Gold Price Outlook: Uninspiring Returns
There’s value for tracking and writing about gold for three reasons:
- Gold has historically acted as a hedge and storage of value during times of uncertainty and dollar devaluations.
- Gold isn’t an institutional asset class and is not widely covered by the major banks. As such, it is not an efficient asset class and so a global macro strategist or analyst has a good chance of making an accurate prognosis of future prices.
- Gold acted as the singular anchor for the world’s monetary and financial system as recently as the early 1930s and was the currency of choice for virtually all prosperous civilizations over the last 3,000 years.Because of the historical association of gold with wealth and riches, the metal still invokes an emotional response and thus is subject to big boom and bust cycles (and arguments at the dinner table on whether the U.S. should abolish the Fed and go back to the gold standard).
This is all you need to know for 2022: The recent weakness in gold prices – despite the rapid rise in global liquidity since March 2020 (Michael Howell’s proprietary measure of Global Liquidity has risen from $130 trillion pre-pandemic to around $190 million today), higher-than-expected US CPI/PCE prints, and the new South African / Omicron variant (which has resulted in traders pushing Fed rate hike expectations from June to September 2022 as I write this on Friday, November 26th) – doesn’t bode well for the metal next year. Figure 1 below shows the failed price break-out despite real rates recently hitting an all-time low while inflationary expectations continue to rise.
When the price of an asset fails to rise on positive news, particularly when most investors are also expecting higher prices, it typically isn’t a bullish sign. Gold may still rise in 2022 if the U.S. dollar weakens (which I expect), but my opinion is that an allocation to gold today doesn’t provide a sufficiently high reward to justify the risk, especially since the Fed is now tapering and is expected to hike rates next year.
Reviewing Gold at the 10,000-foot Level
- As you can see from Figure 1, real interest rates (blue line) are only one of many variables driving gold prices. E.g., during the 2001- 2011 secular bull market in gold, real interest rates took a dive after the dotcom bust, making a trough during summer 2003-summer 2004, and yet gold prices continued its liftoff from around $400 during summer 2003-summer 2004 to $630 an ounce in December 2006 despite the 1-year real interest rate rising from -1.3% to +3.4%. Back in the mid-2000s, despite higher real rates, gold continued its bull market due to:
- Higher relative growth in the rest of world outside the U.S. As U.S. growth and innovation went into a cyclical decline in the aftermath of the dotcom bust, 9/11, and the rise of the Euro as an alternative reserve currency to the US$, foreigners sold U.S. financial assets and reallocated elsewhere, and gold became relatively more attractive, especially to US investors.
- China’s overdrive to industrialize and grow its economy through exports and accruing US$ in the process. Much of the US$ accrued by China was kept as official FX reserves, but this newfound wealth also led to the creation of the Chinese middle class. China is a prolific gold jewelry consumer. From 202.3 tonnes in 2002 (accounting for 6.6% of total world demand of 3,067.4 ounces), Chinese gold demand increased to 452.4 million tonnes by 2010, accounting for 10.9% of total world demand of 4,162.2 ounces. Note this surge of Chinese demand by volume occurred even as the gold price rose from $309 in 2002 to $1,225 an ounce in 2010.
- The creation of the first gold ETF, the SPDR Gold Trust, which increased access for retail investors interested in buying gold. By the second day of closing on November 19, 2004, holdings in the SPDR Gold Trust had already surged to 1.86 million ounces, or almost 4x the holdings (472K ounces) in CEF. Last year, gold demand from ETFs surged to 873.9 tonnes, accounting for 18.5% of total world demand. Figure 2 below shows the rise in gold ETF holdings from 2004 to today.
The 30,000-foot View
To better forecast gold prices, we need to break down its underlying demand factors, and most importantly, the demand dynamics that drive the metal’s short- to medium-term fluctuations and trends. Before we do that, however, let’s zoom out further and take a 30,000-foot view, as gold doesn’t exist in a vacuum, i.e., gold competes with other asset classes from an asset allocation perspective, as well as consumer goods & services (in the case of jewelry demand). Figure 3 below shows when gold is more or less favorable from an investor’s perspective.
- The four-quadrant model suggests that most of the returns/risks of all major asset classes are driven by just two factors: 1) global GDP growth expectations, and 2) global inflationary expectations. By far the biggest source of return of any major asset class, in the long run, comes from these traditional “beta” factors
Within each quadrant, there is one or two dominant asset class that is the most liquid as well as being most sensitive to the underlying two factors from a U.S. investor perspective, which are:
- Inflationary bust, or stagflation (rising inflation expectations, lower GDP growth expectations): gold and US TIPS, e.g., 1970s, April 2020-Summer 2020
- Inflationary boom (rising inflation expectations, rising GDP growth expectations): commodities, e.g., WWI, 1950s-1960s, 2003-2007, 2021 (and at least through Q1 2022, new South African / Omicron variant notwithstanding)
- Disinflationary or deflationary boom (lower inflation expectations, rising GDP growth expectations): US stocks, e.g., 1920s, much of 1980s to 1990s, Fall 2011-July 2015, February 2016-September 2018
- Deflationary bust (lower inflation expectations, lower GDP growth expectations): long-duration US Treasuries, e.g., September 1929-December 1932, January 2008-March 2009, October 2018-December 2018, March 2020
This four-quadrant framework suggests investors should allocate to at least one or more of the four major asset classes during all time periods, as cash is nearly always underperforming one major asset class. Since 1926, there have only been 3 calendar years when cash outperformed all of these major asset classes: 1931, 1981, and 2018.
Based on this simple, 30,000-foot framework, the investment environment has transitioned from one that is favorable to gold, i.e., when global economic growth plunged early last year as economies shut down while central banks began to ramp up the printing presses, to one that is less favorable, as economies continue to reopen while central banks have begun to taper QE or hike interest rates. Specifically, the U.S/global economy has been transitioning from an “inflationary bust” to an “inflationary boom” since the summer of last year. Assuming the new Omicron variant is benign, global economies will continue to reopen next year. Of course, we don’t know whether the U.S. economy will continue its inflationary path or transition into a disinflationary boom or deflationary bust next year, but for now, this framework suggests that buying gold isn’t an optimal strategy unless you think there will be renewed global lockdowns due to the Omicron variant. On a longer-time timeframe, as long as the US-led capitalist system is allowed to flourish, gold prices should continue to underperform
Bottom Line
As global economic activity normalizes and as the world’s central banks adopt a tighter monetary policy in 2022, the global economic environment has shifted from an “inflationary bust” (peaking during summer 2020) to one resembling more of an “inflationary boom.” With the Fed scheduled to finish tapering in June (and to hike rates by September), the investment environment for gold isn’t as positive as it was last year. While gold prices could continue to rise should the US$ peak and decline next year, there is also a sizable latent source of supply (due to record high gold ETF holdings) should gold prices stall at current levels.
