Factors Affecting Gold Prices, Part 1

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While stock prices, exchange rates and virtually everything else in the global financial markets are notoriously hard to predict, when asked about one asset whose price is particularly impossible to forecast, most financial professionals would probably say gold. Unlike corporate revenues and profits for stocks, or a country’s GDP, inflation and trade balance for currencies, the fundamentals which drive gold prices are more complex and often harder to understand and measure.

Demand
Gold has a very special position in the financial universe and doesn’t really fit into any of the major asset classes. Although it is technically a commodity, it also shares some characteristics with currencies (after all, it was a currency for big part of human history).
One characteristic of gold is that there are different types of demand:

– Industrial demand (e.g. for manufacturing of electronics or medical devices). This is similar to industrial demand for other commodities, but in case of gold it accounts for only a small fraction of total demand (typically 10-15%, but the share can fluctuate a lot).

– Speculative or investment demand – buying gold solely to profit from increase in its price, as a way to enhance risk-adjusted performance of a portfolio or as a hedge against inflation. While some speculative demand exists for other commodities too, its size compared to industrial demand is much greater in case of gold. It is not just individual investors, traders and fund managers; in fact, a substantial portion of investment demand for gold comes from central banks, which keep big part of their reserves in gold.

– Jewellery demand – this can be considered something in between the first two types (while it is related to macroeconomic climate like industrial demand, many people also buy jewellery as alternative investment and store of value). Its size can be enormous – 50% of total demand or more at times. Geographically, the greatest markets are China, India and the USA.

Total demand for gold, which (together with supply) drives gold prices, is the aggregate of these three types.

Supply
Like demand, supply comes from different sources:

– Gold mining – major gold producing countries include China, Australia, the USA, Russia, South Africa, Peru and Canada. In the long run, mining affects gold price in the same way as oil drilling affects oil price: The price is pushed up as the “easier” gold gets depleted and new reserves are deeper or harder to mine, but this effect is partly offset by advances in exploration and mining technologies.

– Recycling – approximately a third of all gold gets recycled.

– Speculative or investment supply – the investors and speculators who have bought gold will, at some point, sell it. They sell when they expect gold price to fall, when they need liquidity and for a variety of other reasons.

What Drives Gold Prices?
Although gold mining output and industrial demand are far from constant, gold price volatility is mostly a result of speculative and investment supply and demand. In the next article we will have a closer look at the factors which drive this demand, like inflation, interest rates or politics.

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