The drop in gold prices this week has renewed concerns that gold’s 30% rally this year was not the start of a sustainable new bull market, and that gold prices could potentially drop as low as $1,050 per ounce (according to Wells Fargo).
Investors can take comfort, however, in the fact that almost nothing fundamentally changed in gold markets to cause this drop. The drop was encouraged by a non-voting Federal Reserve president suggesting a rate hike is due in December (hardly a shock to markets) and news of the Brexit proceeding. The real reason for the drop, however, was that gold breached the key $1,300 level.
That $1,300 per ounce was an important psychological level in the market, and many traders (and algorithms) took the break of that level as a key selling opportunity to either exit trades or to short sell.
The drop in prices will spur demand and support the market
What truly exacerbated the fall, however, was the fact that China was celebrating its “golden week” holiday.
China is a huge buyer of physical gold, and the fact that Chinese investors were away from their desks during the drop meant a key source of demand was not there to stop the fall in prices. Once the Chinese return, it is very likely they will see the discounted price of gold as a key buying opportunity, which should help put a short-term floor under gold prices.
Chinese investors are particularly fond of gold since it is a means to diversify away from the surging real estate market in China. It also provides protection against the potential devaluation of the yuan. In addition, consumer demand, like demand for jewelry, is also set to grow in response to lower prices.
According to the World Gold Council, many buyers have been waiting for a pullback in gold prices to buy and have been holding off on purchases in the last few months due to higher prices. In Q3 2015, for example, a 7% decline in gold prices led to a strong increase in demand for bars, coins, as well as jewelry. The gold council sees strong interest in gold from the Middle East as well after the price decline.
In addition to this, India is also set to see a seasonal increase in demand, and this coincides well with the price decrease. Due to a strong monsoon season, Indian farmers have more cash, and they are likely to spend it on gold since gold is seen as a store of value and also has cultural value. In addition to this, Indian wedding season, known as Diwali, is approaching, and this typically sees an uptick in gold demand each year.
With China and India making up half of global gold demand, interest in these two countries is important and should serve to support the gold market.
In addition, demand from the investment community remains strong. In fact, as prices fell this week, demand for gold from physically backed gold ETF’s actually increased, which is a very encouraging sign.
What about over the long term?
While the above factors should help the gold market over the short term, the long-term outlook for gold is still attractive. Gold does well when long-term interest rates remain fairly low (since it means there is less of an opportunity cost to holding gold) and when global uncertainty is high.
Even if the Fed does hike rates, gold is still likely to do well, according to the World Gold Council, as long as the pace of rate hikes are gradual, and especially if real rates remain negative (that is to say, if inflation is generally greater than interest rates).
Gold mining stocks made their largest weekly declines in almost two years, and this represents a buying opportunity in high-quality names. One perfect example would be Barrick Gold Corp. (TSX:ABX)(NYSE:ABX). Barrick is a senior, well-established producer that is showing good free cash flow, falling debt levels, and sustainable production.
