HAPPY CHINESE NEW YEAR

Last week I drew your attention to the importance of following the patterns of the changing correlations between the gold price and the EUR-USD currency pair.  As I argued, the fall in this correlation should be viewed as an important signal.  And lo and behold – gold has rebounded significantly since the drop-off in the correlation to Euro.  As a result, on Wednesday this week, gold hit an all time high in Euro terms.

This event is often lost on US investors who see the world exclusively through the lenses of the US dollar.  But the US dollar has been used for accounts in America only since 1830s and its dominance as a denominator of international trade and capital flows may have already peaked.  It is therefore crucial to understand how gold behaves in other currencies, as this relative performance has an impact both on the decisions affecting the supply of gold as well as on the demand for the metal.

For the moment, gold denominated in Euro is in a league of its own.  So far, no other major currency has seen the gold price peak since December 3.  Globally, from the perspective of the gold market, currencies fall into two categories.  On the one hand we have the classic “commodity currencies”.  In three of them – Australian dollar, Brazilian Real and South African Rand, gold peaked already a year ago, between February 18 and February 20, 2009.  In the second group we have most of the other significant currencies, including the Yen, the Pound, the Swiss Franc, the renminbi, the US dollar and, interestingly enough, the Canadian dollar, usually considered to be just another “commodity currency”.  All these currencies saw the gold price peak between December 2 and 3 of last year.  Most importantly, this was also the case of the Indian rupee – still the most important currency for physical gold demand, given the Chinese renminbi’s stiff peg to the US dollar.  Contrary to the Chinese demand for gold (more about it below), Indian gold demand is notoriously price elastic.  Encouragingly, the gold price in Indian Rupee is now 8% off its December peak – and some revival of demand could be expected around traditionally auspicious dates.

An investor in gold will naturally pay attention to the currency exposures of his or her own balance sheet.  But s/he is also well advised to look at gold prices in other currencies.  As a rule of thumb, high gold prices in commodity currencies (Brazil, Australia, South Africa) and stable gold prices in gold demand currencies (such as Rupee, but also Swiss Franc) are positive both for gold equity margins and for the underlying floor under the gold price.  Importantly, fat operating margins allow producers to focus on lower grade areas in the mine, assuming that the mine design allows for such flexibility.  This leads, ceteris paribus, to lower volumes of production – and on aggregate should offset the impact of the supply growth from other producers’ rush to push through new projects.

The Chinese demand is a different animal altogether.  In fact, the Chinese gold buying patterns have been the gold bug’s best friend.  Chinese gold demand exhibits strong Veblenian characteristics – typical of the so-called “conspicuous consumption” goods.  Over a hundred years ago, economist Thorsten Veblen developed a novel, “cultural” theory of consumption.  Through his research, he found that much human consumption is driven by habit, convention and irrationality.  Remarkably, Veblen demonstrated that in early, predatory cultures, unproductive consumption was often a proof of prowess and dignity.  Hence the ostentatious attachment to extravagant goods, feasts and gifts, which conferred on the consumer the aura of wealth and importance.

In some extreme cases – as in Africa or among many indigenous populations of the Americas – this ostentation has led to poor capital accumulation and squandering of resources.  But not in China, where the group of common interest is well defined and limited to the concentric circles of families and clans.  Given the unique demographic position of this “one-child economy”, the resources of as many as three generations may now be directed towards the young professionals who live and work in Beijing, Shanghai or Shenzhen.  And much of those professionals’ consumption would go precisely toward ‘status’ goods and investments – among these: a high-end apartment, a big black Buick and… gold.  If you drive these days down the brand new highways of Yunnan, Sichuan or Chongqing, you will be struck by just how empty these high speed routes actually are.  The Buicks are nowhere to be seen because they were bought to show them off to neighbors, not to drive them to another province, where unfamiliar people speak a different language and eat different food.  Last year, the Chinese bought 13.5 million new cars (up from 8 million in 2008), but the gasoline consumption barely budged.  This new vehicle is either parked, or inches around in the main cities’ monumental traffic jams.  Cars are bought because they can be afforded and flaunted as status symbols.  And it is no different with gold – an ultimate aspirational good in a country whose emperor used to wear huangpao – a golden robe.

When at the beginning of this century I studied the elasticity of gold demand to incomes, I was stunned by how steep the demand curve was in China.  PRC gold demand was unlike in any other country because, precisely, it was upward sloping – the more expensive the gold, the more the Chinese bought of it.  The trend has not changed since then, but what has changed is the Chinese consumer power.  For all the bemoaning of the falling contribution from consumption to China’s GDP, in absolute value terms, Chinese consumers have increased their overall spending 3.7 times over the last ten years.  During this formative period of nascent consumption, gold offered them a 10.5% annual return, in renminbi terms.  While the Chinese economic “miracle” may not necessarily outlive the development model based on cheap factor endowment, it has still some way to go.  And this is good news for long term gold holders.

