The TLDR (i.e. executive summary) version is found here.

1. Background of gold

1.1. A socially accepted store of value with some industrial applications

Socially accepted store of value: This shiny yellow metal has been a socially accepted currency and store of value since way before paper money was invented. In fact, even once paper money was introduced, many of the world’s major paper money currencies were essentially backed by gold under the “gold standard”. Understanding the gold standard is important to truly appreciate gold. 

Gold standard – A quick history lesson:

• Bretton Woods (1944): Close to the end of World War II, the Allied nations gathered to establish a new international monetary system to promote economic stability and growth. The outcome was the creation of the IMF and World Bank. But also, the Bretton Woods system, whereby countries agreed to peg their currencies to the USD, which was in turn pegged to gold at a fixed rate. The USD essentially became the world’s reserve currency. 
• De-pegging the USD from the gold standard (1973): The US was financing an expensive war in Vietnam coupled with rising domestic expenditure and foreign countries (e.g., Japan) running a big USD surplus. People began to doubt the US government’s ability to maintain the peg and speculators began putting pressure on the system by selling the dollar and buying gold. The US essentially depleted its gold reserve as it defended the dollar’s value. Hence, the US had no choice but to end the dollar’s convertibility to gold in 1973. 
• De-pegging also occurred in 1933: The US had largely been on the gold standard since 1879. Bank failures and economic turmoil resulted in President Roosevelt putting a stop to the convertibility of paper into gold. 

Some industrial applications: While there are some industrial applications of gold (such as in electronics), it is relatively miniscule and is unlikely to be a key driver of price. At the end of the day, gold is more of a currency than a commodity that is consumed (like oil or steel). 

1.2. Why do people invest in gold? 

Some people love gold, and some hate it – it all depends on your investment philosophy. Warren Buffett is known to be against investing in gold. After all, from a value investing lens, gold has little intrinsic value as it does not yield income. However, billionaire hedge fund manager Ray Dalio is known to be a proponent of gold. From a global macro investing perspective, he thinks that everyone should have a small portion of gold in their portfolio. An interesting video highlighting their philosophies here. 

Some reasons are below: 

• Hedge against currency risks since supply is independent of central banks: With the end of the gold standard, the value of any fiat currency is basically backed by the good faith of the government that issues it. Note that unlike gold, there is no restriction on central banks expanding money supply. The Fed for example theoretically can increase money supply indefinitely by buying treasury bonds on the open market. Hence, gold can be a strong hedge against a scenario when a major currency weakens significantly. 
• Hedge against inflation, especially during extreme price instability: Gold is commonly lauded as an inflation-hedging asset, particularly against rising price inflation. 
• Hedge against market volatility: Seen as a flight to safety; historical track record of safeguarding against short to long term market volatility caused by various kinds of shocks. ‍
• Portfolio diversifier due to low correlation with financial assets: Gold has been shown to exhibit a strong track record of low correlations to major equity and fixed income indices (chart below). Hence, investors commonly include gold in their investment portfolios to mitigate market fluctuations and risks. While it is true that other assets could also act as portfolio diversifiers, there aren’t many with the liquidity and track record like gold.

2. How we analyse the fundamentals of gold 

To analyse gold, understanding its fundamentals is key. Just like how we will perform fundamental analysis on equities by delving into the financial statements and business model of the company, gold analysts do the same, but by monitoring macroeconomic and geopolitical factors alongside competition from alternative investments/asset class to determine a long/short position. 

Below, we dive deep into the factors influencing gold prices. Note that they are all intertwined and should be analysed holistically. I’ll try my best to draw out their relationships with each other.  

2.1. Global fear and panic  

Gold serves as a flight to safety and hedge against extreme risks. It is after all a universally accepted currency that can be liquidated anywhere in the world. Hence, lower confidence about economic growth, political stability, government solvency and monetary disruptions are beneficial to gold. On the flipside, rising confidence levels are a bad thing for a gold bull. 

According to the 2020 Central Bank Gold Reserves Survey, central banks have cited one of the top reasons they are holding on to their gold is because of the precious metal’s “performance during times of crisis”. [Source]

Most recently, fear arising from the series of bank collapse alongside the Credit Suisse/Deutsche Bank saga has caused a rally in gold prices. Below are a series of other events that showcase in numbers, how gold tend to perform well in periods of significant market pullbacks. 

2.2. Interest rates  

Gold prices traditionally have an inverse relationship with interest rates. 

