The end of the gold run

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Gold prices have enjoyed a steady upward trend for the past ten years. However, weakening investor sentiment has caused many market participants to question the sustainability of the bull-run. Here we look at how dynamics of the gold market have changed and discuss the short-term outlook for prices

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Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

The rise of the physically backed ETF

Over the past decade, investment demand has become an increasingly important part of the gold market. Demand for perceived safe-haven assets (which tended to have low or negative correlations with traditional investments, such as stocks and bonds) and assets which were likely to benefit from higher inflation, have been the main reasons why investors have built up substantial positions in gold.

As investment demand for gold started to pick up in the early 2000s, so too did the number of investment vehicles. Although traditional ways of getting exposure to gold – via derivatives for institutions and gold coin and bars for smaller investors – remain in place, the launch of the physically-backed exchange traded fund (ETF) in 2003 made it easier for gold to become a significant portion of investors' portfolios.

How have demand dynamics changed?

As gold became more accessible to the wider market, traditional demand dynamics changed. Jewellery has historically been the predominant source of demand, but as prices rose, demand from the sector declined. As a proportion of total demand, jewellery (which accounted for about 80% a decade ago), lost significant market share and, as of last year, accounted for just over 40% of demand.

Figure 1: Investment demand has been a significant driver of gold prices

On the other hand, investor demand has steadily risen over the same time period. Since the launch of physically backed ETFs, total investment demand (bar, coin and ETFs) has risen from about 10% to around 35% of total demand (Figure 1).

Demand for physically backed ETFs has been so robust that flows have been positive every year since they launched. As of 2012, gold holdings in physically backed ETFs totalled over 2,600 tonnes.

As a result of these changes in demand dynamics, gold prices rose over 5-fold in ten years and eventually peaked at $1920/oz in September 2011. However, since then, prices struggled to regain momentum, leaving prices relatively range-bound between $1800/oz and $1550/oz.

Over the past decade, investment demand has become an increasingly important part of the gold market

Investor sentiment turns in 2013

Although this range-bound trading has remained in place over the past few quarters, the overall price trend appeared to weaken this year. Financial market uncertainty began to subside, while the probability of a rise in inflationary pressures looked less likely in the short term. Additionally, with growth prospects – particularly in the US – picking up, demand for assets with attractive valuations – and more closely tied to the economic cycle – increased. This, in turn, weighed on the appeal of holding assets that do not provide cash flows or yields. As a result, investors reduced net long speculative positions and began to redeem their ETF holdings.

In mid-April, gold prices then fell through $1525/oz (a key technical resistance level), instigating a rapid sell-off (Figure 2). On Monday 15 April, prices dropped nearly 9% (their largest daily loss in absolute terms), hitting $1350/oz (their lowest level since February 2011). Although prices have regained some ground since, many market participants have started to doubt the sustainability of the gold bull-run.

Figure 2: Gold prices have breached key technical levels

We think there have been several reasons for the latest rout. First, slightly more hawkish remarks from the Federal Reserve’s latest minutes suggested that the third round of quantitative easing might end sooner than expected. Second, weaker-than-expected Chinese data appeared to trigger a broader commodity market sell-off. Third, reports stating that Cyprus might sell gold reserves to generate revenue (to contribute to its bailout package) added to the bearish momentum. While Cyprus does not have large gold reserves – in total it holds nearly 14 tonnes, while reports stated around 10 tonnes might be sold – this raised concerns that other eurozone countries might follow suit by selling some of their gold reserves to boost finances.

Figure 3: ETF redemptions have accelerated this year ...

Figure 4: ... but total ETF holdings remain elevated

The combination of these factors led to an acceleration of ETF redemptions. Given the influence of ETFs in the gold market, this represented a significant change in sentiment. Year-to-date about 300 tonnes of gold have been redeemed, which just surpasses the total ETF inflows seen last year (Figure 3).

Prices likely to be range-bound in the short term

Going forward, fabrication demand (i.e. jewellery, industrial and dental demand) – particularly from India and China – will likely pick up now that prices are about 15% lower than at the beginning of the year. This, alongside some bargain buying, should be broadly supportive for prices. Furthermore, we do not envisage any change in central-bank buying activity (which accounts for approximately 10% of total demand). While there could be some sales, we are of the view that central banks will likely remain net buyers, overall, this year.

But with much uncertainty in the gold market at present, prices will likely be range-bound as investors grapple with the recent fragility of the market. Although ETF holdings have declined by more than 10% since their high reached in 2012, the total amount of gold held in physically backed ETFs is still elevated compared to historical levels (in fact, it represents the sixth-largest holding in the world, just behind France's official holdings). If further redemptions occur, prices could weaken. This is the biggest risk to prices, in our view, and the short-term trajectory of prices is likely to be determined by this investment demand for gold, rather than other sources. On the downside, fundamental cost support is estimated to be around $1300/oz, meaning that if prices were to fall below these levels, a considerable amount of output would be at risk, which could provide a (loose) floor for prices.

Gold in a portfolio context

Gold remains a highly emotional (and volatile) investment and, because of this, we would recommend that clients have an appropriate exposure to gold in line with their risk profile. In our Tactical Asset Allocation, we remain neutral on commodities, meaning that investors with moderate risk tolerance should have a 5% allocation to all commodities within their portfolio, and of that, only a small portion should be allocated to gold.