Gold is one of the best-performing asset classes this year, up nearly 24 percent. However we are still 30 percent lower than the highs reached in September 2011. So a lower base effect has been one of the main drivers in 2016. But investors have been asking lately what are the key drivers of gold and should they keep or get exposure? Let us recollect the evolution of gold prices over the last 40 years. In the 1970s a strong rally in the gold price sparked exploration activity resulting in the discovery of new mines and eventually more supply. By the mid-1990s, a strengthening US dollar depressed gold prices. In the gold price glory days between 2000 and 2011 when gold prices appreciated over 500%, the focus of investors was to gain maximum exposure to the rising gold price. Also the gold price embarked on its massive bull run fueled by increased EM demand, the introduction of physically backed gold ETFs and, later, the global financial crisis from 2009. This changed abruptly in 2013, when gold prices collapsed by almost 30% in a space of six months. This created large scale selling among investors. So gold has had large pricing swings which sometimes lasting for decades. So what drives gold prices today? First of all gold moves inversely with the real bond yield (so as real bond yields, which takes into account the rate of Inflation, goes up the price of gold goes down) this is because gold does not provide owners with an income. Secondly, gold moves inversely with banks and is a play on the financial/monetary system failing. As banks are seen as the gatekeepers of economic capital flow, any distress among the industry benefits gold as a safe haven investment. Thirdly, the performance of the USD also impacts gold pricing (again inversely related) as being the major pricing currency of the precious metal. One key feature since September 2011 has been the stronger US dollar. Gold has been clearly negatively impacted. Also as we expect bond yields to start to rise based on the US federal reserve's most probable interest rates increase at the end of this year and add to the fact, there is currently no obvious financial stress in the banking industry and a rising USD, it does seem that Gold may start to face near terms risks to performance. While this may be the case we are still with the belief that gold can have an important role to play in an investor's portfolio for example, gold benefits USD based investors for multiple reasons. It effectively helps manage risk in a portfolio, as it increases risk adjusted returns and reduces the expected losses incurred during extreme market events. In the long term, gold's diversification credentials increases portfolio efficiency, both in good and bad economic times. Likewise a reduction of potential losses over the long term requires fewer often expensive contingency measures to deal with the potential for extreme losses. Over the longer term, gold prices could move higher, as USD strength could start to fade as global markets start to price in the new rate cycle. However, one of the biggest positives for gold is more demand from central banks. There are $11 trillion of global foreign exchange reserves (11% in gold), but a number of central banks hold only a very small amount of gold. If those with less than 20% in gold raised these holdings to 20% of reserves, then gold demand would rise six-folds. The bottom line is that the 3 key drivers of gold price are: i) real rates ii) the US dollar; and iii) fear of financial/monetary instability. Irrespective, if investors have a strong view or not on these drivers, gold will always have a place among global portfolios for the foreseeable future. * The writer is Managing Director Head of Advisory at SEDCO Capital
