Gold enters bear market territory

The pressure by governments to fund their crisis hit economies through sales of gold reserves reverses the demand-driven fundamentals for gold that since the credit crisis has been a key supporting factor behinds its price.

Against stabilising macro fundamentals and a resilient dollar, the inflation-adjusted price of gold is very high and may correct lower further out. As gold enters bear market territory, investors may want to consider a short position over the weeks ahead.

Following Friday’s 5% price slump, gold has entered a bear market. Since its peak it now has lost 25% and the question is by how much gold can fall further.

Since 1970 gold has undergone two super cycles. The first super cycle began with a 10 year rally (broadly speaking that is, as there were mini cycles along the way with significant downturns as well), during a time of spiking oil prices, high inflation and geopolitical uncertainty. Then, with central banks hiking policy rates to curtail inflation, a period of initially high real interest rates followed. But as oil supplies soon stabilised, economies experienced significant stretches of steady growth.

Against this macro backdrop, from the time when it reached its peak until it reached its first trough 2.5 years later, gold fell nearly 65%. Gold is currently in its second super cycle and has come off from its peak following a rally that, similar to the 1970s, lasted around a decade. Different to the Jan 1980s peak however is that the peak of Aug 2011 was preceded by a period of low rates of inflation and 4 years of financial crisis.

As a result, the ascent in the gold price in that time has been steadier and with less accelerating momentum than in the period leading up to the Jan 1980 peak.

Because the oil supply shock back then baked in huge double digit inflation expectations into the gold price, its drop in real terms was disproportionate when those fears dissipated. It is likely therefore that the magnitude and speed with which gold prices could fall further this time around will be less pronounced than in the early 1980s.

Nevertheless, the inflation adjusted gold price remains high by historic standards and is under pressure to adjust lower further out against a global macroeconomic backdrop that points towards a stabilizing China, a healing US and a restructuring Europe. If the sale of Cyprus’ excess gold reserves to plug funding shortfalls compels other crisis-hit governments elsewhere to do the same, the downbeat sentiment on the commodity is set to gain momentum. Aside from Cyprus (which has 13.9MT in gold reserves), Portugal (382.5MT), Italy (2,451.8MT) and Spain (281.6MT) all hold significant amounts of gold reserves.

After years of significant demand for gold by central banks since the onset of the 2008 credit crisis, which in terms of net purchases has been as high as 150 metric tonnes, or 14% of total volumes in the 1st quarter this year (according to GFMS Thomson Reuters), the hoarding of gold now looks clearly less compelling. Central banks, like private investors hold gold on their balance sheets based on market values and when buying expensive means having to recognize potential large losses on the P&L too, the incentive to keep buying at the volumes they have dissipates quickly.

Moreover, as emerging market economies look inwards to stimulate growth as export-led growth to developed market is coming to a standstill, governments are set to accumulate bigger budget deficits and smaller trade surpluses. The ability to accumulate FX reserves and gold diminishes as a result.

 The fundamentals for gold are stacked against its price. Just like in any other asset bubble, whether it is in properties or stocks, the downturn in its initial stages was in price magnitude as fast as the rally that preceded it. As uncertainty is gradually dissipating, so is the alternative investment case for gold over and above conventional assets classes stocks and bonds.”

 

Viktor Nossek is head of research at BOOST ETP

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