I have recently had an opportunity to visit Germany, the famed hotbed of last spring’s physical gold demand jaunt. The image projected onto the global markets was one of Lederhosen-clad savers, spooked by the specter of a collapsing Eurozone and ploughing their nest eggs into stylish Wiener Philharmoniker and Krugerrand coins. German and Swiss desks registered record inflows just as the Indian physical demand continued to weaken.

Now that most of the reassured German savers are driving their distinctive, white caravan vehicles onto the beaches of the Mediterranean, some of the Euro-scare is gone. The recurrent, invariably negative debt news from Ireland, Spain or Hungary fall short of denting Euro’s progress, even against the currencies whose central banks are now on a firmly tightening cycle.

Yet the underlying interest in the physical gold has not disappeared. Rather, it has taken a breather – and every time this happens after a spell of buying panic, speculative gold demand falls off. Such conclusions are easily reached by comparing the Comex positions – good 5moz off the recent highs – and the global gold ETFs, at 67.2moz still notching all-time highs in volume (even though the biggest product of all – the GLD – has suffered redemptions of late). Should this process of bifurcation between long-term buy & hold behavior and speculative trading continue, some time later this year the total ounces under the ETFs may tower as high as three times over the Comex long positions.

German press is full of articles expounding on Euro-skeptical Teutons’ sudden urge to succumb to the yellow glitter. Some academics went as far as to seek evolutionary explanations to the phenomenon. The apparently irrational drive to place savings in non-yielding assets is, according to German psychologists, a response to the basic, atavistic survival fears. Whenever such fears surface, the simplest strategies are always considered first. The simplicity of physical investments would benefit gold, silver and other tangible assets. Such biases in favor of familiarity are well known in behaviorist literature under the term of “ambiguity aversion”. The illusion of competency is one of the aspects of ambiguity aversion and can be easily applied to the behavior of German investors, few of whom can be considered gold market experts (even though for many years there has existed in Germany an OTC gold equity business for retail investors, along with independent, yet highly specialized brokers and analysts).

The underlying assumption of any such comments is that the German equity market with the median dividend payout ratio three times the Japanese levels should remain the adequate destination for “rational” behavior. But individual investors in Germany are also much more skeptical with regards to the merits of their local treasury market, even though the flagship 10 year Bund has actually outperformed JGB of the same maturity by some 30bp so far this year. A generalized aversion to debt has been again underlined by Angela Merkel this week, when she stated that her compatriots would only increase their consumption when the public deficits appear to be under control. Any stimulus would be instantly annihilated by a deeply ingrained beliefs akin to Ricardian equivalence. There is some truth to such claims. I vividly remember visiting German investors several years ago. At a time of low risk aversion in the markets and handy capital inflows into the most exotic frontier projects, Germans we met required that the gold companies run balance sheets with only assets and equity – and thus reflect more adequately the liability-less character of their underlying asset.

Delving deeper into the nature of those “fears”, reveals a deeply embedded Angst over a possible replay of the 1920s style hyperinflation. Equally relevant are lingering concerns regarding longer-term wealth erosion. Interestingly, this fear of loss of wealth is common even among Germans with stable jobs and earnings prospects. Psychologists point out here that German investors are generally more conservative and more risk averse than their American counterparts. One could add to it comparatively poor understanding and even an aversion to capital markets in general. Some of the experts even believe that should any signs of insolvency among Landesbanken return, German investors’ behavior could even jeopardize liquidity of those investment markets where large overseas players and large local public institutions are not overwhelmingly present.

By anchoring on the painful experiences of the 1920s, German investors too often exhibit overconfidence in the doomsday scenario of a debt-swept common currency. The range of probable outcomes for the Eurozone is certainly a lot wider than outright implosion. However, if Euro-skepticism is the main driver of diversification into gold, then it would mean that Germans do not really consider gold an alternative to equities and fixed income. Rather, gold appears as an alternative form of cash whose value responds inversely to deflation/inflation than any other form of cash. Ironically, should this be the underlying reason for stocking up gold bars and coins last May, then this allegedly irrational investment behavior re-emerges with distinctively rational tones.

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Tags: behavioral economics, German gold investment, gold coin demand, psychology of gold investment

The Economist magazine is commonly known as the world’s most reliable contrarian indicator.  And it stays faithful to its fame.  Half way through the northern summer, the Economist has now proudly sported a front page headline: “Why gold has probably peaked”.  The gist of the three page article offers a factually adequate background look at the gold market and its various facets.  But short of bold assumptions about the global economy soon returning to (under-defined “normality”) and the terminally diminishing Asian demand, there is little that would help the reader where the conclusions (and the title) of the article actually come from.

The article offers a perfect opportunity to reiterate our belief that gold has (“probably”) not peaked.