For most people, gold is a non-yielding asset (unless you have a large amount of gold that you lease out). It does not have income potential like bonds do with coupon payments or like stocks do with dividend pay-outs. Hence, gold is very sensitive to alternative investments/asset class. When global interest rates are high, investors will prefer to park money into bonds like T-Bills and hence causing an outflow from gold and naturally having a bearish impact on its prices. 

Relationship with global fear and panic (factor 2.1): When there is global fear and panic, government bonds and investment grade corporate bonds may also be seen as a safe haven alongside gold. Hence, demand for such bonds increase, driving price up and hence yields down. With the yields of such bonds down, gold will therefore appear to be more attractive in comparison, causing higher demand and hence prices to rally. 

As seen below, according to World Gold Council, rates are one of the most important contributors to gold’s performance in 2021. 

2.3. Value of the US Dollar against global currencies  

Gold prices and the USD also share an inverse relationship. 

The USD is the benchmark pricing mechanism for gold and hence there is a strong relationship between the two. A depreciating USD would mean that investors (an ex-US investor looking at the price of gold in their own local currency like SGD) can buy more gold with the same amount of the local currency they hold – hence demand for gold would rise and causing this inverse relationship.

Moreover, since the US dollar is used as a reserve currency, a decline in its value can prompt investors to seek alternative methods of preserving their wealth, and gold serves as a suitable alternative.

Relationship with interest rate (factor 2.2): Higher interest rate generally cause currency appreciation. When the Fed hikes interest rates in the US for example, this will result in USD denominated bonds to appear more attractive. Foreign investors will hence be motivated to buy USD to purchase USD denominated bonds, causing the USD to appreciate in the process. Gold tends to go down as the USD appreciates. 

2.4. Inflation 

Gold has traditionally been seen as an inflation hedge. Research from the World Gold Council states that when the inflation rate outpaces interest rate increases, commodities like gold may outshine some traditional financial assets [Source]. This stems from the belief that with inflation, it would cost more inflated dollars to buy per unit of gold and hence, gold should be rising in value. 

However, long-term correlation between inflation and gold price are weaker. After all, gold is not a commodity that is consumed like oil or steel and so respond to purchasing power differently. Moreover, a period of high inflation may also translate to a period of high economic growth, where equities are rallying. Gold would unlikely perform in such an environment since it would appear to be a much less attractive investment vis-à-vis such high growth, dividend yielding equities. 

Differentiating between normal inflation and abnormal inflation is crucial. During periods of high growth, inflation is normal, and confidence is high. Gold price is unlikely to grow very much in such circumstances. However, persisting inflation during an environment of low confidence is such where gold price would thrive. Or State Street Global Advisors put it, “In reality, gold has been most effective at protecting against periods of extreme price instability”. 

Relationship with currency (factor 2.3): Rising inflation tend to result in a weakening currency, as goods are more expensive and appeal of investing in the country decreases. 

Relationship with interest rates (factor 2.2): Generally, a positive correlation, as central banks would want to hike interest rates to combat rising inflation. 

2.5. Piecing it together 

Again, factors influencing gold price are not static. They interact with each other and thus, it is important to evaluate the fundamentals holistically. Above is a simplified flowchart that aims to put together an example of how the 4 factors may interact. 

There are a whole bunch of factors that could influence gold prices. However, you get sharply diminishing returns from over-analysing. Nevertheless, other factors that are not discussed in depth above include the following:

• Supply of available gold: An increased in gold production would cause gold price to fall. Nevertheless, gold supply is finite. Technological advancement may speed up the mining process, but it is estimated that there is only about 20% of gold left to be mined, albeit this figure is not set in “stone” [Source]. 
• Central banks and their relationship with gold: Central banks across the world hold large amount of gold in their foreign reserves. They can be large gold buyers or sellers and massively influence price. Nevertheless, not that since 2010, central banks have been net buyers of gold on an annual basis [Source]. 
• Jewellery demand: As seen in the chart in 1.1, gold jewellery accounts for close to 50% of gold demand, with the bulk of it stemming from China and India. 

3. Our outlook/house view on gold – Modest near-term overweight

3.1. Global economic contraction almost certain; Gold likely to thrive especially amidst stagflation 

Weakening output: 

Signs of weakening output due to very aggressive interest rate hikes are very apparent, indicating deepening downturn across the globe. Gold tends to perform well amidst recessions (delivered positive returns in 5 out of the last 7 recessions), especially when global uncertainties, panic and fear are at its height. 

