Investors buy gold as for one of three reasons: a hedge, a safe haven, or a direct investment.
Investing in Gold
What Drives Gold Prices
Gold occupies a special place among precious metals. For much of recorded history it has played an important role as money or, more recently, as a relative standard for other currencies. In the latter part of the 19th century, many European countries as well as the United States instituted gold standards, pegging their currency to a fixed amount of the precious yellow metal. This system remained more or less in place until after World War II, when the Bretton Woods system pegged the US dollar to a fixed exchange rate of US$35 per troy ounce. In 1971, the U.S. suspended the convertibility of dollars to gold, transitioning to the system of fiat currency still in place presently. Today, there are no remaining currencies pegged to gold (the Swiss Franc was the last currency to drop the gold peg, in 2000), but its legacy as a store of value still greatly influences the way it is used today. Unlike many other precious metals, gold’s usage is dominated by investing applications: 40% of the new gold produced every year is used in investments, 50% is used in jewellery, and 10% finds its way into industrial applications. All of this is to say that, from an investing standpoint, gold does not behave very much like other metals. It is not very responsive to changes in supply or demand. Rather, gold’s price movements are largely attributable to a number of global economic forces or “price drivers.”
Since the beginning of gold price quotations on international markets in 1970, those prices have been driven mainly by market fundamentals, particularly by changes in demand (e.g. for jewellery and industry applications). This has been the result of the large quantities of above-ground stocks of gold available compared to the average annual mine production, and its limited flexibility in meeting the demand. Exogenous factors, such as the world’s geopolitical and economic environment, and dynamics in the financial sector, such as equity markets, also affect gold prices.
As the world’s foremost reserve currency, dominating international trade and transactions, the strength of the U.S. dollar has a tremendous impact on financial markets worldwide, and by extension on the price of gold. We see this as the number one driver of gold prices. The trade-weighted dollar is widely used to measure the purchasing power of the U.S. dollar, as well as the effects of its appreciation and depreciation against foreign currencies. The Trade Weighted Dollar Index, also known as the Broad Index, uses the currencies of 26 foreign countries, accounting for 90% of U.S. trade, to calculate the trade-weighted dollar. As the dollar rises in value, exports to other countries become more expensive while imports become cheaper. If the U.S. dollar is being debased, for example by loose monetary policy, the price of gold tends to react inversely, that is, to rise. When the value of the U.S. dollar drops, many investors rush to gold as an alternative currency. Conversely, if the trade-weighted U.S. dollar rises in value, gold prices tend to fall.
Gold Prices and U.S. Dollar Correlation
Consumer Price Index (CPI) inflation is the second-most important price driver of gold. CPI, or the Consumer Price Index, is a statistical estimate which uses a representative basket of goods to measure price changes over time, and is usually calculated on a monthly or quarterly basis. The representative basket is composed of a very wide variety of goods ranging from rent payments, to utilities, food, apparel, transportation, medical care, and much more. A rise in the Consumer Price Index represents rising prices of everyday goods and services, in other words an inflationary environment. Gold has historically been a hedge against rising prices, and therefore tends to respond positively to CPI inflation. On the other hand, in a deflationary environment with falling consumer prices, gold would also tend to decline in value. Over the last ten years (12/31/06 – 12/31/16), the annual CPI inflation rate has averaged around 2%, though in any one-year inflation may have been significantly lower or higher than that amount. For example, the annual inflation rate in 2005 was 2.5%, rising to 4.1% in 2007 before falling to 0.1% the following year. Indeed, CPI inflation rates are adjusted as the CPI index is recalculated on a monthly basis by the U.S. Bureau of Labor Statistics, and so can swing from month-to-month. News of abnormally high or low inflation rates would likely have an immediate effect on the price of gold.
The third most important driver of gold prices is derived from changes in nominal yields on 10-year U.S. Treasuries. Loose monetary policy (low or zero interest rates) tends to have a positive effect on gold prices, and this can also be reflected in longer rates on 10-year U.S. Treasury bonds. By combining inflation figures with nominal 10-year rates, it is possible to arrive at a real rate proxy, providing some indication of how gold might respond. In other words, a positive change in nominal yields on 10-year U.S. Treasuries would tend to be negative for gold prices. Gold prices would tend to respond positively to falling nominal yields.
