By Andrew Naylor, World Gold Council regional chief executive officer, APAC and public policy
2020 was a record year for gold. A combination of economic uncertainty and a low interest rate environment saw record flows into gold ETFs.
By contrast, 2021 has been more subdued for gold. Economies are starting to recover, and this has helped bolster consumer demand in gold’s largest retail markets, especially China.
This article looks at the main drivers of gold’s performance, and some of the key issues having an impact on the market – global regulation and the push for sustainability.
Gold market outlook
In the first quarter of 2021, strengthening consumer demand mitigated the impact of ETF outflows.
This demonstrates the dual nature of gold as demand comes from both retail and institutional investment, both with different drivers.
Consumer demand, which tends to be concentrated in Asian markets, the United States and Germany, is more pro-cyclical.
When economies are doing well, consumers buy more gold or consume technology that uses gold.
Institutional investors have different drivers – when the economic situation is uncertain institutional investors may take an interest in gold as it is seen as a risk mitigator and safe-haven asset.
The first half of this year demonstrated how gold’s diverse sources of demand and supply interact. The gold price dropped by over 6 percent in the first six months, as gains during most of Q2 were offset by pullbacks since June.
Gold’s price also underperformed in most key currencies except for the Japanese yen and the Turkish lira, which weakened against the US dollar.
This was driven primarily by higher interest rates and interest rate expectations, including a more hawkish-than-expected statement by the US Fed.
Looking ahead, interest rates will likely remain a major driver of gold in the short and medium term.
In the longer term though, the potential effects of the expansionary monetary and fiscal policies we have seen worldwide could prompt a renewed interest in gold. These effects may include inflation, currency debasement, and higher risk-on asset exposure.
What makes gold a strategic asset?
Gold has unique and diverse sources of demand: as a central bank reserve asset, jewellery, as a component in technology and industrial applications, and as an investment (in both the retail and institutional markets).
This diversity of demand means it could behave differently to other assets and therefore is a potential diversifier.
But it is also coveted as a possible source of returns, for its liquidity (over $US237 billion, $320 billion, of gold was traded every day on average last year), and for its potential impact on portfolio performance.
These strategic motivations also ring true in Australia. As a major producer country (Australia was the third largest producer of gold in 2020 after China and Russia), the Australian dollar (AUD) has a different relationship to gold than the US dollar.
However, gold (in AUD) has outperformed most broad-based portfolio components over the last two decades, including Australian sovereign bonds and Australian equities.
The financial regulatory reform agenda
Whilst the strategic case for gold remains, there are regulatory headwinds that will have an impact on the gold market.
In particular, there has been much recent speculation about the impact of the forthcoming Basel III reforms, especially the Net Stable Funding Ratio and its potential impact on the bullion market.
What is clear is that under the current rules the cost to banks of holding gold on balance sheet will increase – the NSFR entails 85 per cent of required stable funding.
This will increase the funding costs of unallocated gold, an essential source of gold market liquidity.
But whilst the funding costs will increase, the unallocated market will persist. The clearing and settlement regime depends on it, and without an unallocated gold market it will be very difficult to finance (and facilitate) the upstream activities of gold producers and refiners, and the downstream users of gold such as jewellers and fabricators.
The real economy demand for gold relies on the unallocated gold market. So whilst the funding cost of unallocated gold will increase, we are unlikely to see a major distortion in favour of allocated metal due to the imposition of the NSFR.
The United Kingdom’s Prudential Regulatory Authority (PRA) has recently announced a mechanism for banks to apply for an exception in respect of their own unencumbered physical precious metal stocks and customer precious metal deposit accounts.
This will ensure the smooth functioning of the London OTC market, the world’s largest. So, whilst there are regulatory headwinds, the impact will not be as bad as initially feared.
The big issue: sustainability
Another major issue is sustainability. Investors worldwide – including here in Australia – are applying a sharper focus on issues of sustainability.
The gold mining community has undertaken a lot of good work. A recent report highlighted the actions taken by leading gold mining companies as part of global efforts to reach the UN Sustainable Development Goals.
Efforts have also been made to codify environmental, social and governance (ESG) practices. The Responsible Gold Mining Principles, published in 2019, collect these practices into an organising framework so that all stakeholders can understand the material ESG risks associated with gold mining; and understand how responsible gold mining companies are managing these risks and seeking to maximise opportunities for their host societies.
Finally, when it comes to climate change, work has been undertaken by the leading producers to better understand the industry’s greenhouse gas emissions, raise awareness of the efforts already underway to reduce these, and gold’s potential contribution to the development of low carbon technologies.
A lot of work has been done, and a lot more is in the pipeline, to ensure that gold contributes positively to the global economy, society at large, and host communities.
Continuing relevance of gold
Whilst the economic dynamics are changing, gold is still an important strategic asset. It plays a major role in household finances in many countries around the world.
It plays a strategic role in the institutional and official sector investment industry. And it is an important component in many innovative and cutting-edge technologies.
As the third largest producer of gold and a major international refining centre, the gold industry will likely continue to contribute to Australia’s economic resilience.
About the author
Andrew joined the World Gold Council in 2016 and since 2020 has led our regional office in Singapore. Originally part of the central banks and public policy team, Andrew was responsible for our Islamic finance initiative, culminating in the launch of the AAOIFI Shari’ah Standard on Gold.
Andrew started his career at international consultancy firm Cicero Group advising financial institutions on foreign investment and trade policy in Asia, and the global regulatory reform agenda. In this role, he provided economic and political commentary for global broadcasters including the BBC, Bloomberg, CNBC and China Central TV.
This story also appears in the August issue of Australian Resources & Investment.