The following is based on a talk given by Kamal Naqvi at the recent annual convention of the Prospectors & Developers Association of Canada, held in Toronto.
Watching markets and media commentary on the gold market in recent months, one could be forgiven for assuming gold is simply a derivative of the euro; such has been the correlation between the two. As a result of this close relationship, we sense a high degree of complacency throughout the industry about both the level of gold prices and the remaining structural challenges still facing the gold market.
Contributing greatly to this complacency has been growing noise from the “bulls” on major gold-market schemes about why gold is still in the early stage of a major bull run. There are five pillars of this “gold fundamentalism”: gold is “simply” a dollar story; demand will surge, thanks to China (on top of India); supply is falling; central banks will become “believers” again; and long-term investors will return to gold.
We believe that many of these supposedly bullish themes for the gold market are overdone, unproven or wrong. This does not mean that we will see a collapse in gold prices back below US$300 per oz. However, it recognizes that a consensus economic view (that is, of robust global growth) is likely to see gold prices come under increasing pressure. For gold producers this is likely to mean that relative share price performance will increasingly reflect corporate performance rather than merely market perceptions of leverage to the gold price.
A closer examination of the five pillars follows.
‘Simply’ a dollar story
The inverse relationship between gold and the euro now dominates the gold price, but this is not how this gold rally began.
The foundations were set back in September 1999, when the European central banks collectively agreed to limit their sales of gold to 400 tonnes a year and so eliminated the widespread fear of an imminent “flood” of central bank gold sales. The event itself had the unintended impact of highlighting the sensitivities of gold company hedge books to gold prices, volatility and lease rates. This resulted in reductions (initially forced and later voluntary) in these forward positions, which became known as “de-hedging.” The downturn of the U.S. equity markets from early 2000 encouraged investors to look at alternative assets, including gold, while the successive cuts in U.S. interest rates reduced the opportunity cost of holding the yellow metal. Lastly, there were the fears following the 9/11 tragedy and then the Afghanistan and Iraq wars, with gold benefiting from its historical reputation as a safe haven for investors.
Of course, throughout this period, the trend in the U.S. dollar was an important factor in the gold price. Today, most of the other important factors appear to have weakened as a support for gold, leaving it now almost solely dependent upon its relation to the U.S. dollar. We see scope for the euro to appreciate to 1.33 over the next three months, and so see one last leg higher in gold prices. However, we also see a recovery of the dollar back to 1.18 by the end of the year and so, in the absence of any other supporting factors, expect gold to correct back towards US$350 per oz. over the same period.
Demand to surge
China has become the topic for the commodities markets. However, gold has been an exception with Chinese demand largely stagnant over the past decade, compared with several-fold increases for many other commodities. This has led many in the gold market to predict that a massive surge in Chinese demand is imminent, based on income growth and greater liberalization of the domestic bullion market.
However, we should put these expectations into context. First, China is already the world’s third-largest consumer of gold jewelry. Second, China has actually already experienced a surge in gold demand. This occurred from 1989 through to 1992, when gold demand increased five-fold from 40 tonnes to more than 210 tonnes. This increase was driven by general market liberalization, income growth, and depreciation of the renminbi. Notably, Chinese demand has stagnated around these levels ever since.
The Chinese experience was remarkably similar to that seen during the Indian gold demand boom, which followed later in the 1990s. The difference is that Indian gold demand began from around 200 tonnes and rose above 700 tonnes before weakening to its current level and apparent plateau at around 600 tonnes per year.
Part of the explanation for high gold demand in emerging markets is that gold continues to play, in the absence of alternatives, a key role as a hedge against both inflation and currency weakness. However, since the late 1990s, the trend in both China and India (indeed, most Asian markets) has been for currency stability and dis-inflation. More recently, economic growth has resulted in upward pressure on the currencies, while inflation remains controlled. This is not typically the environment in which we have seen a gold demand surge in emerging markets.
However, it is not macroeconomics that is used as the justification for there being huge potential growth in Chinese gold demand. It is population. China has the lowest per-capita consumption of gold in the world, and so the argument says that while gold market liberalization continues in China, so will per-capita consumption. The typical extension of this is that given similar populations and a traditional affinity to gold, one can assume that per-capita consumption in China will rise to a level similar to that found in India and so see a nearly three-fold increase in Chinese gold demand.
Unfortunately, reality is rarely that simple, and such analysis is critically flawed because it does not take account of changing domestic spending patterns. A much more insightful comparison can be made by analysing how much consumers spend on gold. The Middle East, the Indian Sub-Continent, and Asian countries spend a large proportion of their income on gold. The Chinese fall in the middle, and people in Western countries spend the least of their income on gold.
