Is Gold Dying?

Depending on how you look at it, given what’s happened to precious metal prices in the past five weeks, as a gold market commentator, I either picked the very best or very worst of times to take several weeks away from work.

As the chart below shows, gold has been falling in an almost uninterrupted fashion since late April of this year, with a surge in the USD seeing the yellow metal decline by almost USD $200oz at one point, though it has (for now) stabilised in the USD$1,180oz-USD$1,200oz range.

Source: World Gold Council

The decline in precious metal prices, which has coincided with the euphoria at what is being widely reported as the longest running bull market in Wall Street history has seen speculators go record net-short gold futures, whilst ETFs have shed almost 100 tonnes of gold, evidence of just how bad sentiment is toward the yellow metal.

Having been back at work for all of three days – I’ve had a chance to read plenty of analysis of what has happened in gold markets, including updates from the World Gold Council, ANZ Bank, UBS and a handful of analysts in the space I respect.

But arguably the most interesting note I saw that discussed gold came from the blog of Ben Carlson, a portfolio manager for Ritholtz Wealth Management who tweets under the handle of @awealthofcs

For those unfamiliar with Ritholtz Wealth Management, they are one of the fastest growing wealth advisories in the United States, and I would say easily the most digitally savvy, as their staff including @ReformedBroker and @michaelbatnick are prolific producers of quality finance content, which they manage to deliver with humor.

Anyhow – in an August 12th 2018 blog post titled “8 Questions I’ve Been Pondering”, Carlson posed the following question, and his brief thoughts (in italics):

What if gold dies out with the boomer generation? The market value of gold around the globe is estimated at more than $7 trillion. I understand some of the reasoning behind the fact that people still put a lot of faith in the yellow rock — it’s survived as a store of value for thousands of years and can act as an uncorrelated asset. But isn’t it possible faith in gold could potentially die out with the older generations? Doesn’t technology present a massive risk to gold’s standing as a store of value going forward? I don’t know the answers to these questions and I think it’s going too far in the other direction to assume bitcoin or something similar will completely replace gold. But I don’t think you can rule out the possibility that gold’s value to society could be called into question in the decades ahead. And cue the hate mail from the gold bugs…moving on.

What if Ben is Right?

I’ve been a precious metal investor for approximately 15 years. Ironically, given Ben’s comments about technology and its threat to gold, it was the NASDAQ crash that led me to gold. Today, precious metals (gold, silver, mining stocks and managed funds with core precious metal holdings) still make up the largest asset class exposure in my portfolio, though I also own shares, bonds and have a fair weighting to cash.

Over the decade and a half I’ve been investing in precious metals, we’ve seen the market for gold rise, driven predominantly by the voracious appetite of consumers in Eastern markets, who typically prefer to own their gold in jewellery form, and where there is a high correlation between rising real incomes and rising gold demand.

We’ve also seen the re-awakening of central bank demand, who turned net buyers of the yellow metal almost a decade ago, which more or less coincided with the onset of the GFC. Western demand has also grown since the turn of the century, though today, it faces a number of serious headwinds; with turnover for physical bars and coins now back to levels seen prior to the onset of the Global Financial Crisis (GFC), whilst bullish speculators have for now abandoned the space, as we covered above.

Given my role, and my own investment portfolio, I obviously don’t think gold is going to die out, but Ben’s comment got me thinking not so much about the challenge to gold itself, but the challenge to the traditional physical bullion market, and the selling of bars and coins.

From where I sit, apart from the obvious challenge a bear market in the metal would pose for gold sales, I see four main threats to the growth of the industry in decade ahead, which are:

• Emergence of cryptocurrencies

• Competition from ‘gold like’ products

• Cost

• Capital "Controls"

We will go through each of these in turn.

Cryptocurrencies

The newest threat to physical gold demand is the emergence of cryptocurrencies as an asset class. Marketed as ‘digital gold’, and offering life changing returns, the market has exploded, especially amongst millennial speculators looking to make a quick buck.

Some argue that the cryptocurrency market is good for gold, as the emergence of this new form of “money”, especially Bitcoin, is helping educate the next generation of investors about the “evils” of fiat currency, and the importance of long-term stores of wealth, of which gold so far has no peer.

Whilst this is undoubtedly true for some participants, we are not at all convinced its representative of the market as a whole.

Indeed, having spent the last few years working in precious metals, I have had the opportunity to get to know many of the early adopters in the cryptocurrency space, not just those who piled in during Q4 of 2017 and who are now sitting on losses of more than 50%.

