Not All That Glitters is Gold

Traditionally, in periods of high economic risk, gold has always been considered a good investment tool. But despite the instability of the financial markets in recent months, the dynamics of the golden troy ounce are not as promising as they should be. Does this new trend signal the end of gold’s status as an asset-protection tool?

Just last fall, the price of a troy ounce rose to an all-time high, reaching a value above $1,900, and it seemed to all the world that gold would break the $2,000 mark in the near future. But these hopeful expectations were quickly crushed in the face of recent data; for almost all of 2012, gold was barely valued over $1,600. And in the meantime, tensions in the global economy and financial markets remain high - experts are even hinting at new sovereign risks. But not even the seriousness of the spring situation in the Euro zone could push the value of gold back up to its levels from last year.

photo by mhartford

Another thing to keep in mind is the volatility of gold prices. Large investment banks, after assessing the weak results the precious metal generated in the first half of the year, lowered their annual forecasts regarding gold’ quotations. In a survey conducted by Reuters consisting of 29 analysts, the average forecast for the spot price per troy ounce in July was only $1,685, as compared to its forecast from early 2012, $1,765.

The weakening correlation between gold prices and levels of risk can be seen very clearly by comparing the troy ounce quotations with major stock indexes (the WEj used the S&P 500 index) - since last autumn, "mirror graphs" have almost disappeared entirely. In the eyes of many investors, this fact casts doubt on the main appeal of gold as a tool to protect their assets. So the question remains: can gold serve as a "safe haven" in today’s economic environment?

The Strength of the Dollar
Many experts believe that gold has not yet lost its special status - its sensitivity to economic levels of risk have just been dulled. This conclusion can be drawn from a number of different factors, the main one being the strength of the US dollar. The price of a troy ounce is expressed in American currency, and as this currency strengthens, it leads to a decrease in the nominal market value. The European crisis caused a sharp decline in the amount of risks investors were willing to take, but not enough people fell back onto precious metals to significantly raise the price of gold. As a safety measure, financial market players chose to keep their money in US, German, and Japanese government bonds; the return on these securities fell to record lows this summer.

More importantly, the deleveraging process in the Eurozone seems to be giving birth to a new trend, the sale of gold by cash-strapped financial institutions. A similar situation occurred from July-October in 2008; shortly before the collapse of Lehman Brothers, and immediately after, the market price of the troy ounce dropped in spite of the panic that gripped financial markets.

Another factor that hindered the growth of gold this year was the circumspect view of the American central bank. Despite the growing threat that the European debt crisis poses to the global economy, as well as the obvious signs of slowdown in both the US and China, the Fed was in no hurry to appease the markets with a third round of quantitative easing. But this new measure of monetary stimulus could provide significant support for the price of gold for several reasons. First of all, the QE3 will inevitably lead to a weakening dollar. Secondly, the influx of fresh liquidity will spur a new wave of interest over a broad range of assets; quite simply, investors will have more cheap money on their hands. Thirdly, the easing of monetary policy contributes to the rising of potentially inflationary expectations, whereas investing in gold is traditionally considered a good hedge against these risks.

Pessimists believe that the third round of quantitative easing will not be declared in coming months, mostly because Ben Bernanke’s hands are tied by the proximity of the presidential elections in the United States. Monetary levers are the real "heavy artillery" in the fight against the crisis, because they introduce uncertainty into the economy and the financial markets, and regulators tend to be hesitant about using them in tense political situations. However, the hope that the Federal Reserve will soften is constantly ignited, and were this to happen, it would support the position of gold.

Finally, the dynamics of the troy ounce this year are being suppressed by the adverse balance of physical supply and demand. The main blow, strangely enough, cam from India, the world’s largest consumer of gold. Indian citizens have traditionally preferred to invest their savings in jewelry, bullions, and coins, but this year, the Indian rupee collapsed, resulting in the government levying a high duty on gold imports to help replenish the budget. Because of this, domestic gold prices soared, and the demand for gold fell by almost 50%, compared to last year.

So What’s Next?
Gold still has opportunities to fully demonstrate its best qualities. Signs of its re-establishment as a protective investment started to reappear last summer; the cost of the troy ounce started responding to financial circumstances, rising when there was bad news and falling with good news. It is worth remembering that the sale of gold at the peak of the 2008 crisis did not last long - it was followed by a correction, and only afterwards did it grow significantly. This time, however, it seems that only Ben Bernanke will be able to return gold to its highly valued status as an investment tool. If the Fed decides to go for a third round of monetary stimulus, the relative attractiveness of US Treasury bonds will decline, leaving other defensive assets as the main source of protection for investors. And many people hope for this outcome. According to ETF Securities, there was a notable surge of interest in exchange-traded gold funds; the net inflow amounted to $570 million, and the total investments reached an all-time high of 77 million ounces.

Text: Anna Kim