What's been the main driver of the gold bull market?
Low interest rates? Fear of inflation? Currency wars?
Each of the above has certainly played a role in gold's decade-long winning streak.
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But, according to a fascinating new piece of research from US fund manager GMO, the biggest reason for gold's rise is something that most investors still don't fully understand.
And it suggests that gold's bull market could have some way to run
Who's been buying all the gold?
Gold bears often argue that the gold market is now at the mercy of demand from speculative investors, who have piled into exchange-traded funds (ETFs), chasing gold higher. The danger is that if the market turns sour, they could pull their money out en masse and send the price plunging.
But according to a study by Amit Bhartia and Matt Seto of US investment firm GMO, the majority of physical gold purchases in the past decade have not come from speculators in ETFs. Indeed, ETFs only account for a tiny fraction (around 7.5%) of the near-30,000 tons of gold purchased between 2000 and 2010.
The demand didn't come from developed market investors or central banks either in fact, central banks have been net sellers.
Instead, nearly 80% of the total demand for physical gold has come from retail purchases in developing markets. China and India's combined demand alone amounts to more than that of the entire developed world.
In other words, "the main driver for gold's dramatic rise has been the emerging markets consumer", say Bhartia and Seto.
Why? It's pretty straightforward. While trade liberalisation and the commodity boom has enabled emerging markets to prosper, their financial systems have not kept up with the pace of modernisation. Combined with a tendency to save rather than spend money, this has led to a large build-up of savings. (Or, as economists call it, a "savings glut").
Now, what can all these savers in emerging markets do with their savings?
One solution is to invest it abroad. Some argue this led to the low interest rates that drove the credit boom in the US and Europe (as money from Asia flooded into US Treasuries and the like, driving down bond yields). However, capital controls mean that investing savings abroad directly is not really an option for retail investors. And the domestic stock markets particularly in China are far too volatile to be trusted with your life savings.
There are of course domestic savings accounts. Unfortunately, in many countries the banking system is either corrupt or state-run. Negative real interest rates (ie adjusted for inflation) making saving money little better than burning it.
The final course left is to invest savings in hard assets. Property has proven popular. But with prices in China at least at record levels, and now starting to fall, this has become less attractive. That leaves gold.
"Combined gross savings in China and India increased from $557bn in 2000 to $3.4 trillion in 2010", say Bhartia and Seto. In short, there was a huge rise in the amount of money available to invest, "and given the lack of good alternatives, gold was a preferred choice".
What does this mean for gold prices?
You might assume that the tough patch that the Indian and Chinese economies have seen would therefore hit the price of gold. Not necessarily. Economic problems in these countries could in fact encourage people to double down on gold, especially if the banking systems and the property markets bear the brunt of the damage.
Indeed, there is already evidence that far from reducing demand for gold, the collapse of informal lending networks and the end of the property bubble in China have pushed investors further towards precious metals. Year-on-year sales of gold in China increased by nearly 50% in the holiday period from 22 to 28 January.
Gold sales in India also rose strongly last month, Meanwhile, there have been unconfirmed reports that its central bank will pay for its energy supplies from Iran in gold, in order to sidestep sanctions.
Thatraises the prospect of other potential threats to the gold price. Beijing seems to be becoming increasingly uneasy about domestic money going into gold purchases rather than low-yielding bank accounts. At the end of last year, the Chinese government closed down all but two of the myriad of domestic financial exchanges where gold was traded. Although this doesn't directly affect individuals, it could be a first step toward restrictions on retail investors.
On the other hand, a more open financial system could also impact on emerging-market demand for gold. If capital controls are reduced and Indian and Chinese citizens had more freedom to invest abroad, their demand for gold could drop. And if emerging-market consumers, start spending more and saving less in general, then this could hit demand for all savings products.
The gold bull market looks set to continue
However, no significant reforms are anticipated, while capital controls are likely to get tighter not looser in the near future. Therefore the short-term prospects for gold are excellent.
Plus, as Bhartia and Seto point out, the importance of the emerging-market consumer means that those who argue that gold has become a hugely crowded trade among investors in the developed world are simply wrong.
"This analysis indicates that conventional wisdom' demand is far from saturated." Both central banks and developed world portfolios have a lot of catching up to do, suggesting that "gold prices may very well experience another leg up".
We've long been fans of gold, and the GMO paper does nothing to change our minds on that. You can learn more about how to buy gold on our website. Here is a link to our directory of gold providers.
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