In financial circles, gold is colloquially and understatedly referred to as the ‘yellow metal’. But gold is much more than simply a commodity; it is the epitome of the term ‘precious metal’. Since first being discovered during the Neolithic period some 12,000 years ago, only 190,000 tonnes of gold have been mined globally.
Given its intrinsic qualities (durable, radiant, malleable and scarce), gold is one of the oldest means of exchange. Throughout history, gold reserves have been used to back currencies in both coin and paper form and, even though the ‘gold standard’ has been universally abandoned, governments maintain substantial gold reserves. Consequently, the actions of central banks continue to influence the price of gold and expectations in relation to it.
Recently, statements by Italian Deputy Prime Minister Matteo Salvini (also chairman of the Lega Nord and one of the country’s more controversial politicians) caused considerable excitement in the gold market. Salvini called on the Italian central bank to sell its gold reserves to finance its fiscal spending plans. Banca d'Italia's gold holdings (around 2,400 tonnes) are the third largest in the world, after the US Federal Reserve (Fed) and the German Bundesbank. As such, we believe wholesale disposal of this volume of bullion would certainly exert a major influence on the gold price.
However, the current cash equivalent (of around EUR 93 billion) constitutes only about 4% of Italy's national debt. Clearly, Italy's debt problem would not be solved by gold sales from the Banca d'Italia. On the contrary, such a measure could cause the country even greater problems in our view. Article 30 of the European Union Treaty unequivocally demands the independence of national central banks and forbids any form of state financing. Salvini has repeatedly demonstrated in recent months that Italy's withdrawal from the EU is not an option for him. His comments about possible gold sales by the Banca d'Italia can therefore be safely ignored by market participants in our view.
In fact, central banks around the world proved substantial net purchasers of gold during the calendar year of 2018, increasing their reserves by around 650 tonnes (a 74% increase on 2017), making them responsible for around 15% of global demand. This is the second-highest amount ever purchased in a single calendar year, only eclipsed in 1967 when the US dollar was still pegged to bullion. It is now estimated that central banks collectively hold nearly 34,000 tonnes of gold reserves and this figure appears set to increase further in light of elevated geopolitical tensions (gold often proves the ultimate safe-haven) and more resilient emerging market currencies (requiring less central banking support).
Of course, the concept that central banks were very active purchasers of gold during 2018 begs the question as to why the gold price actually receded slightly over the calendar year. The answer to this not only clarifies this apparent anomaly but also frames the outlook. The monetary policy pursued by the world’s major central banks is typically even more important for the performance of gold than the management of gold reserves.
Furthermore, there is a particularly special relationship between gold and the US dollar, making the policy stance of the Fed especially pertinent, since gold (and other commodities) are priced in US dollars. When the value of the US dollar increases relative to other global currencies, gold becomes more expensive (in non-USD terms) and this naturally limits demand. Similarly, it is important to bear in mind that gold is a zero-yielding ‘currency’, which means there is an opportunity cost associated with holding bullion in a rising rate environment. In 2018, the Fed raised interest rates four times and tightened monetary policy further by reducing the size of its balance sheet further. These decisions were viewed as an attempt to front-run the prospect of rising inflation, meaning that real interest rates would inevitably rise in the short term.
Conversely, the Fed and most other central banks have now moderated their stance on ‘policy normalisation’ in recognition that the global economy is slowing. Therefore, the danger that global monetary policy will be pre-emptively used to combat rising inflation seems to have been averted for the time being. Revised expectations in respect of real interest rates and the path of the US dollar have triggered a rally in the gold price this year, which could be further propelled by demand from both central banks and other investors in search of safe havens. In this context, we believe it is worth bearing in mind that gold (and commodities in general) are real assets that can offer an excellent source of diversification and downside insulation for traditional investment portfolios.