Investor sentiment is by its very nature a fickle and difficult-to quantify variable, but it is undoubtedly important. In general, we view it as the fourth-most important price driver for gold, however judging by recent surges in net long speculative positioning in futures markets, it is one of the most important currently. Thanks to gold’s status as a “safe haven” asset, disasters and other shocks to the financial system including wars, financial dislocations, anxieties regarding the political situation (e.g. the 2016 U.S. presidential election), and general instability may push gold prices higher.
Generally speaking, economic cycles are the natural ups-and downs between times of expansion and contraction. Wherever we find ourselves in an economic cycle, whether it happens to be a growth period or a recession, may have some impact on gold prices. However, because the four preceding drivers also to some extent behave as functions of the overall economic cycle, we find this to be the least significant driver of gold prices overall.
Evolution of gold prices since the beginning of the 2000s
From 2001 to 2012, gold prices recorded a historical price rise, gaining about six times their nominal value of 2001 (about 4.5 times in inflation-adjusted terms) to reach an average of $1,670 in 2012. This massive price rise was just 2 per cent lower than their record level of 1980 in real terms. The rise was supported by strong physical market conditions, with gold mine production contracting between 2000 and 2008 (by 11 per cent). This was mainly due to low gold prices during the previous period and the progressive deterioration of ore grades worldwide. In addition, due to the worsening global economic conditions since 2008, the share of gold acquired as a financial asset started to supplant the demand for jewellery and industrial applications. This had a positive impact on prices, which started to rise again. For example, demand associated with exchange traded funds (ETFs) jumped from 253 tons in 2007 to 623 tons two years later. At the same time, demand for bars and coins more than doubled between 2007 and 2008. While the change in ETFs was short-lived, growth in physical demand for bars and coins remained robust up to 2013, when this sector reached a record level of 1,772 tons − an increase of more than 300 per cent compared with 2007.
Since the beginning of the financial and economic crisis in 2008, the United States, followed by the United Kingdom, Japan and, more recently, the EU, initiated a number of quantitative easing programs aimed at increasing money supply, as well as supporting domestic demand and spending by households and companies. This monetary policy, with its potential inflationary and currency devaluation risks, contributed to attracting a new wave of investors into the gold market that considered gold to be a more attractive and secure asset when other financial investments took a dive. For instance, between the first quarter of 2008 and the second quarter of 2015, 10-year bonds lost 97 per cent of their yield in Germany, 54 per cent in the United States and about 75 per cent in Japan.
Since 2010, central banks have become net buyers of gold after more than two decades as net sellers, mainly driven by large purchasing programs initiated by emerging market economies’ central banks, as well as a reluctance by European countries’ central banks to sell their gold reserves (chapter 2). This too has influenced the general trend in gold prices. The highs in gold prices up to the end of 2012 have been compared to the price boom of the 1970s. However, even though the pre-2012 nominal gold prices sharply exceeded the levels of the 1970s, in real terms they remained below their levels of the 1970s. Moreover, price volatility during the period 2002−2012 remained far lower than in the 1970s (figure 19a). For instance, while the average monthly change in gold prices was 2.4 per cent between 1970 and 1980, this percentage dropped to 1.5 per cent between 2002 and 2012. Furthermore, extreme changes were more significant during the 1970s than the 2000s, with several monthly growth rates exceeding 15 per cent during the 1970s.
Investments in gold
Investors buy gold as for one of three reasons: a hedge, a safe haven, or a direct investment. Based on an approximation using annual demand numbers and prices, total investment in investment bars and official coins amounted to $58 billion from 1968 to 2016 inclusive. Obviously, this is only a very loose estimate because of fluctuations in price and volume, but it does give an order of magnitude. The tonnage, at almost 24,000t, is just over 7.5 times the world mine production in 2016.
