Commodities - MARCH 8, 2016

How gold got its groove back

by Frank Holmes

The fact that gold climbed to more than $1,100 per ounce during January and has stayed there since — on the back of a rocky Chinese stock market, North Korea’s announcement that it detonated a hydrogen bomb, and rising tensions between Saudi Arabia and Iran — proves that gold still retains its status as a safe haven among investors.

U.S. gold prices finished 2015 down 10.42 percent, its third straight negative year. Until the new year, sentiment appeared poor, and many gold bulls were finding it hard to stay optimistic. But after the recent price jump, large exchange-traded gold funds saw massive inflows, confirming a shift in investors’ attitudes toward the precious metal.

It is worth remembering that about 90 percent of physical demand comes from outside the United States, mostly in emerging markets such as China and India. In many non-dollar economies, buyers are actually seeing either a steady or even rising gold price. The metal is up in economically troubled Brazil and Russia, as well as in Canada, Mexico, Peru, South Africa and many more countries.

Gold demand in China was very robust last year. A record 2,596 tons, or a whopping 80 percent of total global output for 2015, were withdrawn from the Shanghai Gold Exchange. As for the Chinese central bank, it reported adding 19 more tons in December, bringing the total to more than 1,762 tons.

Precious metals commentator Lawrie Williams points out, though, that China’s total reserve figure is widely believed to be “hugely understated,” meaning the central bank might very well have much more than it is reporting.

Despite the talk of rising interest rates in connection to gold, they are not a dominant driver of price. While nominal rates have tended to make gold less attractive because it does not pay an income, the larger driver are real interest rates. When real rates drop into negative territory, gold historically does well.

The World Gold Council writes in its 2016 outlook that gold’s role as a diversifier remains “particularly relevant.” The report says: “Research shows that, over the long run, holding 2 percent to 10 percent of an investor’s portfolio in gold can improve portfolio performance.”

The reason for this is that gold has tended to have a low correlation to many other asset classes, making it a valuable diversifier. During economic contractions, for example, gold’s correlation to stocks actually decreased, according to data between 1987 and 2015.

For the past three years, gold has disappointed many because other investments have seen huge gains. But with global markets hitting turbulence, gold is looking more attractive as insurance against currency wars.

Aside from real interest rates, gold prices are being challenged by weak manufacturing data around the world. China’s purchasing managers’ index fell to 48.2 in December, down 0.4 points from the November reading. The Asian giant’s manufacturing sector spent a majority of 2015 in contraction mode, managing to rise above the key 50.0 level only once last year, in February.

Although fears of a Chinese slowdown are real, they’re largely overdone. Consulting firm McKinsey & Company’s Gordon Orr calls these fears a distraction, writing that “the country’s economy is still massive — as are its potential opportunities.”


Frank Holmes is CEO and CIO of U.S. Global Investors.

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