Over the past six years, the world has seen striking economic and financial instability, witnessing the deepest recession since 1930s, leading to poor returns in many financial assets. In this environment, the SPDR Gold Trust ETF (GLD) has performed strongly, doubling in price since 2007. However, in recent months, gold prices have seen less strength and have dropped considerably. For some, this marks the end of gold secular bull market and more downside should lie ahead. Even though I'm a gold bull, as I discussed in my previous article, Ignore the Doom and Gloom and Buy Gold, I think a balanced approach leads to higher investment returns over the longer-term and therefore, I present in this article the bear and bull cases for gold.
In recent years, economic uncertainties and risk sentiment have elevated gold prices while GDP growth has remained moderate at best. If global growth recovers faster than expected, it would drive steeper yield curves around the world, and would probably would lead central banks to tighten monetary policy. Gold does not have a yield on its own, so the opportunity cost of holding increases with a rise in rates. Therefore, lower liquidity and higher interest rates would then be clearly bearish for gold.
Although the Federal Reserve's balance sheet will most likely continue to expand for the next few months, it may end during the next year. The most obvious factor that could lead to an earlier termination of asset purchases is faster than expected improvement in the labor market. If the unemployment rate declines rapidly to below 7%, the Fed will most likely end its asset purchase program. However, outright sales are not expected to begin until the first rate hike, which should not occur before 2015. Nevertheless, the Fed's tapering, possible rate hike, and shrinking of its balance sheet are all negative for the gold price.
As the US economy accelerates, bond yields should continue to rise. This can support the recent dollar strength over the next couple of years against major currencies on the back of higher Treasury yields and an improvement in the US national balance sheet. If US households and eventually the government reduce their reliance on debt, the credit quality of the country will improve and the greenback should appreciate further. Furthermore, the dollar used to rally in periods of market stress thanks to its safe-haven status and fall in risk-on periods. This relationship broke up recently, with the dollar now benefiting from stronger US macroeconomic data. As the dollar and gold prices are negatively correlated, this should also be bearish for gold.
One of the main motivations of holding gold is to hedge inflation risks, as gold is generally seen as a good hedge against the debasement of fiat money. However, inflation expectations at present remain muted across most developed economies and hence are supportive of lower gold prices. On the other hand, inflation may be a bullish catalyst for gold, especially if the U.S. achieves GDP growth above 3% and Europe gets out of recession, resulting in higher inflation going forward.
In my article on gold mentioned above, I discussed how the production cost of gold and central banks' balance sheet expansion are bullish for the precious metal, thus I will focus on other factors here.
In the US, the fiscal outlook has been deteriorating for some time. Over the past decade, the government wasn't able to post a budget surplus, and the US debt increased significantly. Since 2000, the debt-to-GDP ratio increased from 32% of GDP to more than 100%. This explosion in public debt coincides with the bull market in gold ,and unless you think the US will stabilize its debt trajectory, this will boost gold prices. Moreover, in Europe, the fiscal outlook is even worse, so gold should remain a safe-haven asset in periods of debt crisis unless governments begin to balance their budgets and return to sound fiscal practices.
Gold can also be supported by consumer demand, especially in China. Up until this year, India has been the world's leading consumer of gold, and it may continue to be, though it's expected to duel with China for the leading sport throughout this year. The growth in Chinese demand for gold has been heavily influenced by the ways in which consumers can access investments. There are still very few ways that Chinese investors can diversify away from the equity markets and property. With China's economic growth rapidly decelerating, possibly leading to losses on equities and lower real estate prices, gold will be on demand as a safe-haven asset. Gold is therefore a simple way for the Chinese to protect the real value of their investments. Indeed, over the past few years China has become one of the two major gold consumers along with India, and Chinese demand should remain an important support for the gold market. However, this will significantly boost gold prices only if a hard landing scenario occurs in China's economy over the next few years.
Moreover, central banks all over the world have been net buyers of gold over the last few years. For instance, Russia has been accumulating gold for the past 10 years, with the purchase of over 20 million ounces in the last decade. In 2012, the net increase in central bank gold buying was almost 15 million ounces of gold, the highest value since 1964. This will certainly continue for the foreseeable future, especially as emerging markets central banks diversify against a cataclysm with the dollar, euro, pound, or any other reserve currency.
The outlook for gold is clearly mixed and is considerably driven by macroeconomic factors. Depending on your personal view of the world, you can be on the bearish or bullish camp. Personally, I think the debt deleveraging process that began in 2008 is still ongoing, implying weak growth in developed economies and that more quantitative easing by the central banks is needed over the following years. Therefore, I think the secular gold bull market is not over, and gold's recent sell-off is a buying opportunity.