Economic recovery, inflation may hit gold prices

The behaviour of various asset classes over the past six months, suggests that the markets are not sure about the global economic recovery. While the domestic equity market has remained somewhat trapped in a range, gold prices have showed a significant swing as it posted an all-time high in December 2009.

Gold’s subsequent performance in 2010 indicates a further boost to its status as a store of value. The physical (or consumption demand) for the yellow metal slumped to multi-decade lows while the investment or speculative demand has increased. This makes for an interesting recipe while assessing the future outlook of gold price.

The continued accumulation of gold by exchangetraded funds (ETFs) and bullion traders/investors, suggests that the price movement from here on will largely be driven by investors’ sentiment, which in turn, depends on the pace of the global economic recovery and inflation trajectory in key economies. Any sign of weakness in the global economy or the specter of run-away inflation could support a rally in gold and conversely, a better-than-expected economic growth or moderation in inflation will lead to a sell-off in the yellow metal.

SAFE HAVEN

Unlike other commodities, gold is regarded as a monetary asset since the precious metal’s physical consumption is restricted in jewellery making and to an extent some industrial applications. This uniqueness was more than apparent in the past two years when gold withstood the debacle in the equity markets and posted a y-o-y gain of 25% in 2008.

Even if the usual negative correlation that the yellow metal shares with the equities has been put to test in this duration, the deviations were caused by margin requirement in the market plunge of 2008 and excess liquidity in 2009. Since the last quarter of 2009, there has been more than one development highlighting gold’s status of an alternative currency.

In October 2009, CME (Chicago Mercantile Exchange) announced that the exchange will accept gold as collateral for trading. In the same month, the commodity made its intermediate high of $1098 per ounce when the Reserve Bank of India (RBI) bought 200 metric tonne of gold from IMF (International Monetary Fund). More recently in 2010 following the Greece debt debacle, the gold prices not only surged by 5% but also showed a divergence from the decline in Euro, a currency with which it generally maintains a positive correlation.

FUNDAMENTAL SHIFT

Even fundamentally gold demonstrated a striking new demand supply equation in 2009. The first dimension of this equation was a decline in the jewellery demand to its lowest level in nearly two decades. As can be seen from the chart, the jewellery demand, which on an average contributed nearly 70% of total consumption during 2002-2008, accounted for just half of the total gold demand in 2009.


Secondly, the scrap supply reached an all-time high in 2009 growing by 27% yo-y for a second consecutive year. The overall supply also got a boost from a rise in mine production for the first time since 2005. The mine supply was up 6% from 2008 in turn contributing to an 11% growth in total supply during the period.

Collectively, these factors indicate the weak fundamentals for gold prices as a commodity. On the other hand, certain aspects of the demand supply equation reiterate the higher weight gained by gold as a monetary asset. The retail investment demand in the form of bars, coins and other such products dropped by a fifth from that that in 2008.

However, it still remained 35% higher than its average in the preceding five years and on quarterly basis showed rebounded in Q2-Q4 from a substantial drop in the first quarter of 2009. ETFs (exchange-traded funds or products), yet another part of the investment or speculative demand, almost doubled in 2009 to its highest since their inception in 2003.

The last but probably the most outstanding factor that highlights the increasing role of gold as a monetary asset is the plunge in sales by the official sector, central banks and monetary authorities, for a second consecutive year. Furthermore, on a quarterly basis, the official sector turned net buyer during the past three quarters of 2009.

Besides the much talked about buying from RBI, central banks of China and Sri Lanka, countries like Russia, Philippines and Belarus have added a substantial chunk of gold in their reserves in the past two years. While India and China make into top 10 official holders of gold in absolute terms, when compared to the US and many European countries gold still constitute less than 10% of their total reserves (1.6% and 6.9%), respectively.

ECONOMIC RECOVERY VS INFLATION

Given the backdrop of the lower physical demand and visible recovery in economic conditions; inflation and persistence of the investor demand could act as catalyst and give a further push to gold prices. It is observed that typically gold outperforms other asst classes in the event of extended recession.

In the past three out of six recessions since 1971, gold prices maintained a positive momentum. However, in the four instances prices also experienced a pressure in its initial stages of the economic recovery. However, this time around that does not seem to be the case given that since March 2009, which is believed the beginning of the economic recovery, gold prices have gained close to 20%. The reason behind this gain could be the fears of inflation, which is likely to follow the massive liquidity the global monetary systems have experienced since 2008.

INDIAN PRICES: CATCH 22?

Following a three-fold increase in prices in the past six years, the consumption demand from India, one of the biggest contributors to the total jewellery demand, has declined by nearly 30%. As can be seen from the chart, the average quarterly consumption demand from India dropped to 120 tonne from an average of 175 tonne during 2004-2009.

In line with this decline, India’s average monthly imports of gold experienced a 35% fall to 28.30 tonne in 2009 from an average of 43.30 tonne in 2008. The local prices, which are a function of the international gold prices and movement in Indian rupee, have established a higher base, particularly since March 2009. The fluctuations in the rupee exchange rate cause excessive swings in domestic gold prices.

An analysis of the fluctuation in the monthly prices of international spot gold, MCX future prices and the rupee exchange rate since 2008 substantiates this distortion. During this period of 27 months, there were 17 months when the monthly swing in rupee exchange rate was more than 1% in any direction.

Out of these 17 months, percentage change in the MCX future prices, a gauge of the domestic prices, deviated from the change in the international spot prices by an extent of the change in rupee exchange rate.

For example, at the end of March 2010, while international spot prices declined by 0.4% compared to the previous month, the decline in gold March future on MCX was 2.9%, thanks to a 2.5% appreciation of rupee (or a 2.5% decline in absolute rupee dollar exchange rate) during the month.

The correction in international gold prices generally follows a strengthening US dollar. However, a stronger dollar causes the rupee to depreciate in turn limiting the extent of price decline of the domestic gold prices.

OUTLOOK

Currently, the international prices are trading near $1140 per ounce while domestic prices are hovering around Rs 16,600 per 10 gm. To gain further momentum, it would be essential for the international and spot prices to overtake the near time highs of $1170 and Rs 17,200, respectively.

However, in case of a correction, supports for international prices are expected to come near $1100-1070 while the local prices could fall in the range of Rs 16,300-16,000. A decline below $1070, or Rs 16,000, will be essential for the correction to turn into a freefall.