Scotiabank looks at disconnect between physical demand for Gold and investor inflows


In its latest commodity update, Scotiabank looked at “quantifying the struggle between the East (physical/jewelry demand) vs the West (investor inflows).”

After a major sell-off mid-March, gold has seen a massive rally, boosted by its safe-haven appeal during the COVID-19 crisis. The precious metal even neared $1,800 an ounce level in April.

However, physical demand for the metal out of Asia has been unusually weak.

“Jewelry sales fell to their lowest on record (-40% YoY), with physical trade imports / flows into China and India mimicking that (down ~65% & 40% YoY respectively). In addition, the pace of CB purchases has fallen off materially (on an annualized basis they have bought +3.7mn oz, the slowest annual pace since 2008),” Scotiabank commodity strategist Nicky Shiels pointed out, citing data from the World Gold Council’s Q1 Global Demand Trends report.

Considering such a significant drop in physical demand Shiels examined whether increased investor interest was enough to justify gold price at above $1,700 an ounce.

“What is key … is determining whether the slowdown in physical more or less offsets the ramp up in investor (ETF+ COT) flows, and attempting to model the impact on prices,” Shiels wrote last week.

To get the answer, Shiels compared three demand drivers – jewelry, central bank buying, and investor demand.

“Jewelry demand is running at a annualized rate of 42m oz.; that’s 30m oz. (-41%) less demand vs the average ‘jewelry bid’ seen from 2009-2019. CB purchasing power is running at a 3.6m oz. annualized rate in 2020; that is 8.9m oz. (-70%) less vs the average trend seen the past 10 years … Through this proxy/lens, CBs and jewelry demand together is losing on average ~39 m oz. in 2020,” Shiels estimated.

“That compares to a ramp up in investor demand (COT+ETF) which is running at 12.3m oz. on an annualized rate, or only 7.6 m oz. larger than the average annual inflows seen the past 10yrs,” she noted.

Based on this, it looks like gold price should be closer to $1,350 an ounce, Shiels wrote. And if the sentiment in the market turns, prices could be in for a sharp downfall.

“By this approximation, the loss in physical demand, at this rate, is 5x larger than the increases in investment demand. But gold is up 11% YTD … The correlation between these dominant drivers, and the annual gold price performance is +0.56, which puts the model implied gold performance, using the past 10yrs of data, at -12%. IE: Gold should be closer to $1350, showcasing a large disconnect between the negative omen from the physical backdrop and price action,” she said. “Unknown OTC flows, stemming from strategic and/or official sector explains part (not all!) of the difference.”

And even though there is a solid case for having gold in any portfolio, balance is important, Shiels added.

“While the unprecedented interventionist monetary and fiscal response to counter the effects of COVID-19 provides a great case for gold to play an increasingly large part of any portfolio going forward, the lack of physical support does make a case for those overexposed to lighten up,” she wrote.