With close to $80 billion of investor assets, GLD and IAU have become the go to vehicles for investors in search of physical gold exposure. For many, these ETFs have provided their first exposure to gold as an investment. Unfortunately, these investors may be in for the rough ride over the short term. Two bullets have been fired that could significantly harm the value of gold. What are these two bullets and will gold be able to dodge them? Let's take a closer look.
The two bullets heading towards gold are a slowdown in demand and a stronger U.S. Dollar. Both of these bullets are a result of separate yet related events across the globe.
There are two nations that lead the world in gold consumption - India and China. Both countries have strong cultural ties to gold and heavily support the number one driver of gold demand: jewelry. However, now both countries are showing symptoms that could materially impact their consumption of gold thus firing a shot at gold prices. China has publicly revised its economic growth expectations downward. India is expected to do so as well after recent discouraging GDP data. These economies which were significant growth engines - even during the financial crisis - are slowing down. That will weaken gold demand and thus prices.
In addition, India has now targeted gold with a move to double the tax on imported gold. While a 21 day national jeweler's strike in reaction to increased gold taxation recently ended, it seems likely that the doubling of taxes on imported gold will occur. This is a negative influence on gold demand in the largest consumer of gold in the world as of the 2011 calendar year.
So can this demand bullet be dodged? The answer is yes. China's economic slowdown could occur in a soft enough way to minimize impact. In addition, its central bank could use weakened gold prices as an opportunity to purchase more reserves to back up its massive exposure to paper currency including the U.S. Dollar and Euro. India is trying to jumpstart its slowing economy by cutting interest rates and the cash reserve ratio for banks. This excess liquidity has the potential to boost economic growth and thus demand for gold. In addition it also has the potential to strengthen the rupee, a currency that has weakened due to repercussions from the EU debt crisis. A stronger rupee makes gold more affordable to the second most populated country on Earth.
U.S. Dollar Strength
The second bullet is the strengthening of the U.S. Dollar. Gold is primarily denominated in U.S. Dollars so a stronger dollar means gold is worth less dollars. What's behind the threat of a stronger U.S. Dollar? Simple, the EU debt crisis. Recently Spain has elevated this threat, with France potentially right behind it. In late 2011 it was fueled by the flare up in Greece. Gold swooned versus the U.S. Dollar during that period as investors went "risk off" and jumped into greenbacks. (see chart near the end of the article) Now as Spain heats up and pivotal elections near in France, this bullet seems to have gained in size and velocity.
So can this bullet be dodged by gold? The answer is not entirely, or in other words no. Gold has already been impacted by drama in Spain, but substantial damage has not occurred yet. If Spain can be contained and bailed out by the EU establishment, the impact on gold could be similar or less to Greek crisis. Remember markets have been through this event not that long ago.
The big concern is not Spain but an implosion of France. The debt to GDP ratio in France officially is 86% - more than Spain or Britain. Unofficial calculations put that figure closer to 150%. Perhaps that's why the markets are making France pay almost twice the borrowing costs of EU partner Germany. Don't tell that to the Socialist party in France however, as they dislike austerity and instead want to spend their way out. (more on that below from the BBC) In addition, this party predictably has issues with Germany's austerity push within the EU community. President Sarkozy, under election pressure, has even begun to break with the Germans and the ECB.
If the upcoming French elections skew toward the anti austerity and anti EU movement, gold is headed for pain. Why? First, France could get closer to the fiscal edge, if not go over it. Some wonder if it is too large to bailout. Second, the French and German front could seriously dissolve, right along with the markets' confidence that the EU debt crisis can continue to be contained. (cue the "contagion" discussions) Both scenarios flood the demand for U.S. Dollars and hurt gold prices unless a QE3 comes to the rescue and can weaken the greenback.
For further color on the political situation in France, the BBC reports this about the potential new President of France:
The Socialist candidate Francois Hollande - and the favourite to be the next French president - challenges what has become the German orthodoxy. He believes the focus must move away from austerity to growth. He is likely to challenge German leadership in the eurozone crisis. So - realistically or not - he would spend billions on hiring new teachers, on training young people and finding them jobs.
A slowdown in demand from China and India is a threat gold may be able to avoid. The escalation of the EU debt crisis and thus a stronger U.S. Dollar is already close at hand and the only antidote may be the hope of or an actual QE3.
So what could the damage be? Here's the performance chart of GLD and the U.S. Dollar during the boiling over period in the Greek debt crisis last year. Not pretty.
Based on my current analysis, I believe there is a high likelihood gold declines based off the EU crisis and the current anti QE3 mood of the Fed. This correction should provide long term gold investors with a buying opportunity.
Finally, for those who may intensely disagree or agree with my analysis, here's a list of all inverse and leveraged gold ETFs and ETNs from GoldETFs.biz. Express your opinion wisely!
Additional disclosure: Christian Magoon publishes GoldETFs.biz and his opinions are not to be taken as investment advice.