Is Gold Still Gold?

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An appraisal of the yellow metal's fundamentals

My post on Friday considered what could be learned from gold’s long-term price trend, the so-called technicals. I concluded that while gold’s inflation-adjusted returns may continue to be poor in absolute terms in the near term, they could still be better in relation to those from equities, bonds, and cash. Particularly if inflation remains high for the next few years.

I also suggested that the trend rate of appreciation in the inflation-adjusted gold price of 1.7% per annum over the last five decades should remain in place on the basis that it was likely the growth rate of global real wealth would continue to exceed that. However, this was overly simplistic, and presupposed that the fundamental reasons for buying gold will not change greatly, an assumption that should be challenged.

This post looks at the underlying reasons for gold’s popularity, together with its supply dynamics - its fundamentals - to see if they still justify the aforementioned historical trend real price appreciation of 1.7% per annum remaining in place.

Gold is a siderophile - iron loving - element, meaning that it is heavy, dissolves readily in iron, and does not like to bond with oxygen - oxides of gold in fact are thermodynamically unstable. It is thus found in greater concentrations at depth in the Earth's core and mantle rather than in the crust.

Compared with very low overall crustal incidence, mineable gold deposits are even more sparse. Furthermore, mineable deposits have now been depleted to the extent that annual gold production has flat-lined since 2016. In the absence of a significant change in mining technology and/or fall in energy prices, this deceleration in annual production is likely to persist.

Gold's chemical inertness make it ideal for use in in jewellery, electronics, dentistry, aerospace and as a store of value in the form of bars and coins. The World Gold Council estimates as of the end of 2021 that 205,238 tonnes of gold has been found/mined in the last 6,000 years and that proven un-mined reserves total 53,000 tonnes - this latter figure is down from 54,000 tonnes in 2019. It is also estimated that there is 15,000 tonnes of gold dissolved in the world's oceans, equivalent to around 10 parts per quadrillion.

It is gold's inertness and rarity that endow it with intrinsic value i.e. its utility, usefulness. Investor Warren Buffet once famously wrote,

[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

I doubt that Warren Buffett is going to bling up any time soon but he should surely see that many humans for millennia have done, and will almost certainly continue to do. Also, if he has a mobile phone or tooth fillings he may have benefitted from gold's utility to a greater extent than he cared to mention.

As for the breakdown in the uses of the 205,238 tonnes of the above-ground stocks, jewellery accounts for 46%, privately-owned bars, coins and ETFs for 22%, central banks for 17% and other uses such as electronics, dentistry and aerospace for 15%. It is also estimated that today up to 80 per cent of the gold that is newly mined or recycled is used in jewellery manufacture.

What of the future?

To be clear, I am not interested in factors that might influence gold's short-term price performance. They are essentially sentiment driven and unpredictable. Moreover, short-term performance pales into insignificance compared with possible percentage moves over the longer term.

In other words, the factors that really matter are the ones relating to fundamental supply and demand. They are what will determine the longer-term performance of the inflation-adjusted gold price - whether it will rise 300% over the next decade, say, or fall 75%. It is this that, in my humble opinion, you should be focussing on, not on whether the dollar (nominal) price will fall below $1,500 in the coming weeks.

What follows is a brief appraisal of the main sources of supply of and demand for gold.

Supply - mined gold

As noted above, annual gold production has been in decline and since 2016 has flat-lined. Environmental issues limit the potential for new discoveries. Advances in mining technology relate to such things as use of drones, virtual reality, autonomous vehicles, and blasting optimisation. They do not, indeed cannot, address in a meaningful way the fundamental law that dictates that the deeper you want to dig, the more energy it takes.

Supply - recycling

While 75% of annual gold demand is satisfied through supply of mined gold, the shortfall is made up by recycling, mostly of jewellery. In the short term, the supply of recycled gold is sensitive to the gold price. Beyond this, it is unlikely that the dynamics behind the fundamental supply of recycled gold will change significantly.

Demand - jewellery

The first known use of gold was as a decorative bead around 6,000 years ago. It is hard to see how such well established popularity is going to change fundamentally. According to The Word Bank, world real GDP has grown 3.1% per annum since 1971 which compares with trend appreciation in the real gold price over the same period of 1.7% per annum - in total, over the fifty years, world real GDP has risen 360% compared with the rise in the real gold price of 130%. In other words, the rise of the gold price over the last five decades has been more than supported/justified/explained by the increase in global wealth.

