A brief update on gold

Up to mid-2011, demand for gold had swelled as market participants attempted to protect their investments from a potential surge in inflation, US dollar depreciation, possible government defaults or, more generally, a collapse in the financial system.

This strategy proved a real success until September last year: the gold price rose by 25% from June 2010 to September 2011 as the US dollar weakened by 20% from 1.20 to 1.49 against the Euro. When the greenback resumed its appreciating trend, many investors skimmed off their profits, especially as the threat of hyperinflation seemed to have vanished. The slight upturn in the outlook for the US economy explains why the USA’s net retail investments in gold decreased by 27 tonnes last year.

In contrast, the ongoing Eurozone crisis resulted in a net increase in retail investments in gold of more than 70 tonnes from European economies alone, whereas on a global scale, retail gold for investment purposes increased by about 325 tonnes. This 37% increase in 2011 shows how eagerly sought after this precious metal becomes when a safe haven is needed.

In other parts of the world, China continued to be a major consumer, with its jewellery consumption increasing by 15% and its retail investments by 38%, the latter despite inflation coming down. Although the gold price has come off its historical highs in almost all currencies, this is not the case in India, the world’s largest consumer, where the bullion price is still pitched close to its historical top in Indian rupees. This has undermined India’s jewellery demand for gold which fell by 15%.

All in all, in 2011, the decline of 50 tonnes in jewellery demand was notably offset by the rise of 290 tonnes in investment demand, a tendency which should continue this year and, given how slowly the global economic picture is evolving, is most likely to run on into next year as well.

Indeed, the main reasons that have ensured gold’s success are still topical.

First of all, fears of hyperinflation stemming from the excess liquidity pumped into systems drove investors to seek refuge in gold, yet these fears were visibly premature. In fact, liquidity feeds through into inflation when the banking sector passes the extra money on to consumers. However, until now, the banking system has stayed on its guard, with them still showing great reluctance to lend their money. Risks of hyperinflation are thus likely to resurface once the financial outlook improves and banks resume their normal activity.

Secondly, it is most likely that, if the Eurozone does find an acceptable solution to its crisis, the US dollar will once again weaken against the euro, which should benefit gold quoted in USD. Should, on the contrary, the situation worsen in Europe, there is likely to be renewed interest in gold for investment purposes. This should boost the gold price, which will increase in Euros and periphery currencies if the intensification of the crisis remains localised to Europe, but, possibly, in most other currencies as well if there happened to be a contagion effect spreading into the global financial system, with a subsequent slowdown on world economy.

Despite an encouraging outlook for the USA, the global economy is still fragile, most notably in Europe, but also in usually more robust countries which are now experiencing some slowdown, as is currently the case for China. How the Eurozone crisis will evolve remains most uncertain, and it is this uncertainty that should ensure gold being underpinned by a price floor at USD1,500 an ounce, whereas any intensification in the crisis should push it back to higher levels.