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September, 2010 |
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Gold: Will the glitter continue? |
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Rohit Chawdhry, Feb 2010 |
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Consistently higher gold prices since 2003 has been an inescapable trend. While most other asset classes reverted to the 2003/2004 levels post collapse from their peak in 2007, gold went up higher, suggesting relative out-performance by the yellow metal.
With asset classes bottoming in the first quarter of 2009 and then rising significantly for the rest of the year, gold continued its upward march. This implies that the shift has perhaps been driven by pure fundamentals rather than just liquidity as was the case for equities and commodities last year.
Conventional explanation for such a move in gold is usually intertwined with its inverse relationship with the dollar. However, examination of currencies from 2004 to 2009 suggests otherwise. The period between 2004 and 2007 marked a structural shift in the global economy which used to grow at around three per cent prior to this period. Over the six-year period from 2004, world economy grew at 4.5 per cent in real terms, with 2009 being a year of contraction but still gold gained in that year.
Gold gained 150 per cent during 2004-2009 but surprisingly the US trade weighted dollar index stayed flat, suggesting breakdown in the conventional wisdom. Gold also gained 130 per cent against euro, Swiss franc and Canadian dollar. Gold’s gain against Chinese yuan was lower at 100 per cent. GCC currencies were devalued against the precious metal due to the region’s dollar peg.
Bottomline: Gold has been getting revalued upwards against all currencies since the start of the super cycle for world growth. In other words, investors have been busy shorting the global central banks by being long gold.
But, why short the central banks? With the global economic growth expected to be anaemic in 2010, courtesy weak US and European economy and high probability of a credit bust in China, global central banks are reverting to their good old friend, the printing presses.
The Federal Reserve has tripled its balance sheet in the last couple of years which has clearly signalled debasement of its currency. Euro is facing its own set of problems with Italy, Greece, Spain and Portugal who are feeling stifled in the existing mechanism. It would not be surprising to see these countries exit the euro.
In the east, Japan is facing headwinds against the ongoing carry trade unwind resulting in an appreciating yen. This will likely make any economic recovery anaemic.
Finally, the excess capacity created by China, on the back of artificial demand in the US generated out of leverage, has started to collapse as is evident from rising bankruptcies/closures in the middle kingdom. Clearly, the world is facing the risk of fiat currencies. Put differently, the possibility of a global currency crisis implies that alternative currencies such as gold may have their day under the sun.
With the dollar forming 30 per cent of the total world reserves compared to just 12 per cent for gold, the probability of a continued uptrend in gold remains high. Though the share of dollar has been declining from almost 45 per cent a few years back, it is expected to collapse considering the total debt to GDP ratio of the US at above 350 per cent.
Considering the favourable fundamentals of the yellow metal, it is highly plausible that gold may become the second most important reserve currency, surpassing euro’s current share at 15 per cent.
Statistics by the World Gold Council (WGC) reveal that the top six Eurozone countries along with the UK currently have gold reserves of US$300bn out of the total reserves of US$500bn – a share of 60 per cent. By the same measure, world’s leading exporters – China, Japan, Brazil, Korea, Taiwan and Russia – have just under US$70bn in gold reserves compared to their total reserves at US$4tn.
Apparently, these countries have used gold as part of their mercantilist strategy of keeping exchange rates undervalued against the dollar. They have achieved this by artificially maintaining low levels of the yellow metal in their reserve portfolios. But with the US economy and the dollar’s future uncertain, such a strategy seems less likely to pay off.
Moreover, as the share of domestic consumption rises, relative to exports in the GDP of these export-oriented countries (especially in a protectionist environment), central banks of such nations are expected to do away with their dollar reserves for other currencies including gold. Similarly, GCC central banks and sovereign wealth funds could be expected to have a higher share of gold in their portfolios as dollar loses the role of being the region’s anchor currency.
The boom-bust economics of 2008 and 2009 in the region has made it impossible to have any set of reasonable policies. First, negative real interest rates during 2006-2007 encouraged overborrowing and speculation in asset markets, raising risks from the financial sector.