First and foremost, the fact that gold hit a recent high at $1263/oz tells us nothing about the potential of this asset to move in price up or down.  Nor does the all time high of the 1981 ($2185/oz in current dollars) tell us anything more.  Gold bugs would love us to believe that the price somehow has to “revisit” these levels.  Gold bears believe that the price may fall to long terms lows of 2001.  Both arguments are nonsensical.  There is nothing in the 30 year chart of gold prices that tells us what could happen in future for the simple fact that gold is not a mean-reverting commodity.  This is because it resides outside the simple supply and demand framework.  With 7000 days of inventory available for consumption it could just as well be lying worthless, but it is not.  And nor are there 30-year mean reversion “cycles”.

Once we have cleared this misconception of naïve chartism, let us focus on what we believe are 10 good reasons for gold to still surprise us, on the upside.

1.  Scarcity of safe haven assets in the global investment universe.  Currently, the Treasury debt of US, Germany, Japan, (sometimes) UK, and, by extension, US dollar, Japanese Yen and Swiss Franc offer the safety valves par excellence.  Gold does not offer a yield and trades more like a (small) currency.  But it is a currency that cannot be debased by the whim of central banks, many of which are slowly losing their orthodox monetarist armor.

2.  The debt overhang in the OECD economies has forced the authorities to begin the tightening cycle by imposing austerity measures.  Too much austerity cold dip the brittle global economy into recession.  A more plausible scenario is that fiscal austerity has to be offset by continued loose monetary policy.  By allowing the inflation rate to run ahead of the nominal interest rates, some of the debt is monetized, alleviating the burden, but also guaranteeing negative interest rates – tested friends of non-yielding assets, such as gold.

3.  Should the double dip become a reality, further monetary activism by central banks cannot be ruled out.  Whether this means a new wave of unsterilized QE or other forms of liquidity operations, any signal of further injections would benefit gold before other assets climb upon the bandwagon (as the lessons of late 2008-early 2009 showed us).

4.  Gold lease rates remain stubbornly low despite the fact that Libor has now rebounded from the record lows it enjoyed since late summer 2009.  Low lease rates are negatively correlated to gold prices due to the nature of the gold value chain and inventory financing.

5.  Emerging market growth continues.  In several large emerging markets, gold is a conspicuous consumption item.  Even if the jewelry demand slows down (as it has over the last 2 years), the very pace of growth in wealth accumulation portends well for the demand in the longer term.  For this to happen, the momentum in the appreciation of gold (in local currency terms) has to slow down, and, importantly, the gold industry has to ensure that attractive product appears on the market for the new generations of more affluent, urban consumers.

6.  Central banks are net buyers.  The history of the last 20 years is one of central banks selling gold.  Not anymore.  Western central banks have used only 10% of the 400t annual selling quota.  Meanwhile, there is no purchase quota for central banks which continue to accumulate $640bn in foreign reserves annually.  Thanks to the purchases by South East Asian, South Asian, Central American, Middle Eastern and Russian central banks, for the first time in decades, central banks are now net buyers of the metal.  The combined forces of the current account surpluses and the injection of western private surpluses into the emerging markets ensure that the continuation of this trend is highly probable.

7.  The recent liquidity shock means that most global economies are now engaged in competitive currency depreciation.  The market frontruns some of that activity.  While it is often lost on casual FX observers focused on specific currency pairs, long term trend in most currencies is one of progressive debasement – captured well if the currency is denominated in gold price, or – among the western economies – on a trade-weighted basis.  This is the world of competing weakness – dollar vs euro.  Gold aligns its destiny with the one which is periodically stronger, flipping the correlations in the process, and showcasing long-term asymmetry to these two dominant currencies.

8.  There is a broad consensus that a recovery, should it occur, would be highly inflationary, given the $3 trillion of stale liquidity now hoarded in private (corporate and household) surpluses in the western world.  This remains one of the main reason why the recent purchase of gold by European investors focused mostly on allocated physical holdings, rather than “gold-backed” products.

9.  Inflation is, however, clear and present danger in many emerging markets.  India is a prime example, with reserve requirements AND interest rate increases introduced to slow down the runaway prices.  India could be the future of many other emerging markets, as they continue to shift away from their overdependence on exports.  The development of domestic consumption, in absence of strong currency, would be inherently inflationary, but could be necessary if the US consumer does not recover its $11 trillion dollar purchasing power anytime soon.

10. Finally, gold as investment continues to be a tiny market.  Only 2.5% of the overall gold stock is traded annually.  A little over twice that much is available to equity investors worldwide (both in ETF form and as gold mining stocks).  This is the the equivalent of the value of 300moz – roughly three and half years of the global gold production.  There is little chance that this production accelerates in the near term.  Consequently, the gold market is dependent upon continued sales of secondary product.  Only this flow – from the used jewelry in Asia and the Middle East saves the gold market from dangerous bubbles.  And let us hope that it continues.