Almost to a person, they are no longer interested in gold, or precious metals at all, whilst one gentleman, who runs a very large cryptocurrency exchange claimed his clients “hated gold”, because it was too boring.

This sentiment was reinforced in another conversation I had with another crypto enthusiast who has a very solid understanding of monetary history. When I asked him if he would “turn to gold if Bitcoin failed”, he was unequivocal. No was the answer, because another, “better crypto” will come along.

I was initially surprised by these conversation and statements, but on reflection, I shouldn’t have been, After all, this is a market dominated by mostly young, mostly male participants. They don’t want long-term stores of wealth. They don’t want stability. They want risk, 100 baggers and #whenlambo. That’s the whole point for them!

In time, I am confident that many of these cryptocurrency enthusiasts will end up embracing precious metals, perhaps through a “stable coin” (a cryptocurrency tied to actual physical gold rather that some of the harebrained “gold backed” cryptocurrencies we’ve seen emerge in the last year or so) but even then, it won’t do much good for most physical bullion dealers, for two reasons.

The first is that the only reason a millennial will abandon cryptocurrencies is if the prices crash, far worse than they already have. If that happens, they may turn to gold and silver, but by definition, they’re unlikely to have much left to invest, even if a few made out like bandits in the great crypto bull market.

Secondly, even if they turn to gold, they’re far more likely to buy it via a CFD or a futures contract, where they can goose up their exposure with a bit of leverage, and they’ll also buy via an app, rather than wanting to sift through hundreds of coins and tablets, and worrying about where they’re meant to store them.

Competition from Gold-Like Products

Note – in this section, we’ve deliberately excluded gold mining equities from this analysis as those are a vastly different, riskier, and potentially more profitable asset class than gold itself. This was a subject we dedicated an entire chapter too in our 2016 book, “Gold for Australian Investors.”

Arguably the biggest challenge to direct physical gold demand has come from the product innovation we’ve seen in the financial space in the past ten to fifteen years.

In the “old days”, if you wanted physical gold exposure, you had to buy gold bars and coins, or a depository product from a bullion dealer.

That is no longer the case today.

The “threat” is best seen through the emergence of exchange-traded funds (ETFs), which allow investors to get a proxy physical gold exposure through an investment via their stockbroker.
In truth, these products are, in many cases, more expensive than trading and storing physical gold (especially for larger investors with a long-term investment timeframe), have less trading flexibility, and are less secure than owning real physical gold.

But perception is the reality as the saying goes, and to most people, buying a gold ETF is seen as being far easier than choosing between 100 different bullion products from a bullion dealer, and having to worry about where to store said metal.

It’s also easier because most investors already have a brokerage account, so buying an ETF means they don’t have to worry about a separate account with a bullion dealer just for their gold purchase.

To help visualise how big a threat this product innovation has been, the growth in gold holdings held inside ETFs since 2003 can be seen in the chart below.
 

Source: World Gold Council, ABC Bullion

At a minimum, that is nearly USD $100bn of gold value, not to mention ongoing storage fees, that bullion dealers have missed out on selling.

In this sense, the evolution of “stock-markets” to investment supermarkets with ETFs, actively managed funds, LICS etc. over the past 15 plus years has been arguably the biggest threat to growing the market for gold bars and coins.

ETFs aren’t the only threat either, with CFDs and futures now far easier to access for all investors. Anyone with a popular trading app like IG markets can go long or short gold in a matter of seconds, without the need to open a stand alone account with a bullion dealer.

Technology has combined with this product innovation like a pincer movement attacking demand for physical gold bars and coins.

It’s barely 10 years since the iPhone hit the market, yet today; nearly every investment provider has an app. On my iPhone alone I have apps for my pension fund provider, my bank, my insurance provider and my stockbroker.

In the precious metal space, Bullion Vault, Gold Broker and Gold Money – all traditional bullion dealers, have apps, but it’s not just them. Companies like Glint, GoldEx, Send Gold, and InfiniGold, all offer bullion products.

In most cases, these are essentially depository solutions, some of which come with not insignificant bells and whistles like payment cards, and remittance capabilities, with many also offering physical redemption for the very small percentage of their target market that may require that offering.

This of course isn’t even accounting for the financial services providers (like online brokers and CFD traders), who offer gold as well as a constantly expanding universe of asset classes and products for the investor to choose from.

The point being, investors today have a universe of choice for getting gold exposure in their portfolio, without having to buy bars and coins or a depository product from a traditional bullion dealer, and this is reflected in the waning interest for said products, especially minted tablets and coins amongst younger western investors.