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Tags: Chinese gold demand, commodity currencies, conspicuous consumption, gold demand currencies, upward sloping demand curve, Veblen

Two weeks ago, I argued on these pages that the respite from the Greek panic would offer an opportunity to go long Euro and long gold. After the street recently banked some $8bn on short Euro trade last week, this hope for a “rebound” now feels a bit like a crowded trade. And yet, this mid-term opportunity remains in place. The more the street gets nostalgic about “another ERM” type of trade, the bigger the expected return for patient investors. Alas, the timing is everything.

There are two interrelated issues to consider. First we need to consider the scenarios for solutions to the Greek dilemma and how they may affect global risk aversion. The second is the nature of Euro – gold correlation in the coming weeks.

First, the threat of Greek “default”. There is ample evidence to show that anytime the Street gets excited about the possibility of Greece “leaving the Euro”, “defaulting” or its sovereign paper no longer being accepted as collateral for liquidity operations – the Euro gets pounded, and the commodities are caught in the downdrift, including gold. The “stocks down-US yield down-dollar up-gold down” reaction has been a common feature of these bouts of Greek drama since early December (with similar consequences to the height of Dubai panic). Many of my friends on Wall St are convinced that the end is near and that, under market pressure, the Greek equivalents of Mr Lamont, Mr Major and Mr Hazeltine will eventually throw in a towel just as the Bank of England did in 1992. Yet the stakes are today completely different and the participation in the 10-year old currency union is an entirely different matter if compared to a theoretical 10% trading band imposed on ERM participants two decades ago. For one, there is no mechanism for Greece, or any other country, to simply “exit” the Eurozone. The costs of such a move would be incommensurably higher than the costs of fiscal retrenchment the country is facing now. For starters, Greek Euro-denominated debt would become foreign debt, the spreads would rocket, it would become nigh on impossible to raise new funds, and even if “drachma-2” were to lose the 30% of its value, it would take time for tourism, shipping and retirement industry to reap the benefits from the depreciation. Meanwhile, inflation would jump, debt costs rise and frictional trade costs with EU partners would be reintroduced. However tortuous and painstaking, the help from Frankfurt, Brussels and Paris will come in some form or another – loans, aid with conditionality, joint Euro bond issuance, technical assistance, you name it. Market pressure on Greek spreads and CDS is a good thing to focus the bureaucrats’ minds a bit. But an exit from Euro? You gotta be kiddin’

So in this overwhelmingly Euro-bearish spell, gold and other commodities have taken a breather. In some cases the sell-off has been driven by product-specific sentiment but there is no denying that much of the trade was largely chained to dollar’s renewed strength. We should therefore focus on the second big issue – i.e. the probability that gold would recover from the current support level (or even from 1035/oz) in a convincing fashion should the EUR/USD exchange rate stabilize.

We looked at several historical precedents of strong gold price momentum (in USD) and its relation to the behavior of EURUSD pair. We picked the four quarters during which gold flirted with nominal $1000/oz and subsequently retreated, as well as the quarter during which this resistance level was finally broken, as well as the period during which the metal hit an all time high, over two months ago. In each case, the table below illustrates the preceding month’s returns for gold, EUR/USD, as well as the characteristics of that period daily correlation between the two markets. Finally we compare these months’ volatility and coefficient of determination, and set them against corresponding annual figures (for the 12 months preceding the gold price spike).

First thing that does not surprise anyone with at least a 12 month memory is the unprecedented move in gold in 1Q09, when the physical and ETF interest offset the dollar strength. The market behavior during this period remains an outlier. Only in two cases (Mar 08 and Sep 09), the correlation peaked on the day gold price hit a high, but in both cases the beta between the two markets had radically fallen off over the preceding month, as compared to the preceding year. In other words, the high correlation between momentum-driven gold price swings was accompanied by the fall in the volatility of gold price movements in relation to EUR/USD. Note that overall, long term beta was considerably lower in 2009 than in 2008, which is not surprising, given the uniqueness of market events in 2008.

Where does this all leave us now? Both the long term beta and coefficient of determination have picked up strongly again for Gold vs EUR/USD, but with a tendency for the correlation to ease over the last month (from 0.63 to 0.017). Without a pent-up demand for physical gold (as in 1Q09), this easing of the daily correlation did not bode well for gold returns. In other words, the height of gold – Euro correlation (in late November, early December) was a dangerous place to be, leaving little upside for the market sentiment, short of another Central Bank purchase. But luckily the market has cooled quite a bit since.

The correlation is unlikely to weaken for much longer. What this analysis is telling us is that should a positive signal reverse the current EUR –USD trend, the pick-up in gold momentum may be more akin to moves in 2008, or Spring – Summer 2009, than the relentless run towards the end of last year. Now it’s up to Germans to warm up to Greek shores again.

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Tags: beta, correlations, euro, Greek default, momentum

Earlier this week, ANC’s Youth League issued a policy statement, warning the mining industry of “nationalization [which] may involve expropriation with or without compensation”.

