The Role of Gold in Central Banking May Be Shifting...Here's How

Guild Investment Management |

As we have noted in several recent letters, we do not believe that China is melting down; we see growth that is slowing, but still robust, and we see an epochal shift away from industrial growth to growth of the consumer sector in China. (We also see the rise of “Chinese millennials” as a demographic phenomenon -- but we will discuss that in a future letter.) China’s banking system may yet cause genuine problems, but not in the immediate future. We believe that much of the negative news about China’s economic condition may be originating in the ongoing struggle of Xi Jinping’s government with endemic corruption. 

However, some of the effects of the growth transition to the consumer, and of the negative news flow about Chinese economic fundamentals, are significantly affected emerging markets, where currencies and equities have been feeling the pain.

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One potential beneficiary of this development is gold. 

The role of gold in central banking may be shifting; there may simply not be enough gold on the planet to be a store of value as significant and useful to central banks as it has been historically. If this change is happening, though, it does not change the fundamental nature of gold as a hedge used to express mistrust of government. When trust in government’s competence, honesty, transparency, and effectiveness goes down, the price of gold tends to rise. 

Thus, as investors in emerging markets begin to lose confidence that their governments “have it under control,” that they can effectively manage the knock-on effects of shifts in China’s economy (whether real, psychological, or a mixture of the two) -- they will begin to store more of their wealth in gold. 

We have seen some signs of this shift occurring in a rise of demand for bullion in India and China, although demand has not reached the levels of 2013. However, even in the face of imminent Fed tightening, gold could find support from the demand generated by an emerging-market swoon. 

Moreover, the mistrust of government shown in the early U.S. election polling results is manifesting itself in many other countries as well. It turns out that social media is a big opening to advocates of change in many countries; a recent example is Guatemala. News of corruption and misuse of power travels faster and can be backed up easily via social media. We anticipate that this change toward a “throw the bums out” attitude in many countries will lead to a desire to hold more gold by some citizens worldwide. This makes us more optimistic that the end of the gold bear market is gradually approaching. 

Investment implications: Gold is first and foremost a hedge through which investors express their mistrust of government. Although the role of gold may be shifting, with central banks unable to hold enough gold for it to continue as a major component of their reserves; and although an imminent Fed rate rise is not constructive for gold; the current swoon in emerging markets may find retail investors again casting their votes against trust in their governments, and in favor of the yellow metal. We are seeing indications that a bottom in gold is nearing. We are not sure of the date of its arrival but we will keep you informed when we believe it has arrived.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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