In 2013 gold lost 30% of its value. In 2014 the yellow metal has made an impressive comeback and rebounded 13% in March, beating many other assets. Now its price is approximately $1,300, which still means 6% recovery this year.
What lies behind this rise? Apart from the Fed’s actions, which were widely analyzed in earlier Market Overviews, geopolitical concerns were one of the most important factors that affected the price of gold in 2014. This confirms that the gold price depends on many different factors, not solely on the Fed’s actions. The biggest geopolitical concern in Europe is military conflict in Ukraine and the resulting tensions between the USA and Russia, not to mention Middle East turmoil (Iraq, Libya, Palestine, Syria). The list of geopolitical risks continues with China flexing muscles in the South China Sea, the first re-arming of Japan since WWII, the Ebola virus in Africa, default in Argentina, and the old-new problems in the Eurozone (recession in Italy and Portuguese economic hardships).
How do the geopolitical risks affect the gold market? Generally, gold prices are positively correlated with the rising tensions. There are many examples: 1979 and American diplomats taken as hostages in Tehran, as well as the Soviet invasion of Afghanistan when gold skyrocketed from $380 to $850 per ounce. After 9/11 the gold price in the London market rose from $216 to $287 in one day. More recently, after escalating tensions in Iraq (i.e. President Obama’s decision to send 300 military advisors), on 19 June, 2014 gold reached its highest point in two months. Similarly, gold surged 7 points after the Ukrainian attack on a Russian convoy in August 2014 (Graph no. 1).
Graph no. 1: Rise in gold price due to escalating tensions (attack on Russian convoy) between Russia and Ukraine on August 15, 2014
Source: telegraph.co.uk
Why does such a correlation exist? The reason is quite obvious. As Jim Rogers said, “[It] is not good for anything except for real assets because people need real assets during the time of war – whether they are involved in the war or just protecting themselves.” In times of high uncertainty, investors abandon investments that might be affected and turn to real value. Precious metals may then be a smart option since they do not entail counterparty risk. This is why gold is considered as a safe-haven investment – it is the ultimate means of payment in hand when all other means of payment fail.
“Flight to gold” refers not only to retail investors, but also to central banks. Since local currencies usually suffer during war, central banks may be eager to increase their gold reserves. Iraq in Q1 2014 bought 60 tonnes to support the Iraqi dinar. And according to the World Gold Council, in Q2 2014 central banks continued to be strong buyers and purchased 118 tonnes, i.e. 28% more than the year before. Keep in mind that the Middle East was responsible for 6% of consumer demand and also for a significant share of the central banks’ holdings last year.
There are also three other reasons why geopolitical factors can support the gold market. First, political turmoil often increases government spending and creates inflationary pressures because wars are generally paid for by excessive money printing. Needless to say, gold is considered by the investors, rightly or not, as an inflation hedge.
Second, military actions, especially in the Middle East, but also the potential escalation of the conflict between Ukraine and Russia, may disrupt the supply of gas and oil, which means higher gold mining costs and even more turmoil in Europe due to lack of energy supplies. As such risks increase, the price of gold should also rise thanks to its “insurance” function.
Third, geopolitical tensions can lead to a slower pace of economic growth, either due to higher uncertainty and less investment, or due to imposition of economic sanctions which curb the gains from international trade. Gold, as a defensive asset, gains relatively in the slow economic growth environment. Recent data from Germany suggest that the situation in Ukraine can slow down global recovery: the index of German economic sentiment dropped from 27.1 in July to the weakest in 20 months – 8.6 in August – meaning significantly below expectations.
Summing up, geopolitical risks generally affect the gold market positively, but one needs to be careful before applying this general rule into practice. Only those events that are likely to really alter the geopolitical stability or materially impact the world economy are likely to have meaningful impact on the price of gold. Market’s reaction also depends on the prevailing emotional attitude of investors and traders. When traders are very bullish, negative news could simply mean a pause, not a decline, but when traders are bearish, negative news could ignite a big plunge. Stay updated on the latest developments in the gold market by joining our gold newsletter. It’s free and you can unsubscribe in just a few clicks.
Arkadiusz Sieron
Sunshine Profits‘ Market Overview Editor