The evidence suggests that as economies develop, the range of spending and investing options expands considerably. This helps explain why Chinese gold demand has stalled over the past decade despite the rapid income growth over this period. The reality is that in the competition for growing Chinese disposable incomes, gold is quickly losing market share. Given that China’s economic development is likely to continue and the growing global influence of Western culture (and this tends of be negative for gold), we can expect China’s income spending on gold to continue to decline. Indeed, this is not just the case for China but for the other large spenders as well.
This trend towards lower income spending on gold is why we strongly believe that a rejuvenation of Western World gold demand (both jewelry and investment) is crucial for the long-term viability of the gold industry. Not only does the west provide the greatest potential demand growth (for an increase in percentage spend); it will also help reinforce gold’s existing position in emerging economies and so slow its declining share of disposable income. Of course, such rejuvenation is a far-from-simple task, but that does not make it any less vital.
Despite the rising trend in both official-sector gold sales and supply from old gold scrap, the expectation of a large and sustained fall in gold mine supply has been a major theme asserted to support a rising trend in gold prices. There is a basis for this argument: mine output has clearly stagnated in recent years, and with the decline in exploration spending during the 1990s and expected depletion at several major ore bodies in the coming years, a fall in mine output is a reasonable conclusion. The main problem with this argument is that it is biased by the experience of Western World gold mining companies and their output profiles in the traditional leading-producer countries of South Africa, the U.S., Canada and Australia. Depletion, rising costs and environmental pressures are causing falling mine output in South Africa and North America, and we expect this trend to continue.
However, although production in the traditional four largest gold producing countries has been falling since 1996, global gold output rose until 2001 before stagnating. This was due to growth in South America, Africa and Southeast Asia, while more recently we have seen growth in the former east bloc. This growth has offset losses from the traditional producers. The potential and current activity in countries such as China and Russia suggests that this trend is set not only to continue but accelerate, particularly given the current level of prices and availability of both equity and debt financing for project development. Given this, we strongly believe that expectations of a significant fall in global mine output are unwarranted.
Central banks
One of the “gold bull” themes that has grown in stature in recent months is that Asian central banks will look to substitute their massive and growing reserves of U.S.- dollar-denominated assets for gold. These hopes and, in some cases, expectations were given a boost in January by the following comments from Japan:
“There are various discussions about the positioning of gold in foreign reserves, even among currency authorities. . . . As it might affect the gold market, we will consider various things carefully. I say something too simply, I think there could be a large effect on gold markets, . . . so I would like to consider it carefully.”
We shall leave aside the reality that the Asian dollar reserves are rising as a result of intervention to prevent currency appreciation rather than any sort of asset allocation decision. Indeed, not only would buying gold not support their currencies, but evidence that Asian central banks were beginning to buy gold instead of U.S.-dollar-denominated assets could well give the greenback a further push lower.
The argument for Asian central bank buying of gold is based on two notions — that they have become overexposed to the weakening U.S. dollar but remain wary of buying either yen or euros, and that the opportunity cost of holding gold has fallen significantly, owing to low interest rates.
There is no doubt that the large Asian central banks have a low proportion of gold as part of their total reserves, compared with European central banks and the U.S. However, it should be noted that Japan (at 765 tonnes) and the People’s Bank of China (600 tonnes) are already among the top 10 largest gold holders and hold a similar amount to the European Central Bank (767 tonnes). The difference, of course, is in gold’s share of the total reserves, where the Asian banks hold a far smaller proportion.
We have tended to dismiss hopes of Asian central bank buying of gold, perhaps jaded by the past decade of experiencing large-scale and widespread central bank gold sales. However, perhaps it is wise to revisit our skepticism:
q Low yield — We could argue that low yields on U.S. dollar assets have significantly reduced the opportunity cost of holding gold. However, gold is not only an extremely low yielding asset but there is also limited lending potential — only around 4,000 tonnes of the total official sector holdings of 30,000 tonnes being lent. The lending market, at present at least, is driven by borrowing demand and this has fallen significantly due to reduced producer forward selling, minimal speculative short selling and depressed physical demand.
q Low liquidity — According to a central bank survey of foreign exchange and derivatives market activity, released in March 2002, average global daily turnover in foreign exchange markets was nearly US$1.2 trillion. This compares with average daily gold turnover in April 2001, according to data from the London Bullion Marketing Association, Comex, and the Tokyo Commodity Exchange, of US$7.3 billion. According to data for the major bullion markets, liquidity in gold is slightly more than in the New Zealand dollar.
q No escape route — The need for European central banks to have an agreement in order to reduce their gold holdings could not be a more stark example of how difficult it is to exit a large physical position in gold. The very existence of this agreement is a major discouragement to other central banks that may consider increasing their gold reserves to a significant level.
q Impossible to build — Even if a major Asian country wanted to increase its gold reserves to a significant level, the gold market is not large enough to allow it to do so without a major price reaction. For example, if Japan wanted to match the European Central Bank’s proportion of gold in its reserves (initially), then 15% would equate to a requirement to purchase nearly 6,800 tonnes. This represents 2.6 years of global mine output and would be impossible to transact in anything other than a massive off-market transaction.
