Today, we are introducing Global Macro Research to Cents Invest. Many long-time ROIC members know MacroHenry, who has been a Cents contributor for well over a year. He has provided the Cents community with great macroeconomic coverage in the past and we’re excited about his future research contributions.
Find his other work and future updates in the Macro + Markets section of the ROIC Portal.
Also, see the Macro – Markets section of our Discord for more real-time discussion.
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Gold Price Outlook: Uninspiring Returns
There’s value for tracking and writing about gold for three reasons:
- Gold has historically acted as a hedge and storage of value during times of uncertainty and dollar devaluations.
- Gold isn’t an institutional asset class and is not widely covered by the major banks. As such, it is not an efficient asset class and so a global macro strategist or analyst has a good chance of making an accurate prognosis of future prices.
- Gold acted as the singular anchor for the world’s monetary and financial system as recently as the early 1930s and was the currency of choice for virtually all prosperous civilizations over the last 3,000 years. King Ferdinand’s orders to Christopher Columbus on the eve of his voyage in 1492 was “Get gold, humanely if possible, but at all hazards—get gold.” Because of the historical association of gold with wealth and riches, the metal still invokes an emotional response and thus is subject to big boom and bust cycles (and arguments at the dinner table on whether the U.S. should abolish the Fed and go back to the gold standard).
This is all you need to know for 2022: The recent weakness in gold prices – despite the rapid rise in global liquidity since March 2020 (Michael Howell’s proprietary measure of Global Liquidity has risen from $130 trillion pre-pandemic to around $190 million today), higher-than-expected US CPI/PCE prints, and the new South African / Omicron variant (which has resulted in traders pushing Fed rate hike expectations from June to September 2022 as I write this on Friday, November 26th) – doesn’t bode well for the metal next year. Figure 1 below shows the failed price break-out despite real rates recently hitting an all-time low while inflationary expectations continue to rise.
When the price of an asset fails to rise on positive news, particularly when most investors are also expecting higher prices, it typically isn’t a bullish sign. Gold may still rise in 2022 if the U.S. dollar weakens (which I expect), but my opinion is that an allocation to gold today doesn’t provide a sufficiently high reward to justify the risk, especially since the Fed is now tapering and is expected to hike rates next year.
Reviewing Gold at the 10,000-foot Level
As you can see from Figure 1, real interest rates (blue line) are only one of many variables driving gold prices. E.g., during the 2001- 2011 secular bull market in gold, real interest rates took a dive after the dotcom bust, making a trough during summer 2003-summer 2004, and yet gold prices continued its liftoff from around $400 during summer 2003-summer 2004 to $630 an ounce in December 2006 despite the 1-year real interest rate rising from -1.3% to +3.4%. Back in the mid-2000s, despite higher real rates, gold continued its bull market due to:
- Higher relative growth in the rest of world outside the U.S. As U.S. growth and innovation went into a cyclical decline in the aftermath of the dotcom bust, 9/11, and the rise of the Euro as an alternative reserve currency to the US$, foreigners sold U.S. financial assets and reallocated elsewhere, and gold became relatively more attractive, especially to US investors.
- China’s overdrive to industrialize and grow its economy through exports and accruing US$ in the process. Much of the US$ accrued by China was kept as official FX reserves, but this newfound wealth also led to the creation of the Chinese middle class. China is a prolific gold jewelry consumer. From 202.3 tonnes in 2002 (accounting for 6.6% of total world demand of 3,067.4 ounces), Chinese gold demand increased to 452.4 million tonnes by 2010, accounting for 10.9% of total world demand of 4,162.2 ounces. Note this surge of Chinese demand by volume occurred even as the gold price rose from $309 in 2002 to $1,225 an ounce in 2010.
