LAUNCESTON, Australia (Reuters) - Gold bulls have been tempted out of hiding by bullion's strong start to the year, but the basis for optimism looks unsteady and largely hostage to what happens in China and India.
Spot gold has gained 8.8 percent so far this year to end February 19 at $1,311.32 an ounce, recovering almost a quarter of its 28-percent loss in 2013.
The World Gold Council (WGC), which represents producers, is unsurprisingly upbeat, with Marcus Grubb, the managing director for investment, saying 2014 is going to be "much better" for gold investment and returns will be positive.
Notwithstanding that the council's job is to portray gold in a positive light, it's worth looking at why it thinks this is the case.
It basically comes down to three factors, ongoing strong demand from China, a recovery in Indian imports as the government relaxes restrictions and an improvement in investment demand, reversing 2013's huge outflows from exchange-traded funds (ETFs).
China became the world's top gold consumer last year, overtaking India, with demand rising 32 percent to 1,065.8 tonnes, according to the council's Gold Demand Trends report on February 18.
The surge in demand in China was largely due to a consumer response to the sharp fall in prices.
Given that a further slump in gold prices is something the council doesn't expect, it may be logical to assume that Chinese buyers will be aware that the time to buy at bargain prices is past.
Chinese consumers also tend to buy gold when they fear inflation is rising, or when other financial assets such as shares are likely to drop.
Inflation in China remains well contained at 2.5 percent, well below the recent 6.5-percent peak from mid-2011, while the benchmark Shanghai stock index is up modestly so far this year.
Premiums on the Shanghai Gold Exchange have also eased recently after the demand boost ahead of the Lunar New Year holidays at the end of last month and the start of February.
The current backdrop in China does little to suggest that gold demand will again surge by more than 30 percent in 2014, although equally it doesn't suggest that demand will decline.
Rather the outlook for China is for steady demand growth, which will be supportive for gold prices, but not enough to spur a rally by itself.
Turning to India and the hope is that the authorities will lower the record high 10 percent import duty and ease the requirement that 20 percent of all imported bullion is re-exported as jewellery.
This is based on a request by Sonia Ghandi, the leader of the ruling Congress party, to review the import tax.
The import tax, and the re-export rule, were imposed in a bid to curb India's ballooning current account deficit, and gold was the best target, as it was second to oil in import value and it doesn't create much economic value by itself.
The rules certainly worked, with imports plunging in the second half of 2013, with official figures showing a 63 percent drop between July and October.
Overall Indian demand remained strong, with WGC figures showing 2013 demand at 974.8 tonnes, up 13 percent from the prior year.
The important point is that much of that demand is being met by increasing recycling of domestic gold as opposed to imports, although the council also believes that smuggling has increased dramatically as well.
While it is possible that India may relax its import duty and the so-called 80-20 rule, this is unlikely before the second quarter, which should keep import demand muted until then.
There is also the possibility that Congress will lose a general election due by the end of May to the opposition Bharatiya Janata Party, thereby introducing uncertainty to gold policy.
While demand is certainly present in India, there is no guarantee that it will translate into higher imports in 2014, especially if the import duty and re-export requirement aren't relaxed as quickly as hoped.
A return to popularity for ETFs also seems optimistic, even though there has been a slight uptick in net purchases so far this year.
The biggest ETF, the SPDR Gold Trust, has seen net holdings rise by 0.4 percent this year, but this has to be seen in the context of a net reduction of 41 percent in its holdings last year.
With the U.S. Federal Reserve seemingly committed to a gradual tapering of its bond purchases amid signs of recovery in the world's largest economy, the case for significant flows into gold ETFs looks somewhat wobbly.
A stronger U.S. dollar as quantitative easing is wound back also mitigates against investment in gold.
While the outlook for gold demand in China, India and for ETFs doesn't suggest prices are likely to decline in 2014, it also doesn't give confidence that there will be a strong rally.
Editing by Joseph Radford