What Goldbugs Have Been Waiting For: Goldman’s New Primer On Gold

The good news is that Goldman believes “precious metals remain a relevant asset class in modern portfolios, despite their lack of yield” and disagrees with Ben Bernanke and the naysayers “They are neither a historic accident or a relic. Indeed, by looking at each of the physical properties of an ideal long-term store of value…we can clearly see why precious metals were initially adopted and why they remain relevant today.”

It was sounding really good – and there was 91 pages to go - although when it came to the drivers of precious metal prices, Goldman did not exactly re-invent the wheel “We see two key drivers of the precious metals markets: Fear and Wealth”

That said, there was a new take on what, in Goldman's eyes constitutes fear as “in our new framework we see a closer link to growth expectations. However, we ?nd that many risk factors are relevant, depending on the sub-component of gold demand: real interest rates, debasement risks, sovereign balance sheet risks, geopolitical risks and other market tail-risks. Stated more simply, we are talking about the drivers of “risk-on”/”risk-off” behavior in markets.”

On the wealth angle, the good news for gold was that “as economies grow, they tend to go through a rapid gold accumulation phase at around per capita GDP of $20,000-$30,000, following a ‘hump-shaped’ relationship between per capita income and gold demand. As more EM economies (including China) are set to grow to these income levels over the next few decades.” 

As in-depth students of gold market research, our mood was lifted by some genuinely original research. Goldman found that the ratio between gold purchases and household savings (global we assume) has been broadly stable at around 1.7% for almost 40 years. Who knew that.

Goldman approximates the gold supply available for households to purchase as new mine supply plus net central bank sales. It goes on to use some simple maths “we can view the equilibrium 1 .7% share of savings allocated to gold (?*) through the following relationship, where the equilibrium real gold price is p*, the amount of household savings is Y , and the supply of gold available to households (de?ned as mine supply plus central bank net sales) is S.”

Solving the equation for the real price of gold suggests that gold is positively correlated with savings and negatively correlated with the value of mine supply and net central bank selling. Yet again, it’s not a surprise, but we were surprised by the closeness of the fit with the real price of gold since 1980 (left hand chart).

Goldman’s analysts tweak the model to improve the fit from fear variables, principally “risk-off” periods when there are portfolio reallocations from equities to gold “We see large and persistent deviations from the long-run equilibrium allocation to gold, driven by ‘risk-on’/’risk-off’ episodes. While the forces driving risk sentiment can shift over time, they are nearly always highly cyclical in nature. Growth expectations and the business cycle are therefore key variables, being negatively correlated to gold demand.”

We are pleased – in the current environment of central bank bubbles – that the establishment’s favourite investment bank emphasised gold’s role as a hedge to systemic tail risk, which is precisely what got most of us interested in gold more than a decade ago. To wit “Gold tends to preserve its real purchasing power over the very long run (albeit with substantial short-term deviations). Since Roman times, the real value of gold has remained more or less unchanged in the face of wars and political, social and technological shocks. Many investors therefore see gold as a way to hedge against structural tail risks, which could potentially erase the real value of all other ?nancial assets…Throughout history, governments have run de?cits and built large levels of debt. Having accumulated a large stock of debt, governments must either pursue austerity, ?nd a way to boost growth, or engineer in?ation (‘print money’) to erode the real value of their debt. Historically, governments often chose money expansion over austerity. Gold has traditionally been in competition with government paper currencies. When there is loss of credibility in the central bank/government’s ability to meet their liability of maintaining the real purchasing power of their currency, gold demand tends to go up. Normally, this happens when the government does a large monetary expansion, which the public fears could lead to currency debasement.”

The report goes on to compare gold and cryptos, asking if cryptocurrencies are the “new gold” and concluding “We think not, gold wins out over cryptocurrencies in a majority of the key characteristics of money.” Briefly, Goldman argues that gold is not subject to competition from alternatives (ignoring silver and cryptos, of course), holding its purchasing power (although cryptos are untested) and much lower daily volatility. It finds that cryptos (on the basis of Bitcoin) are vulnerable to hacking, regulatory risk, network and infrastructure risk, while being superior in terms of portability and divisibility.

The Goldman report touches on one critical feature of the gold market, but only barely, noting that “Investors have become more conscious of the physical vs. futures market distinction in the post-2008 crisis period. As such, the fear drivers have likely tilted demand more in favor of physical gold (or physically-backed ETFs) as a hedge against black-swan events vs. using futures.”

We apologise if we are getting a bit “picky” (not for “serious Goldbugs” perhaps), but Goldman doesn’t address the fact that the global gold market, including the LBMA (over 95% of the trading in unallocated “paper gold”), is a fractional reserve system, in which the ratio of paper to physical was estimated by the Reserve Bank of India at 92:1.

We would also have liked to see the discussion of issues such as

  1. Repeating daily trading patterns which seem to be driven by computer algorithms.
  2. The near-lock step movement of the gold price and the Yen since the Fed and the BoJ expanded QE in late-2012.
  3. Frequent intra-day waterfall declines in the gold price where large volumes of futures contracts are “dumped”, without any attempt to maximise the selling price.
  4. The role of the Bank for International Settlements in the gold market and opaque central bank lending policies of physical metal.
  5. The volume of LGD bars in London vaults (excluding official holdings and known physically-backed ETFs) which is the “float” backing the massive LBMA trade.

These omissions tainted a generally positive view of a report in which Goldman turned surprisingly bullish on gold.