Gold as an asset class
Gold is a highly liquid yet scarce asset, which is no one’s liability. As an investment it can play four fundamental roles in a portfolio:
Our analysis shows that, over the last decade, adding between 2%-10% in gold to the average pension fund portfolio would have both increased returns and reduced volatility.
Most investors agree about the relevance of diversification, but effective diversifiers are not easy to find. Correlations tend to increase as market uncertainty (and volatility) rises, driven in part by risk-on/risk-off investment decisions. Consequently, many so-called diversifiers fail to protect portfolios when investors most need it.
Due to its dual nature as a consumer good and investment, gold’s long-term price trend is supported by income growth. But in the short- and medium-term its price tends to rise during periods of uncertainty, making it an effective portfolio diversifier.
A source of returns
Traditionally, investors view gold as an asset to hold when risk is high and to sell when the economy booms. However, economic growth has a positive effect on gold consumer demand – which is around 80% of annual gold demand.
Our research shows that investors rely on gold during periods of market uncertainty, pushing demand up when inflation spikes or when the stock market tumbles. This generally influences gold prices in the short- and medium-term. However, one of the most important long-run drivers of gold is positive income growth, with a positive effect on jewellery, technology, and bar and coin demand – the latter in the form of long-term savings.
Gold has delivered positive returns over the long run, often outperforming major asset classes.
For large buy-and-hold institutional investors, size and liquidity are particularly important factors when establishing a strategic holding. Gold benefits from a large market. Physical gold holdings by investors and central banks are currently worth approximately US$2.9 trillion, with an additional US$400 billion held in open interest through derivatives in exchanges and over-the-counter (OTC).
The gold market is also liquid. Gold trades between US$150 and US$220 billion per day through spot and derivatives contracts over-the-counter. Gold futures trade US$35-60 billion per day across various global exchanges. And gold-backed ETFs offer an additional source of liquidity for moderate-sized transactions, with the largest US-listed fund trading an average of US$1.2 billion per day.
Investing in gold mining companies
Investing in the shares of gold mining companies is one of the most interesting and exciting areas of stock market investing. It is a broadly observed phenomenon that investors pay much more attention to their gold mining investments than they do to most of their other equity investments. Brokers and others tell stories about how their investor clients will know all about the operations and history of the gold mining companies in which they own shares, but comparatively little about other types of companies they hold.
With gold mining shares there are two ‘betas’ to which investors should pay attention. One is the beta of gold shares to gold prices. The second beta is the relationship between gold shares and the broader equity market.
The history of stock markets is filled with stories of the creation and development of major gold mining companies. When the Financial Times of London republished its first edition for its centennial on January 9, 1988, the vast majority of the articles were about gold mining companies then being developed around the world. It is not just the historical nature of investing in gold mining shares that makes this segment of the equity market so interesting to investors.
Gold mining shares have offered handsome riches and rewards to investors since the middle of the 19th century. Types of Gold Mining Companies There are many types of gold mining companies, and the different types offer different potential rewards to investors. Many gold mining companies represent a combination of growth stocks and gold mining shares. The nature of the company, and thus the nature of what investors should expect in terms of their potential return, risks, and length of investment vary greatly depending on the type of company in which the investor invests.
According to the World Gold Council, annual world gold supply reached a historical peak of 4,477 tons in 2012. It is essentially supplied from two main sources: gold mine production − also called primary production − which accounts for about two thirds of world supply; and the recycling of gold − also known as secondary production − which accounts for the remaining one third.
Investors can also invest in shares of gold mining companies. Gold mining company stocks may correlate with the gold price. However, the growth and return in the stock depend on the expected future earnings of the company, not just on the value of gold. Factors such as effective management, production costs, reserves, mine exploration and project development, and hedging activities are some of the factors to consider when deciding whether to buy gold mining stocks. As such, investments in gold and gold mining companies are often used as complementary investments.
The gold mining sector is large with over 300 gold mining companies listed and publicly traded. Market values of mining companies range from micro-cap companies to those with a market capitalisation larger than US$10 billion.