All the key trends that have contributed to rising gold prices over the past year remain in place. The strong price recovery in commodities across all sectors continues to attract investment into precious metals and into the gold market in particular; the dollar continues to weaken, drawing attention to gold as one of the few real currency hedges available to investors; the producer de-hedging story is still making headlines; and the strong technical picture that has encouraged trend-followers to buy gold remains in place.
Our short-term view is for gold prices to continue rising. Once investor interest in gold begins to wane, the metal is vulnerable to a sharp correction. However, this is unlikely to occur until concerns over the ability of the U.S. to finance its twin deficits recede and the dollar stabilizes.
Investor buying of gold has been the key factor in taking gold prices higher this year. It is a measure of the amount of investment buying that is required in any one year in order to balance the market. We estimate that the implied net investment required to balance the gold market in 2003 has risen to an astonishing 400 tonnes, from 148 tonnes in 2002. This figure has grown so dramatically in the past few years, primarily as a result of strong growth in supply, which in turn reflects rising official-sector sales and strong growth in the amount of gold scrap being recovered. In contrast, gold demand growth has been unimpressive. So far this year, jewelry demand has risen, but it’s still below its 2001 level, and a dramatic drop in bar hoarding has offset this growth.
Under these circumstances, the gold market has only achieved balance thanks to a massive increase in investor purchases, evident principally in buying on the Comex and, to a lesser extent, the Tokyo Commodity Exchange.
An important factor drawing investors into gold this year has been the strong commodities story across almost all sectors. While gold price drivers are different from the factors that affect industrial metals or energy markets, the strong flow of funds into commodities index products has certainly benefited gold. Gold represents the largest share of the precious metals sub-group that accounts for 17.6% of the Reuters CRB Commodity Index, and it makes up 2.3% of the Goldman Sachs Commodity Index. Although gold’s share of commodity baskets may seem small, the flow of funds into such indices over the past 12 months has been extremely large, particularly in relation to the relatively small gold market. While not the main influence on price, this kind of passive buying of gold has certainly been supportive. The commodity bull market still has some way to run, in our view, and we expect institutional investors to continue to add exposure to their portfolios.
Nevertheless, gold has succeeded in outperforming most of the major commodities indices so far this year and there is little doubt that, in addition to being part of the general commodity story, it has benefited disproportionately from the weakness of the U.S. dollar. The daily positive correlation between gold prices and the euro dollar exchange rate (that is, a negative correlation with the value of the U.S. dollar expressed in euros) has been particularly high at times this year. While the relationship tends to vary, making it unreliable as a trading tool, the average correlation for the year so far in 2003 is more than 50%, and at times the 30-day rolling average has exceeded 90%. Looked at in terms of its trade-weighted index, the extent to which funds have flowed into gold as the dollar has weakened is even more striking. Indeed, it was not until the trade-weighted index (in U.S. dollars) began to descend from its peak in May 2002 that funds switched to playing gold in a concerted way from the long side. Since then, as the dollar has steadily depreciated, the Comex long position in gold has extended to its highest level since electronic records began, in the early 1980s.
While the re-emergence of commodities as an asset class is a relatively recent phenomenon, gold prices have been rising since early 2001, and several other factors have contributed to its steady uptrend. The Central Bank Gold Agreement (CBGA) and the reversal of the net flow of producer gold into the market, which resulted from the buying-back of forward sales, have gone a long way toward altering investors’ attitudes to the precious metal.
However, the weakness of the U.S. dollar has been key in determining the timing and scale of investment flows into the gold market, and has been particularly important over the past 18 months. Not until the U.S. dollar trade-weighted index began a descent from its May 2002 peak did speculators in gold swing from net short to net long on a consistent basis. Since then (more than 2.5 years after the CBGA was announced and more than a year after the bidding war for Normandy set the hedge buy-back train in motion), the weekly balance of speculative positions has traded in net short territory on only one occasion (August 2002), and then at only –476 lots. The message is clear: gold’s ability to move higher over the forthcoming year will depend on the continued weakness of the U.S. dollar.
So far, the dollar has failed to respond to better U.S. economic data in the way that many had expected it to, and despite evidence of the biggest acceleration in economic growth in 20 years, the dollar downtrend has continued. One of the key views driving the dollar at present appears to be that strong U.S. growth will lead to an increase in imports, putting further pressure on the trade deficit. Our foreign-exchange experts point to four factors that could support the U.S. dollar:
— a signal from the Fed that a rate hike is imminent;
— a booming equity market;
— a drying-up of the terrorism threat; and
— concerns from the European Central Bank on euro strength.
Any of these factors could signal a shift in investor attitudes to gold, though we do not believe any are likely to happen in the short term.
The outlook for central bank sales and producer forward sales will also determine whether investors continue to buy gold. Let us consider the outlook both for the CBGA and the trend in producer hedge buy-backs.
