Gold price headed down, then up: GFMS

While influential London-based gold research company GFMS Limited is forecasting a falling gold price for the first half of 2006, investors who take heed of the warning might not want to abandon the yellow metal for too long.

GFMS chairman Philip Klapwijk says underlying support for pricing remains strong and gold should make a bullish return in the latter half of the year.

But before getting into the bullish indicators, Klapwijk, speaking in Toronto on Jan. 19, deflated expectations of any investors who believed gold’s recent run would continue unabated.

“In the short term, price correction is probable,” Klapwijk said. “The physical market support for prices has pretty much disappeared at these elevation levels.”

GFMS forecasts that the cooling-off period in the first half of the year will see prices ranging from US$490 to US$550 per oz. with an average price of US$521 per oz. And while such numbers would represent a 22% year-over-year increase, GFMS realizes many investors will label it as pessimistic.

Whether the call is pessimistic or realistic, only time will tell. On this day, Klapwijk was simply outlining the reasons behind the forecast — the most significant being the erosion of the physical market for gold.

GFMS blames that erosion on a decline in jewelry demand and consequently a decline in gold fabrication. It predicts a roughly 25% decrease in jewelry demand for the coming year and a 20% decline in fabrication.

Klapwijk says the decline is directly attributable to the rise in gold prices. As gold becomes more expensive, large jewelry consumers like India demand and therefore produce less of it.

But the jewelry story has a positive element, as well. Klapwijk says buyer tolerance for higher gold prices has significantly increased in just one year.

“We do believe the market will pick up on any significant price dips,” he said.

While a year ago, buyers required a dip into the US$420-per-oz. range to start buying, now he expects revived purchasing to kick in at the $500-per-oz. mark — a big lift in the gold price floor.

But the real antidote for gold’s first-half downturn will have to come from institutional investment, Klapwijk said.

“The most important factor in driving this market higher is investment demand.”

And that’s where things get interesting.

Klapwijk says institutional investors will require an external trigger to move up another gear in gold investment and he thinks the stimulus will come in the form of a weak U.S. dollar.

“We do think at some time the chickens have to come home to roost,” he said. “The U.S. dollar will fall as people start to focus more on its financing of deficits and less on interest rate differentials.”

In further support of the thesis, Klapwijk said interest rates have peaked, and he forecasted a narrowing before year-end. Higher interest rates draw international investment towards the U.S. dollar, and potentially away from gold.

If interest rates push through the market expectation of roughly 4% to 5%, GFMS’ bullish long-term forecast falls into jeopardy.

Other factors Klapwijk touched on that could have a dampening effect on the price of gold are: a peaceful resolution to the Iran situation, a relaxing of tension coming with a U.S. withdrawal from Iraq, and large central banks selling off more gold than expected.

“You can sketch a bearish scenario on all those counts,” Klapwijk said. “But I’d be much more inclined to be on the other side of the argument.”

With the 2006 forecast covered, Klapwijk took time to highlight some of the key factors behind gold’s resurgence in the last few months of 2005.

He pointed to increased demand, driven initially by inflationary expectations, but made more robust after Hurricane Katrina struck and energy prices soared. The influx of investment in energy spilled over into gold and the commodity complex in general — in effect, kick-starting the bull-run according to Klapwijk.

But the most relevant factor carrying over into this year from last, is the increased role exchange-traded funds (ETFs) have played.

While the funds have eaten away at direct investment into physical bullion, they have made entry into gold much easier for investors — supplying strong underlying support for the commodity’s higher price in the process.

“It’s one of the reasons why this market fails to go down when it should,” he said.

The remaining factor Klapwijk outlined was the lustre of a strong gold price, in and of itself — something gold investors hope continues in the coming year.

“Finally, you have to look at price itself. Rising price has certainly attracted trend followers and created excitement,” he said. “It’s in the news, and people want to buy into a success story.”