For the purposes of this post, I have examined gold from a supply and demand perspective rather than taking the traditional assumptions about what should move gold price.
The traditional narrative about gold prices is that gold is a safe haven investment and a way to protect your wealth against one of the following: inflation, weakness in the US dollar, and economic or political turmoil. These ideas are largely the result of gold’s historical use as a currency (or as a means of physically backing a currency) but in reality the most significant link between gold price and any of these factors exists simply because investors perceive that there is some link (and know that others do as well) and purchase accordingly. I would argue that a speculative link is not meaningful and can create a bubble that will eventually burst.
Unlike an investment like stocks, where the investor owns a piece of a company’s assets and profits, gold is a commodity (in the same category as agricultural outputs, oil, and building materials etc.). Stock prices are a result of the markets judgement of a company’s value taking into account, among other things, assets, profits, growth and risk. Commodities, on the other hand, are typically goods that can be spent, consumed or used.
With most stocks and commodities, the market gives frequent signals as to where the price should be. A stock that is expected to experience large growth, for example, will probably decline if the quarterly numbers come in below expectations (even if the company still made money and grew). These frequent corrections make long term speculation less common and reduce the likelihood of a long term bubble.
For a typical commodity, like corn for instance, the value comes from the intersection of supply and demand that creates the price. For example, if more consumers or industries demand corn, the prices will rise. Similarly, if there is a poor year for growing corn, the scarcity might cause prices to rise because of the lack of supply. Speculative markets for corn and other commodities certainly exist (the Chicago Mercantile Exchange being the large one), but the prices receive frequent feedback from the market and the commodities are typically consumed.
Unfortunately, gold is different.
Very little of the demand for gold comes from practical uses and purposes. Unlike other commodities, gold is not consumed by being eaten, fuelling cars, or used in construction. Almost all the gold that has ever been mined is still available for circulation. Only about ten percent of gold sold each year is used for its practical properties, the majority of which is used in technology. Even this gold is not spent or consumed – the tiny amounts of gold used in electronics are still so valuable that they are worth salvaging and very often will be melted, refined and added back into circulation. The rest of gold demand is split between jewellery demand (43%), Investment demand (35%) and official sector purchases (12%).
My colleague Gregory Neilson recently shared his thoughts on the inflationary pressure that is affecting gold prices, you can read his blog post on gold prices here.