The CBGA is due to expire in September 2004, and a renegotiation of the deal will be one of the key events for the gold market in 2004. Since the CBGA came into effect, in 1999, around 1,600 tonnes of gold have been sold at the rate of 400 tonnes per year. During this period, several jurisdictions have filled their sales targets (the U.K. and Austria, for example), while the Netherlands, Portugal and Switzerland will all have outstanding quantities left from their announced sales targets on expiry of the current agreement in September 2004. Given this fact, plus the publicly stated desire of several of the other signatories to be granted a share of any new quota, the total sales figure is likely to be revised upward when the current CBGA is renegotiated.
We believe the central banks that are signatories of the agreement will aim to reduce their gold holdings by around 50% from current levels, following the precedent established by the Swiss National Bank and the Bank of England.
This implies a total sales figure of 5,843.5 tonnes, which, at the current rate of sales, would take almost 15 years to complete. Consequently, the most likely scenario would indicate a CBGA II and III even if amounts were increased. In fact, we believe that CBGA quantities may be negotiated up to between 2,500 and 3,000 tonnes over the next five years, which is substantially higher than the previous agreed limit of 2,000 tonnes. As well as the potential increase in the Central Banks’ desire to divest themselves of gold, this increase can also be justified by the higher gold price and the marked decline in producer hedging over the past 18 months. Nevertheless, we think the effect on investor sentiment of such an upward revision to quantities would be fairly neutral. Importantly, the concept of a controlled supply of central bank gold flowing into the market will be maintained, and possibly even strengthened, while the likelihood of such an increase has already been signalled in advance in the form of public pronouncements from several central banks indicating their desire to increase their sales levels.
Developments in producer hedging over the next 12 months could have a greater impact on the attitude of investors to gold. The catalyst for the funds’ first establishing their long positions in the bullion market can largely be attributed to the prospect of a reduction in gold hedge portfolios after
The subsequent consolidation in the gold mining sector has focused further attention on the different philosophies employed by gold companies, and speculators were quick to exploit the “structural” weakness of the enlarged hedge positions of merged companies at a time of rising gold prices, low interest rates and global political instability. This is illustrated by the relative underperformance of the
However, there is evidence that producer hedge buy-backs are now beginning to wane as a force in the gold market. According to Gold Fields Mineral Services’ third-quarter update on gold supply and demand, the balance of producer hedging activity resulted in a small net inflow of gold to the market in the third quarter, which is the first time it has not contributed to net demand since late 2001. Admittedly, this was partly due to a US$42 increase in the valuation price used to assess options positions that form part of gold producers’ hedge books and so is not conclusive evidence of a change in producer attitudes to hedging. However, many of the major gold producers that were previously in the hedging camp have already changed their approach, and the bulk of their hedge-book restructuring has been completed, in our view.
Furthermore, although companies such as Placer Dome,
We conclude that the dwindling of producer hedge buy-backs is having a slightly negative effect on investors’ willingness to continue buying gold, and that the CBGA, if renegotiated in the form we envisage, is probably neutral. Consequently, the fortunes of the dollar will likely be the major determinant of investor appetite for gold in 2004, and will continue to be a key price driver. If supply and demand trends continue to necessitate large amounts of investor buying in order to absorb the surplus, then further substantial dollar depreciation will likely be a precondition of higher gold prices.
Overview of Precious Metals Markets
— Gold — The yellow metal is grinding higher and has moved above trend-line resistance connecting the highs in 1999 and 2003 at US$400.60 per oz. Trendline supports are progressively becoming steeper, and the implication is that in early January there will be a decisive breakout. As trend-followers, we assume the breakout will be above US$403.85 per oz., which, at presstime, in early December, had not yet been convincingly hurdled. The greater risk is that now that the psychologically important US$400-per-oz. level has been breached, it will result in a return to the highs of the 1990s — around US$418 per oz.
The most recent acceleration in the gold rally that has taken the price above US$400 per oz. for the first time in more than seven and a half years has been accompanied by a strengthening of the market’s fundamentals. The latest data from industry analysts Gold Fields Mineral Services suggest that total demand for gold in the third quarter of 2003 increased by 5%, year over year. Of central importance is the 4.8% year-over-year increase in jewelry demand. During the 1990s, the jewelry market represented more than 75% of total demand for gold on average. While this is supportive, it is important to note that jewelry demand has been stagnating and that this has had a marked impact on gold demand.
Much more important to gold’s recovery has been the increase in investment interest: the average net long on Comex through the second half of the year has been some 81,300 lots, or 8,130,000 oz. This investment demand has been the prime driver of the gold price on its ascent to US$400 per oz. And it is important to bear in mind the nature of this investment demand — activity on the Comex tends to be short-term and speculative, and given the illiquid conditions that persist in the gold market, this is likely to keep conditions volatile.
A key change in recent market fundamentals is revealed by recent industry data showing an abrupt reversal of producer de-hedging, which contributed one tonne of demand to the gold market in the third quarter of 2003 after seven consecutive quarters of declines. It suggests that the high prices are beginning to raise some small interest in hedging again among gold producers despite Barrick’s controversial statement in late November.
