Today, I’ve invited my colleague Nick Hubble, as I think he’s hit the mark on why investors hold gold as a safe haven asset.
In a major financial crisis, virtually every asset class holds some element of ‘counterparty risk’.
That’s because we live in a globalised world where banking, insurance and debt are all mingled across institutions and different geographies.
But gold is one of those rare exceptions.
I’ll leave it to Nick, to explain why this is so important in today’s market…
Regards,
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James Cooper,
Editor, Mining: Phase One and Diggers and Drillers
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Why gold prices don’t correlate with gold deficits and surpluses
They call it the law of supply and demand for a reason. Prices obey. And yet, gold seems to live in violation.
For many years, analysts in the gold market carefully crunched the numbers on demand and supply…
Supply is a combination of mining and scrap recovery.
Every year, mines create a few thousand tonnes of gold supply. Scrap recovery about half as much.
Demand is determined by dentists, jewellers, electronics and investors.
Subtract demand from supply and you get the deficit or surplus of gold each year.
According to the law of supply and demand, a deficit should raise prices. A surplus should lower them.
Trouble is, they don’t.
Gold prices don’t correlate with deficits and surpluses. ‘And if there’s no correlation, how can there be causation’, wrote Jan Nieuwenhuijs in his article on ‘The Essence of Gold Supply and Demand Dynamics’.
And he did the maths back in 2019. And pointed out the analysts must be missing something.
But why does the gold price defy an iron law of economics?
Well, for a start, our definition of supply and demand is wrong.
You don’t use gold
Gold is useless.
You can’t build London Bridge out of it — it’ll be stolen away.
You can’t eat it…at least, you won’t gain any nutritional value if you do. And the gold will still be there waiting for you after you’ve digested it. In exactly the same form and purity. Some might even call it a nugget.
Gold isn’t used up when you wear it as jewellery. It doesn’t spoil if you don’t put it in the fridge.
Most bizarre of all, most of the gold we mine ends up right back where it started — underground. We just call it a vault instead of a deposit.
Ironic terminology when you think about it…
What’s the point of gold, then? Why do we pull it out of the ground, process it, smelt it, refine it and cast it, only to put it back in the ground again?
An expensive way to achieve nothing, isn’t it?
The answer is that gold is more like a currency than a commodity. It’s a form of money that is independent of governments. Which is very useful in an era when governments are overindebted.
Purchasing purchasing power preservation
One crucial characteristic of money is that it’s liquid. You can use it quickly, easily and cheaply.
We pull low-grade gold ore out of the ground, process it into bars, and put it back into the ground for a simple reason. It becomes easier to sell quickly and cheaply when it’s in pure gold bars in a vault with a key. It becomes useful as money.
Another characteristic of money is that it retains its purchasing power. And gold has preserved its purchasing power extraordinarily well over long periods of time.
There has been plenty of volatility along the way. Governments don’t always abuse their power over the currency, so gold’s popularity waxes and wanes. But it holds true over the long run.
This is the opposite to your government money. It has low volatility in the short run. But over long periods, inflation varies wildly. And it’s a one-way trip to devaluation.
So, if you’re trying to preserve wealth, which implies the long run, then gold is useful after all.
You can’t eat gold. But you will be able to buy the same amount of food with it in 50 and 500 years’ time. At least, that’s what the historical track record suggests.
You could say that gold investors are purchasing ‘purchasing’ power preservation. But that’d be confusing.
It’s not just government money that gold is an opt-out from. It’s also the banking system and financial markets.
Gold is the only major financial asset without counterparty risk. If you own physical gold in your possession, you don’t rely on anyone else for it to retain or grow its value. No company directors, fund managers, CEOs or banks.
In fact, gold is a punt that the managerial class will muck things up as badly as politicians do. Whether it’s a tech bubble or widespread mortgage fraud or bank runs or running illiquid pension portfolios doesn’t matter. Gold gets you out.
That explains the demand side — why people buy gold. The supply side is even more out of whack with conventional economic theory.
Gold supply is all gold ever mined
We stick the overwhelming amount of gold ever mined into vaults. What is it doing there? Waiting to be sold, of course.
So the gold sitting in vaults around the world is actually part of available gold supply. It’ll be sold if the price gets high enough.
This is radically different to other commodities. You can’t sell the iron and steel holding up your house. At least, I don’t recommend it.
You can’t sell the grains you ate yesterday, let alone the pork bellies. Their supply is driven by farming.
Mining only adds a tiny amount of gold to the global stock each year. It’s not the determining factor at all.
Of course, you could get a supply shock that does move prices. As John Butler recently pointed out to me, we could discover vast amounts of Japanese war gold in Luzon. That’d move the gold price. Something which can’t happen to bitcoin, John pointed out.
Having the entire stock of a commodity ever produced available as supply is enough to make a commodity trader panic sell. It could all flood the market tomorrow.
And yet, gold’s price is rising.
What drives the gold price then?
Fear. Fear of counterparty risk. Fear of inflation. Fear of mismanagement by those you rely on for all other assets to retain their value.
Here’s how to think about the gold price: yes, gold defies the law of supply and demand. But it enforces other economic laws like inflation, debt and fraud by giving investors a barometer and escape hatch.
And, right now, it’s flashing red.
Until next time,
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Nick Hubble,
Editor, Strategic Intelligence Australia
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