Buried krugerrands or outperforming emerging markets?
Approaching 2014’s half-way mark most major asset classes have returned between 3% and 6% over the year to date. There are two outliers: Japan, which has lagged other markets following 2013’s gains, and precious metals, which have outperformed. So far this year gold is up 9.4%.
There are several possible explanations for the rise of the shiny stuff. Paid-up members of the buried Krugerrand society may link gold’s rise to Washington’s urge to claim jurisdiction over each and every US dollar transaction. Geopolitical tensions, rising body counts in Ukraine, Syria and Iraq, and the gradual withdrawal of the US from the international scene should also increase marginal demand for the ‘barbarous relic’. Investors may also feel that with inflation picking up in the US, and the US Federal Reserve happy to stay far behind the curve, buying precious metals as an ‘inflation hedge’ makes good sense.
The point here is not to disparage these arguments. Nevertheless, we have long maintained that gold is primarily a play on the rising disposable income of emerging market consumers. While most ‘gold bugs’ spend their days dissecting the Fed’s actions, the reality is that roughly a third of global physical demand comes from India, a little over a quarter from China and some 15% from the Middle East. In other words, ultimately it is these three main types of buyer - Indian, Chinese and Arab - that influence the world gold price, not the Western investors who populate the comment sections of financial websites.
- The Arab buyer: Moving higher, elevated oil prices usually equate to more gold purchases in the Middle East - and that’s before factoring in the region’s escalating sectarian strife, which should keep gold well bid.
- The Indian buyer: Indian consumers have not been the force they were since Delhi imposed restrictions on gold imports last summer. But with smuggling booming, it is likely the new government will modify India’s import rules (unless oil prices shoot up and officials start worrying about a deteriorating current account deficit). Still, with the equity market rallying, bank loans expanding, and India’s vibe positive once again, this year’s wedding season should be especially festive, with plenty of demand for jewelry.
- The Chinese buyer: This is the big unknown. Tighter credit and Beijing’s anti-corruption campaign have hurt gold demand. So has the gradual loosening of China’s capital controls - with more investment options, Chinese investors see less need to diversify into gold. On the other hand, Beijing is starting to loosen policy again. Moreover, now that Xi Jinping has successfully consolidated his power like no leader since Deng Xiao Ping, the corruption crackdown should wind down.
The distinction between different types of buyers is important. If gold prices are rising because people are losing faith in the US dollar, or because of fears of a wider Middle Eastern war, or because of a perception that the Fed is poorly run, then the outperformance of precious metals this year is an ominous sign.
But if gold prices are rising because consumers in the Middle East, India, China are feeling richer and buying more jewelry, the signal is far more encouraging. With emerging market equities now rallying again, we are inclined to the optimistic view.
But, should emerging markets underperform, and should gold continue to head the performance tables, then the logical conclusion will be that we are heading for a more uncertain and dangerous world. Fortunately, we are not there today - which is why we see the rise in gold as a confirmation that emerging economies are on the mend and remain bullish on emerging market assets.