Demand - central banks

Net purchase of gold by central banks have been fairly stable in recent years, averaging around 500 tonnes per annum. Gold's utility, both as jewellery and as a store of value, is inextricably linked to its chemical properties. It thus seems unlikely that central banks will lose interest in holding physical gold in vaults in the near or even distant future. Net purchases may vary somewhat from quarter to quarter, occasionally significantly, but the longer term trend appears well established.

Demand - private investment

Private investment demand for gold is perhaps the most interesting of the four main sources. Its utility as a store of value for private individuals is similar to that for central banks i.e. it is linked to its chemical properties. However, economies of scale are such that it is expensive and/or risky for private individuals to store gold at home so most own it in paper form i.e. certificates and ETFs. Supporters of cryptocurrencies have leapt on this apparent inefficiency, claiming that the likes of Bitcoin should be thought of as digital gold, and thus will invalidate gold's current utility as a private sector store of value.

I just don't see this.

Gold's uses as jewellery and as private and public stores of value are inextricably linked to its chemical properties. In other words, demand for gold bars goes hand in hand with demand for jewellery. Bitcoin and other cryptos have no such fundamental properties and never will. It is unlikely that USB sticks on which crypto access code is stored are ever going to be worn as jewellery. Unless of course they are made of gold. Oh, the irony!

The reason I said that private investment demand is the most interesting is that in times of economic difficulty gold may get sold to finance purchases of more essential items, putting downward pressure on the price. However, in times of severe economic difficulty, ones in which confidence in fiat - paper - currencies is lost as a result of high inflation, demand for it as a store of value will increase.

I'm not sure I'd want to live in a world in which gold has supplanted paper as the main currency, but that's not to say that a persistent but gradual increase in economic difficulty over the longer term as a result of, say, rising global temperatures, wars, famines, pandemics etc would not see the gold price appreciate.

A quick word on the various ways in which gold is described in terms of its price behaviour i.e. store of value, inflation hedge, safe haven, investment.

A store of value, as should be clear, is something that holds its value in real terms. Gold has been a store of value to the extent that its inflation-adjusted price has trended upwards over the last fifty years. However, had you bought gold in 1981 you would still be underwater in real terms. In other words, there can be and have been specific multi-decade periods when gold falls in real terms.

Gold's reputation as an inflation hedge was established in the 1970s, 80s and 90s but since then this relationship is not apparent. Indeed, in the naughties, when inflation was falling, the real price of gold rose more than 400%! Thus, I'm not sure that the argument that gold is an inflation hedge holds true, other than in relation to its use during times of severe economic difficulty e.g. the hyperinflation of Weimar Germany.

Is gold a safe haven i.e. defensive? In other words, does it perform well when risky assets such as equities and high yield bonds are performing poorly? Again, there is no real evidence that this is the case; it has not performed well this year, a period in which risky assets have done badly.

Finally, I have never considered physical gold to be an investment. A gold mining company, yes. Gold, no. This is because physical gold - unlike an equity, a bond or property - does not generate income. It is more akin to cash, and a portfolio allocation to physical gold should be considered a cash alternative. That is not to say that there cannot be prolonged periods when a) a high cash allocation is appropriate and b) gold as cash should be preferred to fiat currency.

Demand - other (electronics, aerospace, dentistry etc)

I suspect demand for gold in electronics, aerospace, and dentistry is the most stable. There is around only $2 of gold in a mobile phone so even a big change in the gold price is not going to make too much difference. And, as mentioned, it is hard to match gold's characteristics in terms of its inertness, electrical conductivity, and pliability. As for dentistry, a gold crown costs around $2,500. Rusty teeth are unlikely ever to become fashionable, so I suspect this will continue to be a price worth paying.

In conclusion, it appears that gold's fundamental sources of demand are well established and that sources of newly mined supply are diminishing.

Gold's chemical properties are unchanging and provide it with its utility. Its fundamental supply and demand dynamics may also be unchanging, supporting the case for the inflation adjusted price of gold continuing to trend upwards over the long term at 1.7% per annum. At least.

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

© Chimp Investor Ltd

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