- The creation of the first gold ETF, the SPDR Gold Trust, which increased access for retail investors interested in buying gold. I bought gold and silver for myself and my relatives in late 2000, and I remember the days when UPS would drop a bucketful of Kennedy half-dollars or silver eagles at the house. Aside from taking physical delivery or having gold held in storage at a firm like Monex, the only other way to invest was to buy shares in the Central Fund of Canada (closed-end fund) or in individual gold miners. By the second day of closing on November 19, 2004, holdings in the SPDR Gold Trust had already surged to 1.86 million ounces, or almost 4x the holdings (472K ounces) in CEF. Last year, gold demand from ETFs surged to 873.9 tonnes, accounting for 18.5% of total world demand. Figure 2 below shows the rise in gold ETF holdings from 2004 to today.
The 30,000-foot View
To better forecast gold prices, we need to break down its underlying demand factors, and most importantly, the demand dynamics that drive the metal’s short- to medium-term fluctuations and trends. Before we do that, however, let’s zoom out further and take a 30,000-foot view, as gold doesn’t exist in a vacuum, i.e., gold competes with other asset classes from an asset allocation perspective, as well as consumer goods & services (in the case of jewelry demand). Figure 3 below shows when gold is more or less favorable from an investor’s perspective.
The four-quadrant model suggests that most of the returns/risks of all major asset classes are driven by just two factors: 1) global GDP growth expectations, and 2) global inflationary expectations. By far the biggest source of return of any major asset class, in the long run, comes from these traditional “beta” factors (of course, if you joined ROIC, you are looking for “alpha” as well).
Within each quadrant, there is one or two dominant asset class that is the most liquid as well as being most sensitive to the underlying two factors from a U.S. investor perspective, which are:
- Inflationary bust, or stagflation (rising inflation expectations, lower GDP growth expectations): gold and US TIPS, e.g., 1970s, April 2020-Summer 2020
- Inflationary boom (rising inflation expectations, rising GDP growth expectations): commodities, e.g., WWI, 1950s-1960s, 2003-2007, 2021 (and at least through Q1 2022, new South African / Omicron variant notwithstanding)
- Disinflationary or deflationary boom (lower inflation expectations, rising GDP growth expectations): US stocks, e.g., 1920s, much of 1980s to 1990s, Fall 2011-July 2015, February 2016-September 2018
- Deflationary bust (lower inflation expectations, lower GDP growth expectations): long-duration US Treasuries, e.g., September 1929-December 1932, January 2008-March 2009, October 2018-December 2018, March 2020
This four-quadrant framework suggests investors should allocate to at least one or more of the four major asset classes during all time periods, as cash is nearly always underperforming one major asset class. Since 1926, there have only been 3 calendar years when cash outperformed all of these major asset classes: 1931, 1981, and 2018.
Based on this simple, 30,000-foot framework, the investment environment has transitioned from one that is favorable to gold, i.e., when global economic growth plunged early last year as economies shut down while central banks began to ramp up the printing presses, to one that is less favorable, as economies continue to reopen while central banks have begun to taper QE or hike interest rates. Specifically, the U.S/global economy has been transitioning from an “inflationary bust” to an “inflationary boom” since the summer of last year. Assuming the new Omicron variant is benign, global economies will continue to reopen next year. Of course, we don’t know whether the U.S. economy will continue its inflationary path or transition into a disinflationary boom or deflationary bust next year, but for now, this framework suggests that buying gold isn’t an optimal strategy unless you think there will be renewed global lockdowns due to the Omicron variant.
On a longer-time timeframe, as long as the US-led capitalist system is allowed to flourish, gold prices should continue to underperform. The history of the U.S. shows it has taken extreme events to jump-start a secular bull market in gold. Since the end of WWI, there have only been 3 occasions when gold prices experienced a secular bull market, or a dramatic price spike:
- At the trough of the Great Depression, President Roosevelt devalued the US dollar by re-pegging the gold price from $20.67 to $35 an ounce through the Gold Reserve Act of 1934
- Gold began its ascent from $35 an ounce in the aftermath of the collapse of the London Gold Pool in March 1968, followed by the end of the Bretton Woods System when President Nixon closed the Gold Window in August 1971. Despite a 20- month, 48% correction from January 1975 to August 1976, gold would eventually peak at $850 an ounce by January 1980
- Gold troughed in April 2001 at $255 an ounce and began its bull market in the aftermath of the dotcom bust, the Fed’s zero interest rate policy, 9/11 terror attacks, the Gulf War, and in time would be supported by massive inflows into gold ETFs and the global jewelry market as: i) the US dollar lost its luster to the euro as a reserve currency, 2) emergence of the Chinese middle class and its accompanying affinity for gold, and iii) the Fed beginning its unprecedented QE policies as a response to the 2008-09 Global Financial Crisis. Gold would peak at around $1,900 in September 2011.
