What Drives the Price of Gold?

Revisiting the yellow metal’s fundamentals.

Samuel Lee 11 April, 2013 | 10:26
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There are many ways to own gold, and of them exchange-traded funds (ETFs) are likely among the most efficient. Within Hong Kong and Singapore, there are a number of ETFs tracking gold. The TER levied by Value Gold ETF (03081, listed in Hong Kong, TER at 0.35%) is at the low end, below ETFS Physical Gold ETF (02830, listed in Hong Kong, TER at 0.39%) and SPDR Gold Shares (listed in Hong Kong (02840) and Singapore (O87), which is the cross-listed from the US, TER 0.40%). There is also a gold ETF hedged against RMB, Hang Seng RMB Gold ETF (83168, listed in Hong Kong), which levies a TER of 1%.

 

The best way to think of gold is as a non-yielding currency with a special trait: The only way to "print" it is to pull it out of the earth at great cost. As a currency with no yield and limited practical use, it's unreasonable to expect gold to appreciate by more than gross domestic product growth over the long run. Warren Buffett is right: A century from now gold will almost certainly be less valuable than an investment in stocks compounded over the same period. Gold's investment case largely rests on its ability to insure against currency depreciation. Few people expect to make money by taking out insurance policies. I don't recommend allocating any more than 10% of a portfolio to gold.

 

Fundamental View

Even though gold's long-run return is almost certainly abysmal, I'm reminded that a great economist once said, "In the long run we are all dead." Gold, as a currency, can do well for all the reasons currencies do well: It can yield more than alternatives, be perceived as safer, or have a favorable real exchange rate. We'll treat each factor in turn.

 


The biggest determinant of gold's price is its relative yield, not inflation, as many believe. The gold run got its legs when short-term interest rates hit zero in 2008 and the Federal Reserve began its first round of "quantitative easing," reducing fears of deflation. When short-term interest rates went negative, the opportunity cost of holding gold as opposed to cash became positive. Should real rates rise, gold investors will be slaughtered. Therefore, gold is a bet that real interest rates will remain low for a long time.

Another big determinant of gold's price is market's perception of the dollar's safety. Since 2008, emerging-markets central banks have bought gold to diversify their foreign exchange reserves away from the currencies of the big debtor nations. Prominent investors, such as Bridgewater Associates, have advocated for gold as a strategic holding. John Paulson, who famously made a fortune betting against subprime mortgages, is SPDR Gold Shares 's biggest shareholder. There's a lot of fear baked into gold's elevated price, so investors will have to get a lot more fearful than they are today for this factor to come into play.

 

Finally, gold has a real exchange rate, just like any other currency. Exchange rates tend to converge on the point where purchasing power is equalized. Gold's purchasing power of real goods is at an all-time high: Since 1975, the gold price/CPI ratio averaged 3.5, but now is higher than 7, suggesting gold is overvalued by 100% in real purchasing power against its history. However, unlike with normal currency pairs, there's no mechanism for arbitragers to buy goods in the cheap currency and sell them in the expensive one, so gold can remain expensive for a long time.

 

Source: Morningstar Analysts

 

Aside from the currency factors, there is also a wild card in Chinese and Indian investment demand. As emerging markets become richer, gold demand may continue to rise. In this regard, gold is an implicit bet on emerging-markets growth.

 

 

Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor.

 

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Samuel Lee  Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor

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