Pity the South African miner. Every day he walks into a dark cage which drops him with a screech some 10 thousand feet (3250m) underground. He then takes a little yellow train which will rattle him and his comrades far away from the shaft. When the train arrives he will walk on in dim light, occasionally plunging his muddy boots into puddles of black water. It is over 40 degrees Celsius (100F) and the humidity rarely drops below 80%. Before reaching the workout, he may need to trudge up a narrow, cramped corridor, slipping on unrelenting scree. It is dark, dusty and dangerous. Packs of explosives lie around, live wires occasionally hang from the walls and many of his comrades are HIV-positive. Worse, several others may have perished in recurrent fall of ground accidents (euphemistically referred to as ‘FOGs’). When he finally reaches the mine face, he will stoop to wield a heavy, yet shaky drill, poking it into the hard, hot rock.

It is a relief to see the sunlight back on the surface. And yet, there has not been much of a relief for South African mining industry. Its safety record has been slow to improve. Attempts to mechanize the older mines have only led to very marginal improvements. And then, there is the lingering threat that the genuine efforts of these brave men (and some women) may again be annihilated by the country’s politics. When in May 2002 the first draft of a new black empowerment regulation was leaked to the press, within several days Johannesburg Stock Exchange index lost nearly 9% of its value. Plans to combine South African giants with their North American counterparts had to be shelved. Averting much more damaging upheaval, the industry leaders engaged in a tortuous process of negotiations which led to the introduction of a new legislation and opened equity pools to business groups led by historically disadvantaged South Africans. Only slowly in this process did the government activists understand that the high profile mining executives do not actually “own” the corporations they managed.

There is no denying that even today the leftist activism retains attractiveness among South Africa’s idealistic youth. South African museums extol the bravery of local Communist heroes in the 1960s and 1970s. Not surprisingly, many ambitious firebrands perceive the legacy industry – mining – as the target of the self-styled “distributive justice” and the State as the main tool to implement such a process. Unfortunately, the experiences of nationalized mining in Africa – from Zambia to Congo – are pitiful. Former mining regions are littered with crumbled installations, devoured by rust, long abandoned by the supposedly salutary hand of the State. If the enrichment of Black Empowerment group in post-2002 South Africa has quite not led to improved conditions in the townships, further ‘nationalization’ threats to the mining industry are not a panacea either.

Where does it leave the South African gold stocks? Since early December, the Johannesburg Gold Stock Index has lost 21% of its value and is now at the level where it was two years ago (February 2007), despite the fact that gold itself – denominated in South African Rand – has since appreciated 74%. Something is clearly wrong.

When South African mining industry ruled the global gold market, its companies were viewed first and foremost as value investments. Deep level shafts required heavy upfront capex and investors demanded a payout from day one. Not surprisingly, the dividend payout ratio was high. The model was jeopardized by the success of North American growth stocks in the 1980s, many of which benefited from the heap leach revolution. These US and Canadian stocks offered no dividends, but reinvested earnings into further acquisitions, promising ‘jam’ tomorrow. For as long as the sheer scale of South African towered over the competition, it did not seem to matter. But the days when one South African company accounted for over 50% of global gold production are now long gone.

South African stocks remain cheap. At current gold prices, and unusually for gold equities, Gold Fields and Harmony have leading P/CF ratios in single digits. AngloGold Ashanti is valued slightly higher – probably due to its portfolio’s lower exposure to South Africa. Some of this discount certainly reflects the higher-than-average cash costs of these producers, at the current ZAR/USD exchange rate.

Although the US dollar has been strengthening recently, the Rand has proved rather resistant. More importantly, later this year the South African mining is facing two step changes which will negatively affect its cost base. First, as of April 1, ESKOM will further hike its power tariffs, an event which has to be taken in the context of overall mining inflation. Then, in May, a new royalty regime will be introduced. The formula is structured in a way that even a loss-making company would have to pay a minimum 0.5% royalty. On average, a profitable enterprise is expected to pay around 3%.

The market expectations are low. The onus will be on the delivery by the management – Harmony is expected to reduce its overreliance on South African risk by proving that it can successfully manage its operations in Papua New Guinea and possibly acquire other assets overseas. Gold Fields – probably the biggest disappointment of the recent years – has to come to grips with the damaging seismic events on its mines. AngloGold Ashanti is expected to advance the turnaround of the former Ashanti assets in Ghana and Tanzania and accelerate the hedge book reduction. The success – or failure of these initiatives is what the investors should watch out for, not the politically marginal posturing by youthful, over-excited demagogues. Unless, of course, ANC bigwigs have used the Youth League upstarts to sound out broader opinion. This time at least, the market didn’t seem to be bothered.

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Tags: ANC, AngloGold Ashanti, deep-level mining, Gold Fields, Harmony, royalty, South Africa, value investment, Youth League