Broadly speaking, there are two ways of thinking about the prices of financial assets. First, assets can have an intrinsic value, which is evaluated on the basis of discounted future cash flows. Some critique this model of financial valuation as too Platonic in concept, as it assumes the existence of some unobservable reality that investors must impute from observable, particular data (revenue, earnings, etc). The second conception is that, rather than having some inherent “value”, an asset’s price is nothing more than the ex-post, realized prices that buyers and sellers have decided upon in the course of their negotiations.
Gold is not a financial asset because it bears no future rate of return, so it is difficult to conceptualize an understanding of its “intrinsic” value. To that end, it seems that an analysis of gold has to start from the basis of supply, demand, and realized prices. If we assume, for all intents and purposes, that the world’s supply of gold is largely fixed (or growing at a predictable enough pace), then our primary lever of interest is demand for gold. In other words, gold’s price is primarily a function of investors’ affinity for it. Broadly speaking there are the following concepts for the uses of gold:
- As a currency or currency substitute. In other words, as a store of value, medium of exchange, or unit of account.
- As an inflation hedge. Because the modern world no longer uses gold as a medium of exchange, its primary uses are as a store of value and unit of account. For our purposes, the way that these manifest is that historically, investors have purchased gold and other real assets to protect their wealth against inflation.
- For its aesthetic value. Gold is valuable because it is used in jewelry, as a status symbol, and is considered aesthetically desirable.
Each of these conceptions will be more or less relevant in different regimes. Presently, it seems that the narrative about gold’s decline primarily hinges on the conceptions of gold in relation to the dollar. That is, it is believed that gold’s decline has been driven by investor flows into the dollar. This is because confidence in the value of the dollar reduces the utility of gold as a currency (store of value) and as a hedge against inflation.
If we make the simplifying assumption that this is indeed the right interpretation of current events, then taking a view on the direction of gold is tantamount to taking a view on the direction of the dollar. As such, determining whether or not these dollar drivers will continue will also illustrate the short-term direction of gold. Recent drivers of dollar strength, include:
- Strong growth in the United States due to fiscal stimulus and mid-to-late business cycle dynamics.
- Contained inflation in the United States, which makes financial assets relatively attractive.
- Relatively attractive bond yields and the continued outperformance of US stocks, which attracts foreign investors to buying US assets.
- Emerging market weakness, such as in Turkey as of late and spreading to other EMs, which drives foreign investors out of EM assets and into US assets.
- Trade war developments, that seem to be suggesting to investors that the United States is winning the trade war against China and against Europe.
A detailed analysis of the directions of each of these drivers is beyond the scope of this essay, so I will simply delineate a few broad thoughts on each.
- U.S. Growth. Late cycle dynamics are particularly acute. Growth has been robust and the Federal Reserve is in the early to mid stages of the interest rate cycle. There has been some concern of growth slowing down faster than discounted in the medium-term future as the following factors converge: (1) as the Fed begins tightening above the neutral rate, each marginal hike will bite disproportionally, (2) thinning labor market slack causes wages to rise, raising employment costs, and (3) the “animal spirits” of fiscal stimulus pass through. Slowing growth may, all else equal, be bearish for the dollar (so, helpful for gold), but alone may not be enough to be a bullish pressure for gold.
- Inflation. Labor market slack and capacity utilization are at cyclical highs, suggesting impending inflation as both wages rise and producers struggle to meet demand. As a result, if inflation comes in higher than expected, then we should expect gold prices to increase as the dollar becomes less attractive. However, it’s hard to imagine an inflation overshoot, because (1) as the Fed continues to hike as planned, (2) the benefits of fiscal policy continues to roll off, and (3) the secular forces of automation and globalization continue to keep prices down, it is unlikely that inflation will surprise us. This is to say that unless there is another global crisis (that would spook investors to safe havens) or inflation overshoots dramatically (sending investors to inflation hedges), then we remain in a pleasant goldilocks zone for inflation.
- Bond yields. Barring any unforeseen negative economic developments, as the Fed continues to raise rates, bond yields would follow suit, rendering yield differentials between the US and the rest of the world favorable to the dollar.
- Emerging markets. Relative to the US, EM stocks are are cheaper than they have been in over a decade. As their currencies continue to decline, their exports also become relatively attractive, which may set the stage for a recovery. However, there is still concern about the overhang of dollar-denominated debt that has, as of late, become more expensive to repay as a result of the strong dollar.
- Trade war developments. It’s anyone’s guess here. The emerging narrative is that the Trump administration has the upper hand, because the US imports more from China and Europe than vice-versa, so the US has more leverage in imposing tariffs. Still, reciprocal tariffs is a game of chicken that depends on the capacity of each country’s consumers to withstand economic pain. In this view, it seems relatively odd to me that investors would bet that an authoritarian country would have any trouble taking the trade war to its logical extreme. A material global trade war would hit growth negatively (as a result of less worldwide commerce) and boost inflation (because of higher import prices). As such, an acceleration of protectionist tendencies would be positive for gold.
In short, it seems unlikely for gold to be making a comeback any time soon. The drivers of the strong dollar are likely to continue for the short and medium term futures, and inflation continues to be relatively benign. However, these dynamics are subject to further developments of the trade war, which has the potential to tilt growth, inflation, and dollar strength towards extremes.
We are monitoring these developments closely.
