Username
Password
Forget Password?
  1. Indices
  2. Commodities
  3. Currencies
Straits Times 3,114.16 -11.98 -0.38%
Hang Seng 26,719.58 -128.91 -0.48%
Dow Jones 26,902.65 -123.23 -0.46%
Shanghai Composite 2,938.14 -39.19 -1.32%
Beware Of The Downside Risks For Gold!
Malaysia Perspective | 18 June 2010
By:

Written by Fundsupermart.com

Gold spot price hit a record high of US$1,235 per ounce on 12 May 2010 as the sovereign debt crisis in Europe spurred risk aversion. Investors remain concerned about the details of the 750 billion Euro rescue plan and the externalities of the liquidity injection to the European economy. Gold, as a safe haven and a good hedge against inflation, climbed sharply in a flight to safety.

Traditionally, the gold spot price was inversely correlated with the US dollar. However, gold prices have been moving in tandem with the US dollar in the recent rally. It could be an indication of the overwhelming demand for safe haven assets, which primarily drove gold prices upward this time.

View Full-sized Image

Chart 1

Gold Price Vaulted In Flight-To-Safety
Chart 1 shows the performance of gold prices since Dec 2009. In the first quarter of 2010, gold spot price increased by only 1.4%, lower than the MSCI Emerging Market and MSCI World Index. It also underperformed the average returns of the markets under our coverage in the same period. Gold price was mainly traded in the range of US$1,085 to US$1,140 in the first quarter. This supported our view that gold prices will remain vulnerable as indicated by the sluggish 1-year forward price (Chart 2).

From end-March 2009 till 12 May 2010, as Europe’s debt crisis worsened ominously following a series of bad news, gold spot price surged 9.8%. For example, after the rescue package worth 750 billion Euros was announced, the price of gold surged 2.5% in the following trading day (11 May) as investors worried about the inflation risk in Euro zone economies and the devaluation risk of Euro.

Notably, the recent gold rally is comparable with the spike in November 2009 (see chart 3). From 1 November to 2 December 2009, gold prices jumped 14.8%, breaking away from their sluggish performance in the past 6 months. A double-digit increase in gold prices for a single month is quite unusual. We believe speculation was the dominant force that spurred the gold prices. On the other hand, the return during end-March to 12 May 2010 was lower than the previous rally, even though gold prices achieved a new all-time high. It implied that investors were more cautious about the high gold prices in spite of contagion fears on Europe’s debt crisis.

View Full-sized Image

Chart 2

Similar To Downside Risk For Oil Price In July 2008
Currently, the downside risk for gold prices is similar to that of crude oil’s price in July 2008. From February to July 2008, oil prices rose from US$88 per barrel to a peak level of US$145 per barrel, delivering a 63% gain. At that point of time, some “peak oil” experts predicted that oil prices would hit US$500 per barrel because of the robust demand from emerging markets. Since then, oil prices plunged significantly and fell below US$33 per barrel in December 2008. The Commodity Futures Trading Commission put the blame on speculators for their significant role in driving wild swings in oil prices.

Similarly, the upside momentum of gold prices has no support from fundamentals. The gold rally has been strong and comparable with the crude oil’s price. Since May 2010, gold prices hit a fresh record high and the momentum was also as strong as the rally of oil prices. Investors should be more cautious about the potential downside risk of gold prices.

Demand in jewellery, which consistently accounts for over 60% of the total gold demand, is still very sluggish as shown in chart 4. Jewellery consumption plunged 20% year-on-year in 2009 and 8% year-on-year in the fourth quarter of 2009 (measured by tonnes). On a quarter-on-quarter basis, a stronger growth should be recorded in the fourth quarter traditionally due to Diwali, Christmas and other year-end festivals, but in the fourth quarter of 2009, demand has only picked up by a mere 2.4%.

On the other hand, Exchange Traded Funds (ETF) demand rose 85% year-on-year in 2009 to 594.7 tonnes. The strong demand in 2009 was largely driven by an exceptional result in first quarter, which soared to 465.1 tonnes. Demand in the fourth quarter of 2009 was significantly lower than the demand in both year-on-year or quarter-on-quarter bases, as well as the average quarterly demand over the past 5 years.

Though economic growth is a leading indicator of jewellery demand and will head the demand for the next 2 to 3 quarters, it may take more time to see demand for real physical gold to pick up as the global economy has just started to recover.

View Full-sized Image

Chart 3

Ultra Low Interest Rate Drives Up Price Of Gold
Investors fret aggressive fiscal austerity measures in the Euro zone countries will slow down the region’s economic growth. Uncertainty in Europe will postpone the major central banks’ rate hike timetable. As a result, a massive amount of speculative capital has entered into the markets. The gold holdings of the world’s largest gold-backed ETF, the SPDR Gold Trust, remained flattish in the first four months this year. However, the holdings were increased significantly by 50 tonnes or 4%, to a record high of 1,209 tonnes from 1 to 12 May 2010.

We believe the upside potential for gold price is limited after the rally. The expected return of gold is just 13% (as at 14 May 2010) provided it can hit the target price of US$1,400/ounce which is the most bullish call in the Bloomberg survey (the mean estimate is US$1,180). Investors should note that gold investment does not generate interest. If the Federal Reserve starts to raise interest rates, investors will re-embrace the US dollar and there will be a re-pricing on gold, which could potentially cause a nasty correction in the gold price.

View Full-sized Image

Chart 4

Wall Street Journal and IFAST compilations
Source: Wall Street Journal and IFAST compilations


Join The Conversation
The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

All Rights Reserved. Pioneers & Leaders (Publishers) Pte Ltd. Best viewed with Mozilla Firefox 3.5 and above.