It is difficult to envision gold entering a new bull market so soon after the end of the last one (just 10 years apart), and if a once-in-a-century global pandemic and unprecedented central bank/fiscal easing cannot make gold enter a new bull market, just exactly what would it take? Gold can still make new highs next year, but it is hard for me to see gold sustaining its performance that has occurred over the last few years.
Back to the 10,000-foot view: Reviewing gold’s demand dynamics
Figure 4 below provides a breakdown of world gold demand based on a 3-year average from 2018-2020.
By far the largest source of gold demand in any given year is jewelry demand. In fact – from 2010-Q3 2021, jewelry fabrication has averaged about 48% of total demand, with the pandemic year, 2020, being an outlier as jewelry demand was only 30% of total demand that year. This year, jewelry demand has recovered to 38% of total demand.
As shown in Figure 5 below, global jewelry demand is very sensitive to gold prices. Jewelry demand, especially Chinese jewelry demand, tends to rise significantly when gold prices decline (e.g., 2013), and it tends to not grow as fast (or even decline, e.g., 2019) when gold prices rise. Most importantly, jewelry demand doesn’t really move prices in any given year; Chinese jewelry demand acted as a pillar of support in 2013 when gold prices crashed, but being long-term investors, jewelry consumers typically don’t speculate or “chase prices higher” when gold prices rise. In other words, jewelry demand tends to be more reactive to prices rather than a leading or coincident indicator of gold prices, despite the fact that it remains the biggest source of demand for gold.
Conversely, Figure 6 below shows ETF gold flows have tended to be a coincident or even a contrarian indicator. Speculative flows are what drive prices, and this was demonstrated in:
- 2009: Net gold ETF investments topped 20 million ounces, driving gold prices from $870 to $1,090 an ounce that year
- 2013: Net gold ETF investments were a negative 13.7 million ounces, driving gold prices down from $1,660 to $1,200
- 2020: Net gold ETF investments hit a record of 24 million ounces, driving gold prices from $1,510 to $1,890
Note despite a record high inflow into gold ETFs in 2020, gold prices have failed to maintain their all-time high and is still lower than its prior peak of $1,900 an ounce made in September 2011. Moreover, worldwide gold ETF holdings were just 69 million ounces in 2011; today it is at 101 million ounces, and yet gold prices are still sitting below all-time highs. Finally, investors should be mindful that while gold ETFs have acted as a consistent source of demand since their inception in 2004, they also represent latent supply as gold ETF investors can easily sell their holdings as a reaction to a “renormalization” of the global economy or tighter central bank policies in 2022. This is what occurred in 2013 as the global financial system “renormalized” after the European Sovereign Debt crisis was brought under control. Note the 2013 “unwinding” only totaled -10.9 million ounces, or 3 million ounces more than total 2012 gold ETF inflows, and yet gold nose-dived by 28% that year.
As global economic activity normalizes and as the world’s central banks adopt a tighter monetary policy in 2022, the global economic environment has shifted from an “inflationary bust” (peaking during summer 2020) to one resembling more of an “inflationary boom.” With the Fed scheduled to finish tapering in June (and to hike rates by September), the investment environment for gold isn’t as positive as it was last year. While gold prices could continue to rise should the US$ peak and decline next year, there is also a sizable latent source of supply (due to record high gold ETF holdings) should gold prices stall at current levels.