To understand the role of gold in the economy you must understand China. The country is not only the biggest consumer of the precious metal, but the worlds biggest producer as well. The Chinese economy is showing serious signs of stress and its overheated markets show the tell-tale signs of speculative bubbles - slowdown in growth is inevitable.
Gold prices are dependent on Chinese demand and a weakening Chinese economy will take gold with it. This conclusion is found by analyzing the main factors that drive sustainable gold prices. These indicators are all bearish; U.S dollar inflation seems unlikely, Chinese demand is slowing and global mining output remains high. I believe these factors will take the metal to my price target of $900.
Chinese Gold Consumption.
China has always had an affinity for gold, the metal features prominently in Chinese New Years celebrations, artwork and historical artifacts. Like the West the Chinese often used the metal as money. However, never before has Chinese consumption reached the scale we have seen over the last decade. The country is hoarding vast quantities of the metal and this is occurring for several reasons; the Chinese culture has historically seen it as a store of value, increasing incomes have resulted in large demand for quality metal jewelry and the Chinese central bank seems to view gold as a monetary asset.
It is difficult to get accurate data out of China because of the governments secrecy, but records from Hong Kong indicate that Chinese gold imports have surged by over 700% since 2010. This figure is probably an understatement of the countries total consumption considering the vast amounts that China is able to produce from its domestic mining capacity and obtains from other sources.
Fundamental Indicators for $900 Gold.
The gold price is determined by three factors: Supply, demand and U.S dollar inflation (or speculation that it will occur). All of these factors can be used as the basis for a sustainable long term gold price except speculation on inflation. Speculative price increases, like the one we saw in 2011, are unsustainable and unless the inflation actually materializes they will quickly fall.
1. Deflation. I have already ruled out the possibility of significant U.S dollar inflation and my research suggests that deflation is more likely. A situation of economic deflation is bearish for gold because it weakens commodities/metals and strengthens the dollar.
2. Supply. The mining output of gold producers has been trending upwards for over 15 years and shows little signs of slowing. This is a bearish or neutral factor for the metal, it puts most of price determining power in the hands of demand/USD inflation. Keep in mind, all the gold ever mined is still in existence so the total supply is something that is constantly increasing unlike finite commodities such as oil.
3. Demand. While gold demand is currently stable, the macro-economic factors in China represent a long term bearish indicator. China has experienced exponential growth over the last few years and such growth is the tell-tale sign of a bubble. As the Chinese economy slows expect demand to go down with it. Because of this factor I believe the price of gold will slowly decline towards its cost of production, without hitting it (because that would affect supply). Even the most expensive mines are not producing at over $900 cash cost and the average is less than $650.
The Chinese Economy
The Chinese economy has several blatantly overheated markets, the most severe of which are real estate and stocks. The Chinese real estate market represents a staggering 1/5th of the total economy and it is teetering on the brink of collapse. China already has over 13 million vacant homes and numerous Ghost cities, yet the government keeps building - a failing attempt to stimulate the economy, foster employment and prop up GDP growth. In addition to these domestic slowdowns China has had 13 constitutive months of falling imports. Nominal GDP grew by 6.2 in the 3rd quarter of 2015 a figure that was less then the reported 6.9% real GDP growth. These are the signs of impending deflation and recession.
According to the DailyBeast:
"There is now wide disagreement over the performance of the economy. The official National Bureau of Statistics reported that growth in the third calendar quarter of last year was 6.9 percent, and Citigroup's chief economist has said China is generally growing around 4 percent. People in Beijing were privately talking 2.2 percent in the middle of last year, when the economy was doing better than it is now. Whatever the real number-and no one truly knows what it is-it's clear it is falling. More important, it's also evident Beijing no longer has the ability to reverse the downward trajectory."
The Chinese Stock Market.
The Shanghai Stock Exchange sustained a massive correction in June last year and is currently on life support. The Chinese Government has pumped the markets with trillions of Yuan and imposed selling restrictions on investors. However, this market is still struggling with little hope in sight. If these attempts at intervention fail, and the Chinese market capitulates expect to see trillions of dollars worth of wealth vanish overnight and a recession in China that will reverberate around the globe.
(Another problem with rapid decline in the stock market is investor liquidity traps. During a market decline people often face margin calls, forcing them to sell liquid assets like gold and personal property in order to obtain cash to pay off debts or for necessities.)
Chinese Demand for commodities, including precious metals is decreasing.
Note: Chinese precious metals demand peaked in 2011, just as the 2011 gold bubble burst and the metal's bear market began. This leads me to conclude the Chinese demand is one of the single biggest driver of gold prices world-wide.
Chinese Precious Metals Demand (Blue Line):
Gold Equity Prices 2010-2015:
Chinese demand according to the GSCI index is strikingly similar to behavior of the SPDR Gold Trust ETF (NYSEARCA:GLD) in same period.
When the Dollar is Strong Gold is Weak.
As the Chinese economy slows and possibly enters deflation expect precious metals demand to fall below 40 on the above GSCI index. During periods of deflation fiat currencies, specifically the dollar, tend to strengthen.
Gold is not a safe haven against instability, contrary to what many retail investors think. During times of economic panic it tends to fall along with commodities and equities. The metal is simply an inflation hedge and a protection against weakening currencies. Look at the relationship between gold and the dollar for an illustration of this fact:
Gold compared to (NYSEARCA:UDN), the USD bearish index.
People Don't Buy Jewelry When They Are Broke.
In addition to the bullish effects of a strengthening dollar, gold demand in China will be crushed by consumer discretionary spending cuts during a period of deflation. A large part of Chinese gold consumption is in jewelry, this is one of the hardest hit industries during times of economic distress.
China's jewelry demand has been fueled by its growing middle class, large upper class and nouveau-rich. In 2015 China added 152,000 new millionaires for a total of 1.3 million, or 4% of the global total. This class of extremely wealthy Chinese has led to demand for some of the most ornate and expensive gold jewelry available.
Paper Millionaires, illusory wealth.
Many of these Chinese millionaire are what I call "paper" millionaires. They have assets tied up in stock, real estate and other forms of equity. An argument can be made that if these equities are currently in a bubble the wealth represented by them is illusory. If these markets collapse expect to see trillions of dollars in paper wealth vanish overnight and demand for the expensive jewelry pictured above will vanish with it.
My price target for gold is $900 within 5 years and possibly lower. The threat of a Chinese economic slowdown coupled with deflation and a risk of recession indicate that the metal's bear market is far from over. In the short term I expect minor bear rallies as well as short term price increases fueled by inflation speculation. However, it is clear that when headline inflation does not materialize all the weight of these numerous bearish indicators will crush gold prices in the long term.
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Disclosure: I/we 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.