For many people under 35, if they can’t buy it via an app in under a minute, or invest via a simple to use website, then they aren’t going to buy it at all. Unless one believes they’ll give up the convenience of their smart-phones, this is unlikely to change.

Cost

According to an article in Business Insider, which quoted a Columbia Business School study from 2002, the cost of trading shares has plummeted in the last four decades.

Back in the 1970s, one way trading costs for shares were close to 1.20%, meaning a round trip to invest in shares was likely to set back an investors somewhere in the vicinity of 2.50%, and likely more if the amount being invested was small.

The evolution of trading costs can be seen in the chart below!

Source: Business Insider, Columbia Business School

Brokers no longer have the same pricing power they once did, and by the early 2000s, the one way trading costs had dropped to barely 0.20%. It would be lower still today, as technology has only helped streamline trade execution and settlement etc.

Given gold is a physical product that needs to be found, shipped, refined into marketable form and eventually traded with investors, it hasn’t been able to benefit from the quantum leap in efficiency and cost reduction that trading in financial assets have benefited from.

As such, whilst it may have been similarly expensive to buy stocks as it was to buy a gold coin 40 plus years ago, that is no longer the case today. Combine this with the product innovation that we’ve seen in the financial sector (i.e. gold ETFs), and the threat to physical bar and coin demand is clear to see.

Capital “Controls”

A final factor that is limiting the growth in demand for physical bullion is the increased regulatory control that governs how capital is invested.

In Europe, UCITS legislation makes it harder if not impossible for some investment structures to hold physical bullion, whilst even futures contracts are complicated, as they have an option for physical delivery.

Closer to home, the Australian superannuation industry, which largely forces Australians to invest within ‘ring fenced’ pools for their retirement, is a perfect illustration of this challenge.

Back in the 1980s, workers were not required to put money into superannuation at all, and when the compulsory system was introduced in the early 1990s, it was closer to 3% of employees’ total remuneration.

As such, up until 25 years ago, any Australian that saved money was free to invest in a range of assets, including physical gold bars, coins and tablets.

Today, superannuation takes over 9.5% of every working Australian’s salary, with the overall system over $2.5 trillion in size, and growing every day. It is by far the largest, and fastest growing financial asset for the vast majority of Australians.

In theory, this makes the superannuation sector an attractive ‘target market’ for gold investment, but in practice it's a major barrier.

The reason for this is that the money in superannuation is ‘ring fenced’ as mentioned above, and the investments need to be approved by not only the trustee or responsible entity of the superannuation products, but the Australian Prudential Regulation Authority (APRA), and the Australian Securities and Investment Commission (ASIC), who regulate the overall superannuation system, and/or many of the financial products sold within it.

Now in theory there is nothing stopping every superannuation fund offering gold, but, given the operational hurdles (some real, some perceived), most funds will not do so.

At best, they will offer ‘gold’ exposure via an ETF product, as the ETF, which trades like a share, already operates within the ecosystem that superannuation and financial services professionals are familiar with.

If superannuation funds wanted to offer real physical gold they’d need to worry about purity, pricing, settlement, storage, insurance and audit. The gold industry has some work ahead of it if it wants to “fix” this, and gain greater market share!

For now, gold bullion dealers are almost totally shut out of the superannuation industry, a not insignificant hurdle giving the savings rate in Australia is barely above 2%, and this INCLUDES the compulsory superannuation rate of 9.5%.

Its all well and good educating people about “why gold” to help them open their wallets, but if their wallets are largely empty then there is only so much gold you’ll ever be to able to sell and trade with them.

Conclusion!

Whilst this article might suggest otherwise, we are hugely optimistic regarding the outlook for gold demand in Western markets in the coming years.

With equity markets close to all time highs in many developed markets, political dysfunction growing by the day, bonds looking like their 35 year bull run might finally be over, real rates close to zero and a host of unresolved economic challenges to deal with 10 years on from the GFC, there are multiple tailwinds for the yellow metal.

A highly liquid, zero credit risk monetary instrument of infinite duration, with a history of outperformance in ‘risk off’ and higher inflation environments shouldn’t have any trouble finding buyers in the coming years, whilst prices will obviously continue to be supported by higher levels of demand in Eastern markets.

The key question to answer is “how” this exposure is achieved, as getting that right will be the key determinant of who in the bullion industry wins this market share.

Until next time.

Jordan Eliseo
Chief Economist
ABC Bullion

Disclaimer
This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.