On February 27th, a day before the West Asia conflict began, gold traded at $5,278. One month later, as of this writing, gold is trading at $4,576. A 14% decline, most of which has occurred in the last two weeks, as the conflict shows no signs of resolution. Why has gold, a haven during times of turmoil, crashed?
To answer this question, let’s start with why investors buy gold. Investors buy gold to protect themselves when there is a crisis. When the likelihood of a crisis increases, gold prices go up. At the beginning of February, gold traded at $4,622. This means that gold prices increased by 13% in the month leading to the conflict.
But what happens when the crisis occurs? During a war, there is a first order effect of lost lives and infrastructure in countries directly involved. There is a second order effect of economic disruption that spreads widely. In this case, the crisis is the disruption to the supply of oil and gas.
The second order effects in this conflict are particularly high, given the importance of strait of Hormuz to global energy markets. The price of Brent crude oil has gone up by 40% in the last month. Crude oil is an essential commodity. How do oil importing countries absorb the cost?
The link between gold and oil
First, consumption drops. But even with that, the import bill is higher. Now, to pay more for oil, a country needs more dollars. And this is where gold shines. Sell gold, earn dollars, and use that to cover the higher import bill.
Why do we buy gold in anticipation of a crisis? So that we can use it when the crisis occurs. The fall in gold prices means importing countries are selling gold to pay for oil and gas. Gold prices aren’t going up again until oil prices have stabilized.
Gold is not the only asset to fall in value. Stocks and bonds are down too. Everything is down, other than commodities in short supply. Other assets play a similar role as gold does. Stocks and bonds can also be sold to help cover rising import bills.
If the conflict continues, asset prices will keep falling. Financial assets are vehicles for savers to park their funds. A recession or economic crisis reduces overall funds available to save and invest. Lower demand leads to lower prices.
A roadmap for investors
How should an investor handle the current market? For a well-resourced investor, today’s market perhaps presents buying opportunities. The mantra of buying when others are fearful is a time-tested approach that works. At some point, the crisis will end. And when it does, investors who bought during the crisis will benefit.
But every approach has its risks. Gold and other markets could fall much further before recovering. In the near term, households are likely to be squeezed with higher prices and stagnant incomes. If the current crisis causes a recession, people will lose jobs and witness declines in income. And if this risk is high for you, it is better to remain in safe assets.
Disclaimer:
Note: The purpose of this article is to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educative purposes only.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in Economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.