• Yield curve screams recession: The yield curve is already heavily inverted. US 10Y-2Y yield spreads is at -58bps [Source]. The current streak is the fourth longest in US Treasury market since the 2Y Treasury yield was first reported on 1-Jun-1976. Note that every US recession over the past 50+ years was preceded by a curve inversion. While it is not a precondition for recession, there has also been no false signal, where an inversion happened without a recession. On average, recessions started 16 months after the inversion, and the market peaked 11 months after. Since the Yield Curve first inverted in Jul-22, a recession can be expected late 2023. 
• US Purchasing Managers Index indicates economic contraction: The Purchasing Managers Index is a diffusion index summarizing economic activity in the manufacturing sector in the US. It is an indicator of economic strength and is currently at a low of 46.30 (down from 64.70 in March 2021) [Source]. The 2 times it went this low the past 20 years was in 2008 during the global financial crisis and 2020 during the height of covid-19. 

The above factors make us pessimistic of a possible soft landing – if it happens, which would of course be detrimental for gold since it will boost investor confidence. 

Persisting inflation. A rate pause is beneficial for gold too: 

In addition, despite persisting monetary tightening by central banks across the globe (which is also causing the contraction we talk about above), we still see inflationary pressure remain. In fact, just couple days ago, OPEC+ announced slashed oil production in a surprise move, further rekindling fear of prolonged inflationary pressure [Source]. Clearly, such persisting inflation differs from the healthy inflation you would associate with growth. 

Furthermore, recent market volatility due to the banking crisis may entice central banks to opt for a more moderate rate path than they would have. Combating inflation is likely to only return to the forefront once things calm down. Of course, a pause in rate hike (or rate cut, though very unlikely) is beneficial to gold as well since gold and rates have an inverse relationship. 

We also think that a pause in rate hike might not be fully priced in yet given the Fed’s persistence in combatting inflation. In fact, even if the Fed chooses to continue hiking, it might end up sparking further panic (be it whether it is justified or not) on the state of the banking system – benefiting gold anyways. 

Stagflationary outlook is real: 

Weakening output combined with inflationary pressure mean that stagflationary outlook is real – especially with (1) a globally synchronised hike in interest rates coupled with (2) record high debt level, (3) record low unemployment rates and (4) geopolitical tension causing supply chain and labour constraints. Gold performs very favourably during stagflation, as seen in the chart below. After all, it’s not hard to understand why investors would flock to a stable and safe asset like gold during such times. 

3.2. Still room for Central Bank demand for gold, especially with the current state of the world’s reserve currency

Central bank demand for growth at record high in 2022:

• 2022 saw the second consecutive y-o-y increase in demand from central banks for gold, with net purchases totalling 1,136t – the highest level of annual demand on record back to 1950 [Source]. 
• The World Gold Council’s annual central bank survey highlights that the 2 key drivers for purchase are (1) gold’s performance during times of crisis and (2) gold’s role as a long-term store of value. Notable purchasers were China (straining US-China relations) and Turkey (monetary crisis). 
• Especially with the current levels of uncertainty across the globe, further coupled with the current state of the greenback, it is not hard to see why there is likely room for further demand for gold from central banks. 

Confidence in the USD is gradually eroding. Gold is a prime alternative to replace USD in central bank’s foreign reserves: 

• As mentioned above, the world’s reserve currency is basically backed by the good faith of the US government and how the Fed manage their monetary policy. 
• Eroding confidence: The numerous QEs (QE1 during the 2008 financial crisis, QE2 in Nov-20, QE3 in Sep-12, QE 4 aka QE infinity in Sep-19) have already eroded confidence in the US. What probably really accelerated the move to diversify into alternative currencies is when the US used the USD as a financial weapon against Russia. Hence. for nations with more geopolitical tensions with the US, it is clear what they need to do. 
• Dropping the USD: Most recently, Brazil and China have ditched the USD for trade payments, favouring the yuan. This is not new. Note that Russia and India have already agreed to drop all use of the USD and Euro in bilateral settlements while Saudi Arabia have expressed that the nation was open to trading in currencies beside the USD. BRICS nations are also working on creating their own common currency.‍
• Implications: More obviously, central banks are eventually going to rely less on the USD as a foreign reserve and a clear alternative is gold. In addition, demand for US assets and the USD may fall. Since the USD has an inverse relationship with gold, this will likely benefit gold as well.

