Gold loses its allure as a defensive asset

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Gold bugs have had a rude shock in recent weeks, with the price of their precious metal falling below critical support levels. It begs the question: is the bull market in gold over, or is this a good time to buy at cheaper prices?

On a purely technical basis, now would seem to be an especially dangerous time to be venturing into the market – as the recent break down in price appears quite serious.

Still off highs

Note for all the ongoing bullish talk in recent years, the metal has not made a new price high since touching $US1,900/ounce in September 2011. Since then gold has tried and failed to make new highs, though with each market retreat found support at similar levels around $US1,550.Technically, this pattern of lower highs but similar lows is known as a “descending triangle” – and as we’ve seen – usually warns of a serious downside break in the market.  That came with the drop in prices below previous support levels of $US1,550. Prices have also dropped below their 200-day moving average, and the next major support is around $US1,300 – which represents a 50% retracement from gold’s advance from the lows of October 2008.

Gold prices touched a low of $1,321 last week.  After the $US1,300 level, the next support would be at around $US1200 – or a 61.8% “Fibonacci retracement” of the advance since late 2008.

Note a fall retracement to the lows of late 2008 would push prices back to around $US700 – which is close to its long-run average price in real terms in today’s dollars (deflating by the US consumer price index).Given the speed of the decline in recent weeks, the market could consolidate or even try to re-test the break of $US1550 in coming weeks/months. Should that happen, however, it might be a good time for long-term investors to consider lightening their exposure – in the view of the apparent shift in trend and more worrisome fundamentals.

The risks

Of course, with central banks in Europe, Japan and the United States still printing cash, it might be argued the long-run outlook for gold remains positive – as inflation is surely to rise.  Countering this view, however, is the inconvenient truth that inflation in developed markets has failed to rise all that much so far – due to still high unemployment and cautious spending and borrowing by both consumers and business alike.Should inflation eventually rise, moreover, one can’t discount the risk that central banks (given their independence) would raise interest rates and slow economic growth to keep prices in check – as happened in the 1980s.

Higher interest rates and weaker demand – which would likely also affect gold jewellery demand – is not a great backdrop for expecting gold prices to zoom a lot higher.

Indeed, while there has been much focus on money printing by developed economy central banks – part of the reason for gold’s decline since 2011 seems to reflect reduced consumption demand in emerging countries such as
China and India. Economic growth in both China and India has slowed in recent years, which together with already very high gold prices, has undercut jewellery demand.In a recent research paper, Amit Bhartia and Matt Seto – analysts of fund manager GMO – noted that Indian gold demand has eased since late 2011, due to its weaker economy and new measures to limit the trade deficit by clamping down on gold imports.  And after strong growth in 2010 and 2011, Chinese gold demand fell in outright terms last year. Due to ongoing strong credit growth, China’s economy also faced troubles and its slowdown is by no means over.

The GMO authors conclude “gold prices not only have extensive exposure to China and India, but their exposure to these countries is pro-cyclical by nature. Given both the cyclical and structural challenges the Chinese and Indian economies are facing, we believe the risks to gold prices today are particularly high.”

In short, gold is not necessarily the defensive asset many imagine – as demand is still critically dependant on the health of emerging economies like China and India.  And while it might provide a hedge against escalating inflation, that scenario – and gold’s effectiveness as a hedge in that eventuality – is by no means assured.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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