Economic Indicators and Business Research

Gold has long been a sought-after commodity, and it remains a prominent component of modern financial portfolios. Over the last 20 years, the metal has given attractive long-term returns, with yearly gains of about 8%. However, its price has been highly volatile, falling by around 40% between 2011 and 2015 until fully recovering in 2020. At the time of writing, the gold is reaching new all-time highs, surpassing $2,180 per ounce on March 11, 2024. Gold prices are controlled by a complex interaction of macroeconomic and supply/demand variables. Understanding its distinctive traits and benefits is critical for investors seeking to build portfolios that will last through cycles.

This essay will identify and evaluate the key determinants of gold prices, how they have changed in recent years, and how an adequately sized gold investment might possibly add value to a portfolio from an asset allocation standpoint. Because gold is valued in dollars, the value of the US dollar (USD) has historically been inversely tied to gold prices. When the US dollar drops, gold becomes relatively cheaper for holders of other currencies, increasing demand. And the contrary is often true, with gold falling when the dollar rises. However, this link may fail over extended periods of time. In 2012-2013, for example, gold lost -18% of its value while the USD remained relatively constant, increasing less than 1%.

Looking ahead, we believe the dollar situation will be somewhat supportive of gold prices

Following a big rebound in 2022 and a flattish 2023, the dollar is now trading 10%-15% above its fair value, as implied by interest rate differentials and its own long-term average. Over the longer term, we believe the dollar will revert to its mean value, and its overvaluation will eventually be reversed. This process could take some time, since the dollar may be maintained in the short term by the United States' cyclical growth outperformance compared to other major economies. However, any strength beyond existing levels should be minimized. We expect U.S. economic growth and interest rates will gradually "catch up" with the rest of the globe as labor market wage rises slow and the Federal Reserve begins decreasing rates, most likely in the second half of 2024.Gold prices have historically had an inverse association with real yields (inflation-adjusted interest rates). Because gold does not generate interest income, real yields can be interpreted as the opportunity cost of owning it. When real yields fall, gold becomes more appealing relative to interest-bearing assets like cash and fixed-income instruments.

This inverse link explains a significant portion of the increase in gold prices since the 1990s, as real yields fell, indicating a structural deterioration. Large gold rallies, such as those from 2008 to 2012 and 2019-2021, can also be ascribed to real yields falling into negative territory, which were severely hit by global quantitative easing and zero interest rate policies. However, over the last two years, there has been a significant divergence between gold price swings and actual interest rate fluctuations. In early 2022, the Federal Reserve began an aggressive tightening cycle at an unprecedented speed, despite persistently high inflation and increased global supply disruptions caused by the commencement of the Russia-Ukraine war. Real yields surged from profoundly negative territory to their greatest levels since the 2008 Global Financial Crisis. 10-year US real rates surged by a record 250 basis points in 2022, followed by another 20 basis points in 2023. In this context, gold prices were extremely resilient. Prices remained basically constant in 2022, despite severe volatility, and achieved a +13% return in 2023, completing the year at a record high of $2,068 per ounce.

Has the correlation been permanently broken We feel it has momentarily altered and will most likely restore itself at some point

For the time being, we find that gold continues to react to movements in real yields, albeit in an uneven fashion - it decreases less when rates increase and rises more when rates fall. Why? The solution is largely due to a recent change in supply and demand dynamics.Supply and demand are the fundamental driving forces behind all commodities. As previously noted, various factors influence gold prices, but supply and demand are critical. Global gold mining has been very constant for many years, thus the demand profile is particularly important and distinct. This distinguishes it from other commodities. There are three main sources of demand for gold: industrial, investment, and reserve management.While investment and reserve management demand make up a lower fraction of total gold consumption, they can occasionally be a more major driver of gold prices. In recent years, reserve managers and central banks have had a greater impact. Fabrication of jewelry. Jewelry demand accounts for approximately half of overall yearly gold consumption. Gold is highly valued as a beauty, permanency, and prestige symbol, with demand especially strong in Asia, particularly in India and China.

Technology. Industrial and technological applications, including as electronics, dentistry, and aerospace, account for around 10% of gold consumption.Central banks have been important gold buyers for decades. During the nineteenth century, most countries tied the value of their currencies to gold, which became known as the Gold Standard. Central banks were expected to maintain sufficient gold reserves to support their currencies and enable for currency conversion into gold. This approach was extremely disciplined, yet it proved to be ineffective during times of crisis. Governments eventually recognized the need to extend monetary supply beyond the constraints of the gold standard, and the system was abandoned after WWII to be replaced by the Bretton Woods System.

This extraordinary purchase momentum persisted in 2023, with a dizzying rate of 1,037 tonnes

This is widely recognized as a major cause of gold price stability amid the recent rise in real yields. There are a variety of reasons why central banks raise their gold reserves. However, it has become clear that in some situations, governments who are not allies of the United States have began to attempt to diversify their reserve mix away from dollars, recognizing the hazards of maintaining these reserves exposed to sanctions. Other governments hope to provide some protection against higher and more erratic inflation as the developed world exits the era of ultra-low inflation following the Global Financial Crisis. Because of its scarcity, gold can occasionally serve as an inflation hedge, albeit this is usually temporary.

This system fixed the dollar's value in relation to gold and international currencies. Unsurprisingly, this too proved impractical, and as the United States began to run significant deficits, tensions began to surface. In 1971, the United States completely abandoned the gold link, resulting in the Bretton Woods system's collapse. This enabled the price of gold to fluctuate freely on worldwide markets. Although there was no longer a necessity to hold gold as a reserve asset, its scarcity made it enticing to central banks as a store of value. This role has fluctuated throughout time, but as seen in the chart below, central banks around the world presently hold approximately 20% of their foreign exchange reserves in gold.Following a long pause, central bank acquisitions have increased significantly in recent years. According to World Gold Council statistics, global central banks' net purchases hit a record 1,082 tons in 2022, more than twice the average annual buy over the preceding ten years.