Is there any hope? For believers in gold, there is always hope. Before September 1999, few in the market would have believed that the European central banks would come together to agree to conduct and contain gold sales as a group — but it happened, and fundamentally altered the market.
If one of the major Asian countries had wanted to raise its gold reserves as a proportion of total reserves before the new European gold sales agreement (which increased gold sales to 500 from 400 tonnes a year for another five years), it could have approached Europe with an offer to buy several thousand tonnes in a major off-market transaction. In our view, a massive, single transaction is the only practical way in which a major Asian central bank can increase its gold reserves to a significant percentage of total reserves. Hence, the renewal of the European central bank agreement now effectively dashes any realistic hope of large-scale buying of gold by Asian central banks.
Long-term investors
The arguments for holding gold as an investment — portfolio diversification, an inflationary and/or U.S. dollar hedge, etc. — are far from new. The rise of alternative assets and the recovery in the gold price have seen gold return to the radar screen of some investors. However, after a long bear run in gold prices, the practical hurdles for many potential investors, particularly for institutions, mean that investing in physical gold is significantly more difficult and costly than many alternatives.
However, the World Gold Council has attempted to deal with this through the introduction of exchange-traded funds (ETFs) in gold bullion. These gold ETFs are listed like any other security on an equity market exchange, with each share purchased leading the scheme manager to buy one-tenth of an ounce of gold and placing this in an allocated gold bullion account. So an ETF holder has “ownership” of physical gold but without the complications of taking and storing the metal. The scheme began in Australia in March 2003 and rose at a steady, if unspectacular, rate through much of the year. The start of the U.K. listing was more impressive, with net assets rising to 25 tonnes in the first week. Since then, however, investment has stagnated. The great hope is for a U.S. listing, which has been awaited for some months. It is hoped that the massive level of fund holdings in the U.S. plus a traditionally high level of gold equity ownership will see support for such a scheme.
A report recently published by Barclays confirms that investors requiring inflation protection returns should invest in a diversified portfolio of real assets (equities, commodities and property), combining assets with high and low volatility characteristics. The study found that commodities were the best asset to protect against any unexpected spikes in inflation (and this finding has particular relevance to gold). However, the complexity of the actual returns from an investment in commodities is not widely recognized. It is not an upward move in the spot price but the yield from rolling forward futures contracts that is the most important factor in generating a return in commodities over the medium to long term.
An investor in equities is gaining exposure to the future earnings of a company, and in bonds, is gaining exposure to interest-rate variations, both of which broadly reflect expectations about future company performance and general economic conditions. In contrast, commodity market returns are rooted in the real-time interaction of physical supply and demand. In buying an oil futures contract and rolling it forward through time, for example, an investor is positioned to benefit from the kind of supply-and-demand fluctuations that regularly push commodities, such as oil, sharply higher. Even more important than this is the opportunity to benefit from a market feature unique to commodities — that of backwardation.
However, gold is rarely in backwardation, owing to the large overhang of official- and private-sector inventory that is available to the market at extremely low gold borrowing costs (or gold lease rates). As a result, the enduring contango in the gold market means that there is no yield when rolling futures contracts.
The direct implication of the almost permanent contango market in gold and hence the lack of any yield from rolling gold futures contracts is that total returns in gold cannot be guaranteed to match inflation — the foundation for most pension fund allocations.
The possibility of a U.S. dollar “crisis” is an obvious scenario for which an allocation in gold could be considered. However, studies suggest that commodities are the best assets to protect against any unexpected spikes in inflation. This argument applies particularly to gold, which has, over an extended period, proved itself to be an impressive hedge against inflation spikes and has outperformed most other commodities during these periods. Further, the possibility for an upside surprise in inflation is growing, given concerns about loose monetary policy, private, corporate and government debt levels, inflated property prices, and rising industrial commodity prices. We see this as gold’s strongest argument as a tactical or insurance investment.
In summary, we believe that many of the supposedly bullish themes for the gold market are overdone, unproven or wrong. This does not mean that we will see a collapse in gold prices back below US$300 per oz., though it recognizes that gold prices are likely to come under increasing pressure.
— The opinions presented are the authors’ and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the authors at kevin.norrish@barcap.com and kamal.naqvi@barcap.com
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