3.3. A slew of other macroeconomic and geopolitical concerns may support gold prices  

US Debt Ceiling Crisis: 

• The US has hit its $31.4t debt ceiling, which is equivalent to $200k of debt for every US taxpayer. This is massive. 
• If no new debt issued (Unlikely scenario): According to Wells Fargo, if the US does not raise the debt ceiling, the government will begin defaulting on its debt starting between July to September. This will cause a global economic meltdown. If new debts are not issued, the US will be forced into austerity measures equalling budget cuts up to 5% of the size of the US economy. This situation will no doubt benefit gold. 
• If debt ceiling is raised and new debt are issued (More likely scenario): Further levels of debt may cause investors to worry about the US’s ability to pay back in the future. Investors start to lose confidence in the US economy. They fear that the Fed will simply print more money to repay debt, which would result in currency devaluation. There might perhaps also be a possible credit downgrade, which would be highly detrimental to the US (e.g., higher borrowing cost leading to lower household wealth, GDP, etc.). Such a situation will also benefit gold. 

Geopolitical threat level remains high:

Not to mention, (1) continued US-China tensions (e.g., US semiconductors sanctions, trade tariffs, potential TikTok ban, etc.), (2) the war in Ukraine, and most recently, (3) a surprise output cut by OPEC+ that rekindled fears of prolonged inflation. All of which are huge macro events that are still evolving. I won’t be surprised if new developments in the above spark further panic and fear in the short-term. 

Fear of contagion risk in the banking sector:

‍After the collapse of several regional US banks and especially amidst the most recent Credit Suisse bailout and Deutsche Bank selloffs. Assurance from central banks across the world have calmed the markets as of now. While it does seem like the bank collapses are due to idiosyncratic reasons rather than systemic issues in the banking system, fear is already rampant. Who knows if something else will break down the line. 

4. Ways to gain exposure to gold 

4.1. Physical gold 

The most common ways are (1) gold bullion, (2) gold coin and (3) gold jewellery. Jewelleries are likely the least efficient way to invest since there will be significant markup from design and workmanship cost. 

Authenticity is obviously a key issue, so purchasing from a reputable party is critical. For bullion and coins, you can head down to UOB Banking Hall Basement to purchase directly from the bank [Source]. The selection is not super extensive, but the gold purchased will be sealed in the bank’s official packaging alongside a certificate. Alternatively, you can also head down to any reputable dealers across Singapore.  

Note that transaction fees for physical gold can be high at 1-2% and you still need to account for storage cost if you intend to purchase larger quantities. 

4.2. Gold ETFs 

Essentially a fund that holds gold bullion held in the vaults of the custodian bank. The main perk of gold ETFs is probably its accessibility and convenience. 

• Much lower amount of capital needed (e.g., IAU is at around US$38 per unit vs an ounce of gold at upwards of USD$2,000)
• Removes the logistical hassle and cost of owning physical gold. 
• Better liquidity and you can trade anytime via your broker. 

I personally have exposure in iShares Gold Trust (IAU), but here’s a list of other ETFs for you to consider. Just like any other ETFs, take note of its expense ratio, tracking error and reputation of the counterparty.   

4.3. Others 

• Gold Savings Accounts: They work quite similarly to gold ETFs. Offered by local banks like OCBC and UOB, you essentially own paper gold. Do run your own calculations to see if ETF or a gold savings account make more sense. 
• Gold Mutual Funds: Less ideal than ETFs since they do not trade intraday on national exchanges and tend to have higher expense ratios than ETFs. 
• Gold Futures: Essentially an agreement between a buyer and seller to complete a gold transaction for a fixed price at some point in the future. Not recommended for retail investors like us, as it requires pretty high capital outlay (most contracts represent 100 ounces) and involves a steeper learning curve. 
• Gold Stocks: Ownership of mining companies. This is less ideal since it is an indirect exposure to gold. Obviously, there are a host of other factors like the company’s operational decisions to consider. 

5. Concluding Thoughts – What are we doing?

As Warren Buffet puts it, “if you own one ounce of gold for an eternity, you still own one ounce of gold at its end”. Gold tends to underperform the stock market in the long-term. After all, it has no income potential (hence very little intrinsic value), and its value stems a lot from fear. Gold is basically an alternative to cash, and in the long-term, it will probably perform only slightly better than cash. 

To us, gold performs well in climates like the ones we are in now – where fear is rampant due to so many uncertainties from an economic, monetary, and geopolitical lens. We have a small portion in gold ETFs (i.e., IAU) since our last article on the banking crisis. However, we see this as a short-term play – closely monitoring the global macroeconomic and geopolitical situation. 

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