Gold has had a great run this year. Spot rates are approximately 24% higher than the levels in the beginning of 2016. And yet if we look at the five-year chart, the yellow metal is trading 27.6% below the five-year high of $1795/ounce on November 11, 2011. In other words, if gold were to sparkle like it did in 2011, it would have to gain an additional 36% to match the prices in that period. In this piece, I have sought to understand whether its current run is being supported by sustainable demand factors that will keep supporting its uptick or whether the call for its further ascent is based on pure hubris.
Demand in Jewelry
Jewelry consumers are the single largest source of consumer demand for gold. In the 2013-2015 period, jewelry represented approximately 57% of total gold demand. And since more than half of that demand is created in India and China, both these countries are often referred to as cultural heartlands of gold. The beauty of jewelry demand is its elasticity. When prices are up, people especially in India and China tend to liquidate their jewelry and when prices go down, there is a rush to make more jewelry. Even the World Gold Council admits that a 1% increase in price leads to 0.6% increase in the supply of recycled gold. When gold prices were at a record high in 2011, jewelry represented just 43% of total demand. In 1H16, demand for gold from jewelry has ebbed substantially, and represented 40% of the total gold demand.
Since gold is denominated in dollars, exchange rate risk is an additional factor that dictates gold consumption in India and China. For example, in Indian Rupees, the five-year high gold price is just 10% higher than the current market price. A good thing is that the Indian Rupee has been among the most stable emerging market currencies and we are unlikely to see a rout in its value if the Fed were to raise interest rates. However, the current prices are still too high in the Indian context. Unless there is a correction, we are not likely to see a surge in gold consumption for jewelry this year in India.
Gold demand in technology industry
The demand for gold in the technology industry is in a definite downtrend. The market for electronic goods such as smartphones, which represents around 80% of gold demand in technology, has saturated. There are fewer first-time buyers of smartphones today than there were a couple of years ago. Incremental change rather than a quantum leap has become the new mantra for new product launches. There are therefore, fewer motivations for customers to replace their gadgets with the latest ones. Manufacturers are shunning gold for cheaper alternatives to keep costs low in an extremely competitive environment. In some other markets such as dentistry, gold is dying a painful death because it's not fashionable to have a gold-toothed smile anymore. Therefore, I don't think gold is up for a recovery in the technology sector anytime soon and by definition won't become a source for an uptick in gold spot prices.
Investment demand for Gold
Probably the most interesting part in gold's price discovery, investment demand can be divided into two parts - bar & coins, and ETFs. I also like to call bar & coins as boring demand as it tends to be reasonably stable. Volatility in bars and coins is often driven by investors seeking exposure to gold in small denominations. On the other hand, ETF inflows and outflows are extremely volatile. In the last 14 quarters, there were just 3 quarters (1Q15, 1Q16 and 2Q16) of net positive flows into ETFs. Two of these quarterly inflows were mammoth in size and both occurred in 2016. In 1Q16 and 2Q16 respectively, ETF demand represented 26.7% and 22.5% of total gold demand. Increased global risk and the perception of gold being a safe haven have contributed to record inflows into these gold ETFs. However, is there a case for risk capital inflows to stick and keep supporting the supply of gold on a perpetual basis? I have my doubts. There are already murmurs of profit-taking in some of the ETFs. As demand for all other requirements declines in strength, investors will have to pour more and more risk capital to keep the demand dynamics in balance. This doesn't make sense. It's like saying you should buy additional copper, because if you don't, copper prices will fall. ETF inflows also have a history of being fickle. Quarterly inflows of 3/14 is a terrible record. An additional point to note is that gold has a blemished record of offering poor long-term returns. Therefore, investors sitting on more than 20% profit should be looking to closing out their positions and coming back when the prices seem more reasonable and when the demand dynamics improve.
Note: I have used Bloomberg as my data source for gold prices and statistics from the World Gold Council as my source for demand figures.
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.