The gold price has fallen more than 15 per cent from its latest peak as the conflict in the Middle East has roiled markets, but the pivotal role played by emerging market central banks’ demand for the haven asset could see prices surge in the coming years.
While gold exchange traded funds have suffered more than $10bn of outflows since the Iran war kicked off, central banks have bought more bullion in the early months of this year. EM central banks are the ones that have been buying gold over the past few decades – and if they can help gold continue to take more share of bank reserve assets at the expense of US dollar amid the fracturing of globalisation and American hegemony it could provide a major boost to the yellow metal.
That’s the view of Deutsche Bank strategists Mallika Sachdeva and Michael Hsueh, who put out a very interesting note last week which argues that gold could hit $8,000 per troy ounce in the next five years (from around $4,700 at the time of writing) as the world moves on from the model where EM central banks’ buying of USD helped make it the global reserve currency and gold was thought of as (in Keynes’ phrase) a “barbarous relic”.
Their thesis is that Francis Fukuyama’s famous 1989 proclamation of “the end of history” has proven an illusion and investors now have to consider “the return of history”, a state of affairs which has significant implications for gold demand in EMs and the metal price. Major geopolitical ideological struggles are back, America is pursuing protectionism, de-globalisation is accelerating, and the US banking system has been “weaponised” in recent years (Russian assets were frozen after the invasion of Ukraine). This makes gold more attractive than the dollar for key EM central bank players.
Some historical context is helpful here. Deutsche Bank’s model is based on EM central banks helping get global bank gold reserves back to around 40 per cent, the low-end of the 40-70 per cent share of reserves before the 1990s.
Central banks have built up gold reserves at the expense of the dollar in recent years on geopolitical ructions. The greenback’s share of reserves has fallen from around 60 per cent in the early 2000s to 40 per cent, while gold holdings have tripled to 30 per cent.
EM central banks own only half the level of gold reserves as developed ones, which gives them major space to grow. EM gold holdings may be led by China, Russia, India and Turkey, but nations from Czechia to the UAE have been boosting gold purchases. Some players are taking an innovative approach to increasing gold holdings – South Korea’s central bank is reportedly planning to buy gold ETFs.
As for gold’s role in what the strategists describe as “anchoring a monetary order that builds independence from the dollar”, there are growing signs of movement. The Brics nations (a group of ten countries including Brazil, Russia, India, China and South Africa) are looking into the idea of a common currency which would be partially pegged to gold, according to the Official Monetary and Financial Institutions Forum.
Given the evidence, the strategists’ thesis has merits.
As for what this means for investors, we agree with analysts at quantitative research house Variant Perception that gold and gold miners “should remain a core allocation in multi-asset portfolios”. Financial repression, a topic we looked at last month at Alpha, increases golds’ attractions.
Our Alpha asset allocation models have a strategic upper limit of 5 per cent in gold and they maintained holdings at the maximum level in May. For ideas on ways to play the gold market, read Investors’ Chronicle’s commodities specialist Alex Hamer’s latest sector analysis which discusses London-listed names such as Endeavour Mining (EDV) and Greatland Resources (GGP).
Yet Variant Perception was also right to highlight that the second half of this year could see weaker liquidity in emerging markets because of higher energy prices and inflation. That could mean a further softening of gold demand in the short term.
There are also pressing political and economic factors that could see gold holdings utilised. Poland’s central bank has reportedly been considering selling gold to fund defence spending. In the near term, expect volatility.
Yet, as James Norrington has pointed out at Alpha, the Iran war will ultimately accelerate concerns about dollar debasement. The gold price’s recent decline, impacted by liquidity concerns in the market as hedge funds and institutional investors sold the metal to cover losses in other assets, shouldn’t be considered a sign of inherent weakness for the longer-term outlook.
While the shine has somewhat come off gold in recent months, investors have still done very well out of it over the past two years. There could be much more to come.