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Tuesday, May 24, 2022

Global economic termites are eating away gold price foundations

Even an arch-traditionalist like the late Sheikh Sakhbut learnt that there were alternatives to gold. Today’s investors are finding ever-fewer reasons to hold the precious metal

In the early 1960s, Sheikh Shakhbut bin Sultan al-Nahyan was on the brink of watching his dynasty become one of the richest on the planet. The ruler of the small Bedouin emirate of Abu Dhabi was just beginning to realise the extent of the vast oil wealth which lay under the deserts of his Arabian enclave.

Executives from oil companies queued up at his palace gates for an audience with the potentate, who had grown up in a period when piracy was still not unheard of in the azure waters of the Gulf. However, there was a big problem holding back Sheikh Shakhbut and the emirate from benefiting fully from the potential riches of oil. He only trusted gold.

A traditionalist, Sheikh Shakhbut was known to demand payment for oil royalties in the form of bullion, as had been common practice in the Gulf.

His love of gold was such that he is understood to have kept his treasury’s entire horde of gold coins in a wooden chest under his bed. This obviously caused a problem, as the piles of gold stacked up as ever more oil flowed from under Abu Dhabi’s deserts.

A British merchant banker, known for his diplomacy, was eventually dispatched from London to try to persuade Sheikh Shakhbut to accept paper money in the form of pounds sterling instead of gold.

To his surprise, the sheikh agreed and soon received the first cash payment of £1m for the emirate’s oil. The money was placed in the same gold chest that stored the gold and the banker flew back to London happy.

A few months later the banker is said to have received a phone call from Sheikh Shakhbut’s court summoning him back to Abu Dhabi urgently. On arrival he was told that the money had gone. Termites had burrowed into the chest and gobbled up all of the paper currency, leaving only the metal strips behind. The sheikh was understandably furious and unless the banker could produce another £1m was unlikely to ever accept currency as payment for oil again.

Thankfully, the Bank of England was willing to accept the metal strips as proof that the money had actually existed and issued another batch of currency to replace the cash that was originally eaten by the termites.

Which brings us to the current crash in gold prices , which is beginning to undermine the safe haven “currency” status that Sheikh Shakhbut and thousands of other investors since have trusted.

As the broker Macquarie pointed out this week, gold has always benefited from its “dual nature” as both a currency and a commodity. However, at the moment it is neither.

With the Federal Reserve poised to raise rates and demand for physical gold patchy at best, two of the three pillars supporting prices are crumbling. The third, which is gold’s enduring value as a safe-haven asset for investors to hold as a hedge in times of economic turmoil, is also beginning to crack.

Gold closed the week at a new five-year low of well under $ 1,100 per ounce. The precious metal has lost 16pc of its value in the past year and 43pc since it achieved a record high at the end of 2011. If this rate of decline continues then prices will almost certainly crash through the psychologically important $ 1,000 resistance level by the end of the third quarter. Macquarie, which has revised down its forecasts for gold and silver, now expects the former to be trading at around $ 1,125 per ounce in the fourth quarter, instead of its previous estimate of $ 1,310 per ounce.

Should the Fed bite the bullet and raise rates in September, a further drop below the $ 1,000 level for gold is almost guaranteed. A strong dollar and higher bond yields will crush a large chunk of the demand that remains.

And then there is the China factor. In June, the world’s largest importer of gold bought an estimated 107 tonnes, which, if correct, would be the lowest level since last September.

According to Macquarie, the People’s Bank of China (HKSE: 3988.HK – news) has added 600 tonnes of gold to its reserves over the past six years but it is unlikely to repeat this scale of stockpiling and may even be forced to sell down its stocks should the recent stock market crash prove a precursor for a deeper slowdown.

Certainly, if China’s state-controlled banks were to suffer widespread debt defaults due to leveraged speculation on the stock market, then the central bank would have no choice but to sell gold to defend its financial system.

According to Macquarie: “Gold’s dual nature as a currency and a commodity, which served it so well during the bull market years when both alternatives to the dollar and commodities were popular, is now hurting it on both counts, as investors and consumers shun it alike.”

Gold bulls see price weakness as an opportunity

Of course, there are counter-arguments to this thesis and there are those who argue that the current weakness in prices offers a good opportunity to buy. The World Gold Council argues that although China’s demand for gold has eased since 2013, its growth trend remains in place.

The council prefers to lay the blame for the current downturn in prices on a few isolated trades that have undermined confidence in a sluggish market. This is what happened at the beginning of this week when gold lost 4.7pc in a day after 4.7 tonnes was offloaded without warning on the Shanghai Gold Exchange.

“The recent price fall, in common with similar price action in the past few years, was triggered by isolated trades,” said the gold council.

“These trades are not representative of the broader supply and demand dynamics.”

The exact causes of the current downturn in prices are open for debate. But it is clear gold will continue to have to readjust even after the past five years have made it such a profitable safe haven asset. With the era of low interest rates coming to an end, the times are fast changing.

Just as in Sheikh Shakhbut’s day, the precious metal retains its sense of permanence and allure for investors. Yet the fundamental reasons to own it are being eaten away by the termite-like forces of the ever-shifting global economy.

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