Then, post collapse in the oil prices, higher bank reserve requirements to check inflation had to be rolled back quickly to avoid a hard landing in the GCC. Such a flip-flop in policy has intensified efforts to search for meaningful solutions in which gold can be expected to play an integral part. In short, gold’s future appears bright and should form a part of everyone’s portfolio as global central bankers substitute their long-standing goal of price stability at a reasonable growth for growth at any price.
There is the third element of risk to IMF’s global forecast – rising sovereign default risk, especially in Europe. Countries such as Portugal, Italy, Ireland, Greece and Spain are facing problems regarding their debts.
The problem with Greece is seemingly large as its indebtedness is much more than when Russia and Argentina defaulted. Even the UK hasn’t escaped the wrath of markets. Consider the five-year credit default swaps (CDS) on UK government bonds which trades much higher than the investment grade bonds such as Deutsche Post, Total or France Telecom. Quite clearly, the market is pricing sovereign risks a lot higher considering governments’ future funding needs as fiscal deficits have ballooned beyond sustainable levels. The market may have also started to price in the risks of the UK’s AAA rating being taken away. If the dollar’s fundamentals are bad, those for the euro are downright ugly.
Any examination about gold’s future would be incomplete if some key ingredients responsible for gold’s bull run go undiscussed. Essentially, there have been four pillars to the gold market which bottomed in 1999.
First, starting in September 1999 with the formulation of the first Central Bank Gold Agreement (CBGA), the gold market benefited increasingly from a controlled environment for central bank sales. CBGA I (1999-2004) provided for a cap on collective sales at 2,000 tonnes or 500 tonnes per year and a limit to lending and other hedging activity at prevailing level (.
Second, the market benefitted increasingly from the protracted reduction in the global hedge book and the reversal of accelerated supply following the so-called Hedge Book Crisis of September 1999. Third, the gold market also benefitted especially from a pronounced acceleration in the level of implied and identified gold investment demand over the past decade.
Data from Gold Fields Mineral Services (GFMS) and WGC show that identifiable and implied investment demand have risen from 12.2 per cent of the total demand of 4,154 tonnes in 1999 to 44.4 per cent of an estimated 3,925 tonnes in 2009. In absolute terms, this is an increase from 507 tonnes in 1999 to an estimated 1,777 tonnes in 2009, a 350 per cent increase in absolute terms.
Furthermore, this only counts the identifiable physical gold purchases in bullion and coin form. It excludes sizeable volumes of gold jewellery bought as investments and the large number of paper gold derivatives purchased through futures, forwards, options and gold index securities.
Fourth, in addition to reduced supply risks from central bank sales and producer hedging, the gold price has been positively influenced by a significant reduction in supply risks from new mine production. This in turn has facilitated the absorption into the market of significantly increased quantities of old gold scrap with minimal impact on the price.
A noteworthy feature of the current gold market has been that both in times of falling (late 1998-2001) and rising prices (2002-2008), gold production has remained essentially flat, neither rising above 2,650 tonnes in any year or falling below 2,450 tonnes over this whole decade.
In brief, the demand seems to be rising while the supply has not kept pace with the rising appetite from investors. This is a strong sign of fast improving fundamentals.
Considering all the above, it is only reasonable to assume that given the current global credit and currency crisis, the likelihood of an accelerating uptrend in gold prices seems a very high probability. But that is a long-term view.
In the short-term, given the fact that IMF is looking to sell a major portion of its 3000 tonnes gold reserve it is possible for the yellow metal to consolidate in the range of US$800-US$1,100 per ounce. The consolidation could also set in as euphoria for the yellow metal. Usually, such euphoria should be used as a contrarian indicator for a meaningful correction.
However, any weakness should be used to add gold holdings as part of an investment defence in an increasingly topsy-turvy world.
Rohit Chawdhry is Portfolio Manager at BiSB (Bahrain Islamic Bank). The views expressed are the author’s own and do not reflect those of his employer. The author bears no liability that may arise from investments made based on the article.
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