The essential factor for gold’s ongoing success will be whether this large flow of investment funds into the market can be sustained.
— Palladium — There are few metals that don’t have an attractive long-term technical outlook after the bull markets this year, but palladium is one of them. This market has not shaken off the effects of the bubble in 2000-2001, and the rally in 2003 has been far from impressive. Palladium is trading below its 60-week moving average, which has defined long-term trends over the past six years (US$215 per oz.), and there is no discernable trend-ending pattern or scenario developing. Trendline support at US$181 per oz. is key in the coming quarter; a break of that line would trigger a return to US$166.25 per oz. and possibly a return to US$140 later in the year.
While the palladium price has recovered from the 6-year low of US$140 per oz., set in April, the recent price range of around US$200 per oz. represents a level not seen since that time. Although the fall is precipitous (April’s low represented a fall of 87% from the all-time high of US$1,085 in February 2001), it is worth bearing in mind that palladium has averaged only US$260 per oz. since 1991. Indeed, excluding the 1999-2001 period, the price has averaged only US$167 per oz.
Some 65% of palladium demand is accounted for by autocatalysts. A central factor for palladium is not the absolute level of the palladium price but its spread to platinum — its major competitor in autocatalysts. For chemical reasons associated with emission regulations, palladium demand grew in the early 1990s. At the same time, large-scale Russian stockpile sales in the first half of the 1990s depressed palladium prices, encouraging a switch-out of platinum and into palladium.
As palladium demand grew, the large-scale Russian shipments of the early 1990s began to falter, with export shipments delayed during 1998 and 1999, and this created extreme shortages of the metal, which continue to tarnish its reputation among consumers today. Russia still accounts for almost 60% of global supply.
With palladium trading at a discount of more than US$500 per oz. to platinum, there have been suggestions that auto manufacturers will shift some of their production back to palladium; earlier in the summer, General Motors announced it is switching from platinum to palladium in some of its autocatalyst models. But while supply remains abundant — supported by ample scrap availability — and demand remains subdued, the short-term outlook for palladium remains uninspiring.
— Platinum — The measured rise of the past six months is impressive. Supported by the 60-day moving average (US$734.95 per oz.), the medium-term uptrend has pushed platinum to its highest level in over two decades, without the rally actually appearing over-extended. The risk is that the slow rise is the prelude to a classic commodity bubble, like the one in palladium in 2000-2001. Provided the average continues to limit the downside, we will remain bullish for platinum; indeed, if support at US$752.50 holds, the spike could begin in December. On monthly charts, trend channel resistance is at US$811 per oz.; if that line is breached, we would expect the 1980 high at US$1,049 per oz. to be revisited in 2004.
Since falling back to the US$600-per-oz. level in late April, platinum prices have been in a steady upward trend, and in early December they moved up to test US$800 per oz. The market fundamentals of platinum remain supportive: on the demand side, there is the increase in autocatalyst demand (31% of end-use demand) in response to palladium’s price expansion in 2000, and on the supply side there is the delaying of South African production expansion plans. In fact, the world’s largest platinum producer,
Jewelry accounts for 40% of platinum’s end-use, with Chinese jewelry now representing more than half of total platinum jewelry demand. While it is obvious that jewelry spending will rely on global economic growth and, more specifically, on the ability of the Chinese government to deliver the 8% growth rates that have become common, barring a global economic collapse, demand growth for platinum jewelry is likely to remain strong. In spite of the rapid recovery in Chinese retail sales following the SARS outbreak, demand for platinum jewelry is not recovering so swiftly. Johnson Matthey forecasts that demand for platinum jewelry fabrication in China will slide to 1.2 million oz. in 2003 — 280,000 oz. lower than in 2002, but still the second-highest year of demand on record.
— Silver — Silver demand is divided into three main components: industrial (41% of the total); jewelry and silverware (31%); and photography (24%). The use of silver in the photographic industry has been declining steadily over the past four years, with the 2002 total some 9% below the 1999 level. Not all of this fall can be explained by economic factors. The increasing popularity of digital cameras, from which only a fraction of photographs are actually printed, and disposable traditional cameras, which tend to encourage recycling of the silver they use, pose a longer-term threat to silver demand. In recent months, however, silver has been gaining fund support in line with both gold (silver is still considered a precious metal and moves closely in line with gold) and the base metals, owing to the large industrial component in silver’s demand profile. These factors have combined to take the silver price to its highest level since February 2000. While both of these factors are offering some support, the spectre of photographic demand in terminal decline hangs over the market’s longer-term prospects.
From a fundamental supply perspective, by far the largest source of silver is as a byproduct in lead-zinc production (35% of the total), and while we do not expect further zinc mine cutbacks, neither do we expect any major mine expansions.
— 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 ingrid.sternby@barcap.com
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