WHY IS GOLD NOT MORE VOLATILE? (Because East and West Have Yin and Yang)

I have spent the better part of THREE decades tracking the gold price and the oil price and trying to predict where they might be going.
 
I am still wrong a lot. But while studying these two commodities, one thing has stood out for me: gold prices should be A LOT more volatile.
 
Let me explain: The oil market has had a remarkably steady supply demand curve for the last 30 years—global demand has gone up roughly 1 million barrels a day per year. Some years it has been 800,000, and most years it has been just over at 1.1 million bopd (bopd=barrels of oil per day).
 
Very steady demand, and oil has a schizophrenic 30 year chart like this
 
 
 
 
And only once in our history—from 2004 – 2008—was there ever really any concern that supply could not meet demand. Before that time, and since then, the world has had AMPLE supply. Even today, we are basically drowning in oil. 
 
Yet the chart is crazy; there are only short term trends in this 30 year chart, despite the long term trends being quite set (except for 2008-09 and this year, 2020).
 
I guess because we NEED oil hour-to-hour, our emotions around it make for a crazy chart.
 
Gold on the other hand has the opposite issue. Its 30 year chart is, IMHO, quite smooth (again other than for some blips around sharp recessions)
 
 
(By the way, to me this is a very bullish chart)
 
So gold has a relatively smooth chart—yet there are many more forces—and very strong forces—acting on the price of gold. Demand for gold is unique. It is driven by several forces—which rarely work together. 
 
You could characterize it is a battle of East versus West.
 
The major sources of gold demand are jewelry (East) and investment (West). Both have enough weight to move the market. 

 
Demand from the East – Baubles and Bangles

Let’s start with jewelry demand.  Below is the break-down of gold demand from the World Gold Council. 
 
Source: World Gold Council
 
In 2019 jewelry demand was 2,122 tonnes. This is roughly half of overall gold demand.
 
And what drives jewelry demand?
 
Two countries: China and India.
 
In 2019 Chinese jewelry demand was 682,000 tonnes. Indian jewelry demand was 545,000 tonnes. 
 
Together these two countries made up 60% of jewelry demand, or roughly 30% of overall gold demand.
 
I have a couple of thoughts on this. The first one is that for these buyers what matters is the price of gold in their currency. 
 
It is not the US dollar price that matters most – that is part of the equation for these buyers, but what really matters is the price of gold in US dollars and how their local currency is valued with respect to the US dollar.
 
Second, these are not buyers by weight.
 
When a Chinese or Indian consumer looks to buy gold, they are not going to buy an ounce of gold regardless of the price. Rather, they have 100,000 rupees or 10,000 renminbi or whatever amount they have set aside to spend – if that buys a 1-ounce piece or a half an ounce piece so be it.
 
As US brokerage firm Berenberg points it out “Chinese and India buyers are price sensitive”. 
 
The problem we have right now is that we are at a level well above where Chinese and Indian buyers have typically balked.
 
Source: Berenberg Research
 
The second consideration is, of course, the economy. 
 
Jewelry buyers are economically sensitive buyers. Consider the Indian monsoon season – a clear driver of gold prices. In better years there is more money to buy gold jewelry. 
 
This year we have a unique headwind: COVID. It has already had a big negative n impact in the second quarter, which I expect to continue.
 
Gold jewelry demand was down 56% year-over-year. That’s right – 56%! In India it was down an astounding 76%!
 
As Berenberg points out, Swiss exports to China have “collapsed”:
 
Source: Berenberg Research
 
Is there any other market in the world where, when the primary use for the product falls off a cliff—and the price goes UP?
 
By the rules of simple economics, it’s amazing that gold is up even as jewelry demand has collapsed.
 
Again, think about this from the perspective of an oil investor. We saw what happened when gasoline demand dropped 50% year-over-year during the lockdowns.  The oil price collapsed. In fact, it went negative.
 
But gold just went through a historic collapse in jewelry demand and the price of gold… went up.
 
On the flip side, this dynamic does show why gold is not the counter-cyclical trade it is often made out to be. Too much demand comes from jewelry, and too much of that from China and India. You cannot have end-of-the-world insurance when half of demand needs global growth.

 
Demand from the West – ETFs and Momentum Investing
 
Of course, we all know what happened to keep gold afloat. Investment demand went through the roof.
 
But a close look shows it was not all investment demand. 
 
Overall, investment demand increased 290,000 tonnes year-over-year in the second quarter. But physical bars, coins, medals – all these subsets of investment demand were down 30%-40%.
 
In fact, the investment demand story is really a single chapter—ETFs; Exchange traded gold funds.
 
 
 
Source: World Gold Council

ETF demand was up 434,000 tonnes in the second quarter – more than 300%.  In the last year, ETF inflows have increased over 1 million tonnes!
 
Source: Morgan Stanley Research
 
To say that ETF demand has gone parabolic is not an understatement. The increase in ETF demand in the first half represented 30% of total gold demand. This more than offset the decline in jewelry demand. 
 
It explains how gold was able to shrug off disastrous jewelry demand over the last few months.
 
But ETF demand is fickle. It is extremely volatile. It can have monster accumulations like what we just saw in the first half of this year. But it can also do the opposite, flooding the market with sales as investors rush to the exit.
 
Here is the semi-annual change in ETF demand back to 2010.
 
Source: World Gold Council
 
In 2013 ETF outflows were close to a million tonnes. In 2016 inflows were over 500,000 tonnes. They were 400,000 tonnes in 2019.
 
Between 2013 and 2016 ETF demand fluctuated by almost 1,500 tonnes. In a 4,000-tonne market.
 
Again, compared to oil, this is mind-blowing. A major source of demand that can add or subtract 10% or 20% on any given year? I cannot imagine what this sort of variable would do to the oil market.
 
It is a wonder that gold is not more volatile. 
 
ETF demand is entirely driven by North American and European investors. It is the reverse of jewelry demand, where Indian and Chinese consumers far outweigh purchasers in the west.
 
 
 
Source: Bloomberg, WGC
 
There is another way that ETF demand acts at odds with jewelry demand – and at odds with most any other economic demand.
 
Jewelry demand is price sensitive – as prices go up and less consumers buy gold jewelry. Those that do buy jewelry buy less of it.
 
This is how demand works for most things. Prices go up, demand goes down. Basic Economics-101.
 
But investment demand, and in particular ETF demand, does not always work that way.
 
When momentum starts driving purchases, demand will rise as the price goes up.
 
What is unique about gold is that because investment demand is such a big driver this factor is amplified. It makes up 30% of overall demand. 
 
ETFs only make that worse. Instead of having to go to your safety deposit box, take out your gold and sell it to your dealer, you just press a button.
 
When 30% of demand is tied to a button press… well, that makes me raise my eyebrows a tad.
 
Adding It Up

They say gold is volatile.  Compared to a 10-year treasury – sure.  But when you look at how volatile gold demand is, it is a wonder that the price is as stable as it is.
 
Source: Goldprice.com
 
The chart of gold is surprisingly smooth.
 
I suspect that the truth is that the battle of East and West – working against one another – works to dampen volatility. 
 
When Western investors step away, the price falls and bargain jewelry buyers step in. 
 
As the price rises, the jewelry buyers balk but investors see the momentum and jump onboard.
 
While a snapshot of either buyer alone DOES look chaotic over a several year period, on the whole demand stays relatively constant. However, the same thing happens with oil demand and that chart is a dog’s breakfast of volatility.

Keith Schaefer