CAPE TOWN – Gold has been one of the top performing assets over the past 20 months but my bullishness has worn off.
The “risk-off” strategies really came into play in the third quarter as the gold price surged on its own and against other risk assets. The gold price-to-MSCI Emerging Market ratio, a reasonable indicator of total investment demand for gold, including central bank purchases, indicates that total investment demand increased by between 50 and 100 tons. It may seem pretty mundane given the surge in the gold price.
In the second quarter of this year, total investment demand inched north as central bank purchases increased by nearly 50percent while speculative demand (gold bars, coins and exchange traded funds) was relatively subdued.
It is likely that the gold supply and demand equation changed significantly in the third quarter of this year though.
Speculative demand for gold probably surged by between 150 and 200 tons, fuelled by the intensifying Sino/US trade war and increasing uncertainties in regard to Brexit. Yes, speculative demand in the third quarter could have been as high as during the onset of the debt crisis in the euro zone in the third quarter of 2011.
History has shown that central banks are normally very price sensitive in their gold purchases and normally act as buyers of last resort. They were masters in the second quarter of this year and probably cornered the market and caught speculators short.
I will not be surprised to see that a significant contraction in central bank purchases will be revealed when the World Gold Council’s numbers for the third quarter are published. A reversion to the mean of around 150 tons since 2012 is quite possible, resulting in a decline of around 75 tons in central bank purchases.
Historically, jewellery demand for gold is quite price elastic as significant changes in the gold price have a direct impact on jewellery demand.
The surge in the gold price in the third quarter of this year, coupled with very trying global economic circumstances, probably saw jewellery demand falling off the cliff. It is very conceivable that demand hit the lows of 2011 and 2016 of around 450 tons. Yes, a contraction of up to 100 tons.
Mining production of gold has steadily increased by about 200 tons to nearly 900 tons per quarter over the past 9 years and is rather price inelastic to the gold price due to the long lead times and capital expenditure to bring new production on line when the gold price surges.
It is also not that easy to cut production when the gold price falters, forcing mines to incur operating losses.
The major factor in the supply side of gold is recycled gold, specifically from jewellery. Over the past couple of years recycled gold averaged around one third of mining production, but reached about 60percent of mining production at the height of the euro zone debt crisis in 2011/12.
Recycling is highly sensitive to the levels of the gold price as well as shorter term changes in the gold price. Where central banks act as buyers of last resort, gold recyclers act as the suppliers of last resort.
The supply of recycled gold in the second quarter of this year was relatively unmoved as the gold price only surged toward the end of the quarter.
Do not be surprised if the supply of gold from recyclers surged by 100 to 150 tons to between 400 and 450 tons in the third quarter - to similar levels as at the height of the euro debt crisis in 2011/12 - as the gold price in a basket of currencies in the third quarter and currently finds itself at similar levels achieved during that period.
In my opinion the gold market is currently predominantly moved by speculative demand on the one side and recyclers on the supply side. On the demand side, central banks are probably out of the market and, in fact, if the gold price continues its bull run, they may turn to be net sellers - as happened in the past and add to supply. Jewellery demand is also likely to contract.
The gold price will need to get back to levels where it will bring back demand (central banks and jewellers) crucial to sustain a long-term bull market in gold.
I am not arguing that the gold price will fall in a heap in the immediate short-term. The euro debt crisis resulted in a high gold price over an extended period in 2011/12. It is impossible to guestimate the fallout after Brexit happens at the end of this month.
Brexit may be a non-event as it has been telegraphed for so long and anticipated and priced-in in financial markets and economies.
Or the fallout could be worse than expected and protracted with high risk all over the markets - increasing the demand for risk-off assets such as gold. There is also an outside chance that central banks will join the speculators and drive the gold price higher.
What my analysis tells me is that the risk of investing in gold has increased significantly. It is the speculators squaring off against the recyclers.
The latter is sitting with a war chest of physical gold with the former a war chest of speculative investor funds. The speculators will abandon their positions when they realise that they cannot win the war in driving the price upwards further. Who knows when? When it happens, it is a question of at what level the buyers of last resort - central banks - will come in again.
I am not a gold bull any more at least for now.
Note: The price of gold is mostly watched and quoted in US dollars and the underlying trend is therefore blurred by the strength or weakness of the greenback against other currencies. In order to get a more balanced view of the global price of gold I calculate a weighted gold price index by using the official index of the dollar against other currencies to calculate a gold price index for the world excluding the US. After indexing the gold price in US dollars both indexes are equally weighted to establish a world price of gold.
Ryk de Klerk is analyst-at-large. Contact [email protected] His views expressed above are his own. You should consult your broker and/or investment adviser for advice.