand for gold jewellery remains stable, but investors, not jewellery, are the main driver of gold prices in the short to medium term. And investors have been dumping their gold holdings in recent years. The amount held at exchange traded funds used by investors to speculate on gold has plunged more than 40 per cent since peaking in December 2012.
There are many strong reasons to sell: gold provides no income, unlike bonds and stocks. Continued outperformance of equities and bonds since the crisis has raised the opportunity cost of holding gold. Meanwhile, output from gold mines have continued to surge, especially since the 2008 financial crisis.
Given these trends, we believe gold prices have further to fall.
The key question then becomes ascertaining how far prices can drop? For one, median production costs for gold lie in the range of USD700-USD800 per ounce.
A rate hike by the US Federal Reserve could well be the trigger for an accelerated downtrend
Another way to measure gold is by valuing its inflation-adjusted price over a long time-period. Gold has averaged around USD700 an ounce in inflation-adjusted terms since early 1950s.
These measures suggest gold could fall another 20 per cent. Most other estimates of ‘fair value’ relative to other asset classes price gold well below USD1000.
A rate hike by the US Federal Reserve could well be the trigger for an accelerated downtrend, as higher US rates boost the dollar, while also making zero-yielding gold less attractive.
Before the next leg of the downtrend comes to pass and gold turns full circle moving towards its long-term averages – bearing out Buffett’s prophecy – investors may want to consider cutting their holdings.