By Derick Deale
Traditional expectations indicate that falling interest rates and a weaker dollar, historically the primary drivers of gold prices are likely to continue shaping its trajectory.
However, over the past two years, gold’s price performance has surpassed the predictions of conventional models, demanding a reconsideration of longer-term price expectations.
Investors should take a pragmatic approach when considering gold’s role as a wealth preserver and portfolio diversifier, especially given the current limited investor involvement.
The importance of real rates
Gold, as a non-yielding asset, stands apart from other safe havens like the dollar. While assets like the dollar tend to lose their purchasing power over time, they offer interest, compensating for the loss of purchasing power. Positive real rates increase the opportunity cost of holding gold.
Historically, gold has shown a negative relationship with real interest rates, particularly with instruments like 10-year Treasury Inflation-Protected Securities (TIPS).
TIPS have often been considered the best explanatory variable for gold prices since the early 2000s, reflecting not only the opportunity cost of holding gold, but also inflation expectations, the interest rate fluctuations and environment, market sentiment and other global economic factors.
While this relationship has weakened over the past two years, gold prices have remained sensitive to movements in real rates: with a greater sensitivity to falling rates than rising ones.
Robust physical demand
Recent discussions suggest that gold’s price drivers are shifting from the West to the East, supported by the physical demand and central bank-buying of the East. Concurrently, investment demand trends are diverging, exacerbated by limited investment options for Chinese investors given the declining attractiveness of local assets such as property.
Despite rising prices, demand for gold remains robust for jewellery, bars and coins, with China and India accounting for the majority. However, demand from other regions also shows resilience.
Central banks, particularly in emerging markets like China and Turkey have continued purchasing gold over the past two years, indicating a willingness to bolster their reserves, even at higher prices. Additionally, recent months have seen strong demand from the Chinese futures market and general over-the-counter trading, contributing to price speculation.
While the East’s growing influence in the gold market is acknowledged, we believe that this trend has persisted for years and may not necessarily signal a fundamental shift in the market.
Elevated risks
Since 2022, we’ve seen various manifestations of geopolitical and financial risks, which were arguably not factored into gold prices. During these periods, gold generally saw an increase but then reacted to changes in real rates. Risks have continued to mount due to global elections, rising fiscal risks, the deflating property and credit bubbles in China, and persistent regional conflicts.
We highlight key events below:
∎ In February, 2022 Russia invaded Ukraine, and gold rose about $200 (R3 626) per ounce. Gold largely gave back the rally by May, 2022 with real yields swinging from negative to positive as transitory inflation expectations reset.
∎ In March, 2023 Silicon Valley Bank (SVB) collapsed, and gold rose about $200 per ounce, despite real yields staying broadly flat. The price retraced over the following six months as real yields rose.
∎ In October, 2023 the start of the Israel-Hamas war sparked a more than $200 an ounce rally. The price was supported by falling real yields in subsequent months.
While gold may be susceptible to a correction in the near term as positive speculative momentum wanes, we believe long-term gold price expectations need to be recalibrated for two key reasons:
The first is that higher, more persistent risks warrant an embedded risk premium. The second is that broad-based physical demand is robust, despite higher prices after years of elevated inflation.
Derick Deale is an equity analyst at Sanlam Investments.
BUSINESS REPORT