The price of gold has slumped for the past two years, leading some traders and investors to wonder if gold's best days are behind us. I believe this view is incorrect and I think gold's best days are yet to come! After the recent ten-year bull run in gold, it's not surprising that some traders and investors are having doubts about gold's future prospects. However, current geopolitical events in Ukraine, reallocation of non-Western central bank reserves, and gold market expansion could all be powerful catalysts for the next run higher in gold prices.
Geopolitical events between Russia and Ukraine will fundamentally alter the way sovereign countries view and invest in gold and precious metals in the coming years. As some Western governments have begun imposing sanctions on Russia due to the current situation in Ukraine, some Russian assets held in the West or in Western accounts have been seized. Western governments' ability to seize Russian assets has increased the amount of leverage over Russian authorities. This has made the Russian government more vulnerable. Indeed, as the crisis in Ukraine began unfolding, there was a significant reduction in US Treasury securities held in a custodial account at the NY Fed, leading to speculation that Russia quickly withdrew their US Treasury assets several weeks ago, fearing potential US sanctions.
As a result, Russia will be reluctant to add to their US Treasury holdings going forward. They are already the 12th largest holder of US Treasury securities at approximately $126B. In fact, Russia would be wise to diversify financial holdings away from US securities and invest a larger amount of reserves in gold and precious metals, which can be stored in Russian vaults safely out of reach from the US and other Western governments.
Similar arguments can be made for China. The Chinese likely realize that the risk of future disagreement between China and the US on foreign policy prerogatives could one day lead to the US threatening to seize Chinese assets. In the future, I believe non-Western governments will find gold more attractive relative to other safe haven, low interest bearing assets like US government securities, as the reduced risk of losing gold assets to seizure outweighs the storage costs. In terms of opportunity costs, this argument is even more compelling if the global economy continues to remain in the grip of low inflation and negative real interest rates.
Governments will increasingly engage in acts of financial warfare as we head further into 21st century and that will make physical gold a relatively attractive asset. If trust erodes among sovereign nations and future tensions rise, governments will be more likely to hold a higher level of reserves in gold rather than foreign currencies. For example, suppose Russia decided to respond to US sanctions using financial warfare methods of their own; they might swap the ratio of US Treasury securities relative to gold held as reserves at their central bank.
Over a period of time, Russia could sell roughly $100B in US Treasury securities and use the proceeds to buy gold and other precious metals. That would have a large effect on supply and demand dynamics in the gold market. With current spot gold prices around $1,300 per oz. and 2013 annual production levels at 2,700 tons, shifting $100B of their $493B in reserves from US Treasury securities into gold would buy ~75% of 2013 annual gold mining production! That would have a big impact on the price of gold even if buying were spread out over a couple of years. Furthermore, if other countries such as China began a similar process of reducing US dollar holdings and allocating a portion to gold, that would push gold prices significantly higher over a period of several years.
Gold prices today would be much higher if annual production increased greatly and the size of the gold market expanded. It seems like a paradox, as investors rightly believe most goods and asset prices decline as supply increases. However, the fact that the gold market is so small relative to global central bank reserves, means central banks are likely hesitant to significantly expand current gold reserve holdings.
For example, if Russia allocated $100B into gold, it would take a significant amount of time to build the position, as a faster pace of buying would move gold prices against them. I don't believe China and Russia hold small amounts of gold relative to foreign currency reserves because they believe fiat currencies are more attractive and fundamentally sound; they do it because the current gold market is too illiquid. As the gold market expands in coming years, more gold will trade on a daily basis and increase liquidity. This will increase gold's attractiveness as a reserve holding.
I recommend building a position in GLD as a long term investment. Admittedly, gold investors have become fatigued over the past few years given gold price declines and waning retail investor demand. However, sound investment decisions are not made on the basis of today's price action, but rather on an asset's future prospects. Given future geopolitical risks, a weak US dollar outlook, low interest rates and money printing, today's gold prices also offer a relatively cheap source of diversification and protection from central bank policy errors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.