Goldilocks and the Bear Case for Gold

Last month we stated the bull case for gold, and on balance we remain bullish ourselves. However, we believe it is also important to evaluate the factors which could exert downward pressure on gold. In this note, given that we believe gold is a crowded trade at present, we examine the bear case for gold.

§ We remain bullish on gold, continuing to believe that gold can perform well in either an inflationary or deflationary environment. This supports our positive outlook for the commodity and for gold equities. Quantitative easing programmes are also supportive for gold.

§ But why has gold not moved past its 2008 highs? Gold has made significant gains and gold equities have outperformed in recent months, however it has yet to move past its 2008 highs despite the preponderance of economic news which should be bullish for the gold price. Given the current consensus support for gold, what is the bear case for gold which is preventing the price from rising even more dramatically and what are the factors that could exert downward pressure on gold?

§ The gold price is being driven primarily by investment demand. We believe that investment demand is the primary price-setting segment of the gold market at the moment. Gold's safe haven status in times of economic turmoil drove identifiable investment demand up by 182% year-on-year in the fourth quarter of 2008. However should investment flows into gold cease or turn negative, we believe that this drying up of investor demand will have repercussions for the gold price.

§ We believe the primary bear risk to gold is the 'Goldilocks' scenario. A Goldilocks economy is neither too hot nor too cold, sustaining moderate economic growth and low inflation, allowing for market-friendly monetary policy. Under the Goldilocks scenario the Fed's balance sheet will quickly adapt once economic activity begins to improve as the Fed reduces the money supply dramatically and curbs any major inflationary cycle. Furthermore, under this scenario all other central banks will do the same. Inflation would be averted, and economic growth could continue.

§ This 'Goldilocks' economy would completely remove the safe-haven investment case for gold as a form of insurance against inflation or as an alternative currency. Real yields could once again be obtained in cash and bonds and equities could begin discounting economic growth.

§ Gold is a crowded trade at present, with a prevalence of gold bulls evidenced by record levels of ETF holdings and physical buying. At over 1.4 million tonnes, ETF holdings are close to half the world's annual mine supply. We would expect gold prices to be heavily influenced by any signs that the US toxic debt plans would result in improving economic or financial conditions. A return of risk appetite or improvements in other asset classes could result in an unwinding of investment buying and put considerable downward pressure on the gold price, particularly if global economic and financial conditions begin to show meaningful signs of improvement.