x Abu Dhabi, UAETuesday 23 January 2018

The golden gobble: will emerging central banks drive gold up?

The final analysis: Outlook for the metal remains strong, but don't go overweight.

How much should we read into the recent moves by India, Sri Lanka and Mauritius to gobble up nearly 220 tonnes of the International Monetary Fund's gold? Does it signal a new era after decades of central bank decumulation? "An era can be said to end when its basic illusions are exhausted", said a perceptive playwright. The illusionary era that will inevitably end is one of excess dollar-denominated money supply sans inflationary consequence. In the decade ahead we will wrestle with the twin challenges of mopping up excess money supply while slowly but surely shifting to a multi-polar currency world.

Emerging central banks covet gold only to the degree they believe it will help dilute the US dollar's dominance. Their gold holdings are very small relative to their growing economic weight, so they seek a small shift from the dollar to gold. However, they will be careful to go slow, otherwise they risk devaluing both their gold and dollar reserves. Also, their appetite for gold will be capped by the constraint that in a crisis only hard currency reserves can reliably defend against currency speculation, which is an emerging central banker's key worry.

Yet, ever-vigilant "gold bugs" have priced in higher near-term demand, convincingly driving gold near US$1,200 (Dh4,400) last week. Gold has now outperformed both equities and commodities in each of the past one-, five- and 10-year windows. In the past century, gold has sustainably rallied only in anticipation of inflation, which makes last decade's performance remarkable, given the relative paucity of inflation.

Three factors will boost structural demand for gold while keeping supply short. First, with the profuse printing of money last year to offset dysfunctional private credit markets, inflation is likely to be a high probability for the decade ahead, although not for the next year given slack capacity. Due to the high debt of the world's two largest economies, the Japan and the US, and the high unemployment levels globally, major central banks will not risk additional deflation and will attempt to inflate their way to job creation and real growth.

Second, emerging markets will be net accumulators of gold not only at a personal consumption level, but increasingly at a sovereign level, which is a relatively new demand driver. The temporary but sharp decline in jewellery demand, which accounts for the strong majority of total gold demand, has been offset by relatively new sovereign demand from investment products like ETFs. Third, supply from gold mines is structurally declining while the marginal cost of extraction is rising due to the depletion of the easier-to-reach gold deposits.

While this troika is boldly bullish for gold long term, should we rush to buy it? Such a decision must be evaluated in the context of efficient asset allocation. Specifically, how much inflation hedging is already latent in your investment portfolio? Yes, buy some gold to hedge inflation, but tread carefully: while gold shines, it is about a third more volatile than developed equity markets, so a higher risk tolerance is prerequisite. Also, given the rapid price rise of 20 per cent in recent weeks, and as we are in a seasonally strong fourth quarter, we should prepare for a short-term tactical correction.

Finally, know that gold is only one of many ways to achieve the necessary inflation hedge, so diversify with commodities, inflation-linked bonds and select property holdings, depending on the size of your portfolio. Rehan Syed is the head of portfolio management at ABN AMRO Private Bank Middle East