Understanding Gold Prices

Understanding Gold Price by SG Value Investor, The Value Edge

From 2005 to 2012, gold price increased from USD432.6/oz. to USD1664/oz. which corresponds to a compounded annual increase of 18.0% from 2005 to 2012. Gold price has since fallen to around the USD1200 level. Gold is often perceived to be a hedge against many economic factors and can be complex to understand for amateur investors like us. Through my academic work in NUS, I have a much clear picture now of what affects gold price which I would like to share.

In free markets, prices are often determined by an interplay of supply and demand forces. Gold is no exception in this regard. Supply of gold comprises of gold mine production and the recycling of gold. When we look at the demand for gold, we can break it down into 2 sub-categories – Investment Demand or Non-investment Demand. Non-investment demand relates to the usage of gold for jewelry or technology-manufacturing purposes while investment demand is specifically the demand for gold as an investment asset.

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During the period (2005-2012) where gold price almost tripled, supply and non-investment demand for gold experienced relatively muted changes – jewelry and manufacturing demand actually decreased while supply remained relatively fixed. Therefore, we can conclude that the increase in gold price is mainly attributable to investment demand, which is what we have been trying to understand all along.

To get straight to the point, investment demand for gold stems from its role as a reserve asset and this will be the overarching principle that drives investment demand throughout.

Gold Price

A reserve currency is held as part of a country’s foreign exchange reserves which is used in international transactions. The US dollar and EURO are the 2 most dominant reserve currencies globally, comprising about 60.7% and 24.2% of global reserves respectively. This gives European countries and the United States an advantage in terms of import and borrowings as they do not need to incur transaction costs in exchanging their currencies. On the other hand, the holding of USD and EURO in other countries’ foreign exchange reserves leaves them susceptible to any potential devaluation of the currencies stemming from economic conditions.

As a result, in addition to USD and EURO held in the foreign exchange reserves, countries also hold other reserve assets under international reserves, namely special drawing rights and gold reserves. Therefore, gold has a role as a hedge against the devaluation of reserve currencies. Globally, this happens to be the USD and EURO currently as they are the most widely held.

We now have a bigger picture understanding of gold price. Anything that threatens the value of these reserve currencies would cause gold to become more valuable as hedging asset. These includes weak economic conditions (GDP), or autonomous monetary policies like Quantitative Easing which increases the supply of USD, leading to depreciation.

A long time ago, gold was an official currency. Although this is no longer the case, gold is now instead a reserve currency and its perception as a store of value persists due to its role as a hedge. For instance, the gold price in 1830s in terms of 2010 U.S. dollar value would be around $450/oz., which is very close to the gold price of $432.6 /oz. in 2005. The money we hold now is not backed by any tangible value (such as gold in the past) and is called fiat currency. When fiat money shows weakness in value, the price of gold would in most cases rallies to reflect that weakness. To give a simple analogy, a typical Singaporean would not want to hold more USD if he knows it is depreciating and instead convert it into SGD. However, for institutional investors and central banks, it may not be ideal to change to another currency which has a limited functionality (what are u going to do with so much SGD? It is not an international currency). For them, gold serves this purpose due to its flexibility and its store of value. Therefore, gold can be almost perceived as a currency.

Lastly, gold ultimately does not have any form of yield (coupon/dividends). When interest rate of fiat currencies rises, the opportunity cost of holding gold increases and investors would swap out of holding gold. Therefore, gold serves as a hedge against low interest rates.

When one sees gold as a form of currency, it becomes easier to decipher its price movements. We see how a confluence of factors in both the United States and Europe can indeed drive its price to record highs from 2005-2012. It is also easier to understand why it has lost some of its luster since then; while economic growth still remains sluggish, it is a significant improvement from the peak of uncertainty in 2012.