From a long-term perspective, we believe, nothing much has changed for gold. The main reason we think that gold's fundamentals are possibly intact is the theory that says that the economy can be made stronger via more monetary inflation, further credit expansion and more government spending.
The main influencing factor in the gold market today is the massive and unrealistic amounts of dominant debt throughout the western financial system. This debt is coupled with a paper currency that is positioned as the reserve currency of the world, which however can be issued and abused by a single government. These high levels of debt, combined with slow economic growth, compel central banks around the world to 'print' more dollars and other currencies (in order to pay the bills), stimulate the economy and inflate away the debt burden with an intentional plan of currency devaluation.
The Eurozone is currently like a ticking financial time bomb, as sovereign debt slowly positions itself towards a massive explosion. The intended lending by ECB to European banks in order to ease liquidity and resolve the crisis is much in vain as you cannot solve the debt crisis by issuing more debt and or creating money out of thin air. It's just an extension of the measures undertaken by the Fed towards more monetary debasement. Issues like lack of internal policing and commitment from its member nations render the possibility of a credible fiscal union.
The free market principles and a natural cycle of correcting the malfunctioning and excesses in the economy have been severely hampered by dominant policymaking. This is a cause for real concern. Various tools have been employed like accounting changes, bail-outs and support schemes, currency interventions, etc, - making things go from bad to worse.
This only leaves markets guessing the potential levels that would propel the central bankers to pull their triggers for further monetary infusions creating short term market rallies and adding to the speculative fervor. Markets are functioning on a perverse logic that weak data is good for the markets as it only increases the certainty of further monetary interventions with money created out of thin air that not only fails to address the underlying problems, but complicates problems over the long term and leads to misallocation and misutilization of scarce resources.
Negative real rates still prevail, and with the economic outlook still showing no signs of improvement, these negative real rates will not fade away easily as any increase in interest rates would cause considerable strain to already hampered public finances. They are likely to exist for a longer time and would probably help gold move up as investors look at it from a 'wealth preservation' perspective. Diversification of reserves and investment into gold seems to be the course of action, and is likely to continue in the future as well, thereby supporting gold prices. Such corrective phases tend to drive gold from weaker to much stronger and stable hands thus reinforcing the diversification theme.
To sum up, there doesn't seem to be any material change in the fundamentals that have led to the Bull Run in gold. The factors that have caused a sharp decline in gold prices seem to be more temporary in nature. This is most likely a corrective, consolidative phase in gold prices which has been an integral part of the move and should not come as a surprise.
Long term trends
The relatively high prices seen over the past few years are well supported by fundamental factors. We believe that gold is rightly increasing in nominal value being the only currency whose supply is highly constrained. In simple words, gold is simply adjusting to changes in global monetary conditions. When a central bank increases their money supply, the price of other currencies adjusts upwards. This is true for all currencies including gold.
Long-term trends in gold prices are driven by changes in the overall level of confidence in the monetary system and the economy. Therefore, to analyse gold over the long term, it needs to be seen as a monetary asset rather than a commodity. Given the current economic backdrop, where governments are struggling with problems like rising deficits and unsustainable debts, it is indeed logical for gold prices to increase in value. With policy makers continuously debasing currencies, gold will be viewed as a better alternative, like an island of solace to the chaos.
The macro-economic and supply-demand drivers point to a continued increase in gold prices. Demand from consumption centers like India and China largely seem to be on a firm footing. Investment demand has been robust and would continue to grow lending support to gold prices. We do not believe that there is a 'bubble' developing in gold, as the relatively high prices seen recently are supported by fundamental factors. Gold as a percentage of total investments is still very miniscule. Even a small shift from other asset classes / currencies to gold can lead to large price increase in the value of gold. If concerns surrounding Quantitative Easing, monetization and European sovereign debt defaults trigger another broadly based loss of risk appetite, investors would, no doubt, want to increase their gold holdings.
The uncertain economic environment and looming inflationary threat over a long term reiterates the need for gold in one's portfolio. Make a strategic allocation to gold because it's the counterweight to paper money which is continuing to lose credibility as a store of value.