The Economist was right in the article, underlining the importance of the jewelry market.  There is no robust gold market without successful jewelry sales.  But the jewelry does not drive the gold price, it provides a floor under the gold price, responding to the prices determined in the global markets.  Ten years ago, the jewelry volumes were twice the current level.  The gold price was too low even the Economist’s most vocal bears.

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Tags: 10 reasons to believe in gold market, Economist, gold price future

The week-long pullback in the gold prices is throwing pundits into yet another bout of déjà vu. Indeed, in the northern hemisphere, it is now summer, and a fairly hot one in most capitals. And every summer, far away from the Krishna-tinged dark monsoon clouds, the gold investor sets her nets as deep as the pool allows. Greedy simulacra of value investment are supposed to resurface with vengeance as soon as the days get palpably shorter and cooler, auguring well for a yummy harvest season in September and October.

Since last October, the gold market has experienced five significant pullbacks, the strongest of which occurred after the record highs of early December. Within two weeks, the profit taking and liquidation of spec longs sent the prices down 11%. Since then, a paradigmatic shift has occurred in the gold market. While the December highs were achieved with the then predictable 89% correlation to Euro, six months later, gold hit an all time high while correlating positively 90% to the dollar. Last week’s strengthening of the Euro in response to reduced perception of banking risks in EU is the mirror image of how dollar’s strength would have affected the bullion throughout most of the noughties. We humans like investing such turnarounds with meaning. And the meaning of this correlation flip can be reduced to a simple quip – gold aligns its destiny with what, at that point in time, is perceived as a “stronger” currency. There was nothing secular and eschatological about its long-term correlation to Euro. There is nothing unavoidable about its current relationship with the dollar either.

As is usually the case, gold equities have suffered during gold’s recurrent retracements, but the worst pullback in GDX index occurred in January. December was more damaging for large Canadian stocks, as if the specialist fund liquidation had waited for a confirmation of a trend-breaking pullback. At the time of writing it, it is the Canadian mid-sized stocks (between C$1m and C$5m market cap) that suffer mostly in the market, but this group has already notched an impressive 59% return year-on-year, performing twice as well as gold itself or as generic gold stock indexes. Such divergence is not necessarily surprising in light of the recent survey by FundQuest, which has found that only four types of active portfolio managers consistently outperform passive indices: experts on currencies, small-cap growth, Asia-Pacific diversified equities and… precious metals companies.

How much deeper should the current pullback dig? Over the last week, GDX is down nearly 8% and mid-sized Canadian stocks over 10%. If the experience of the last 10 months can serve as a guide, then another 4% to 10% drop would not be surprising. Yet if that happens, and the upward trend does not resume immediately, it could yet be one of the worst summers for gold equity investors.

In fact, with the exception of the memorable August of 2008, the July-to-mid-August losses on gold stocks have been less than dramatic and on average the 10-year seasonal negative performance is only 4.5% in North America and 6% in South Africa. Gold itself is known to have recoiled by little more than 1%, on average, during this period.

There are three factors that could pull the gold equity performance either way this year. On the one hand, the broader equity market is in shambles, scared of global deflation, stoked by fiscal retrenchment in Europe and increasingly aggressive interest rate activity in price-volatile emerging markets. Regardless of how resilient the gold prices stay throughout the summer, the gold stock holders’ fortunes are not immune to broader sell-out in the equity market. The analysts’ cry of “deeper NAV discount” could be comforting, but the reality is that such deep discount could itself prefigure poor future returns on the underlying asset.

This would be a real worry if gold’s forward curve and lease rates exhibited behavior of growth-dependent, mean-reverting commodities, such as copper, iron ore or metallurgical coal. This is not the case and the binary deflation/inflation cloud which hangs over the markets may explain to some extent why this year’s seasonal weakness may be less pronounced.

The answer, as it often is the case, has to be sought in India. As the wholesale price index jumped to 10.2% in May, the price pressures began to seep from the visible food and energy items, feeding back into the manufacturing processes. This week, the Reserve Bank of India has acted decisively and off schedule, jacking up the rates by 25bp. The inflationary vise has now led to a general strike and an even more general feeling of overheating unease. Not surprisingly, as gold approached $1200 for the first time in two months, Indian buyers resurfaced with volume orders unseen since last January. Such strong demand points to a very robust floor under what could be a less depressing summer.

What could make the bottom fishing even more promising this year is the general nervousness injected into the market after the revelations of larger-than-life BIS gold swaps. While it is true that the liquidity-seeking central banks are ready to go beyond money market activity, the fact that cash strapped monetary authorities use gold as collateral, rather than sell it outright within the constraints of CBGA, is a positive signal.

Happy fishing.

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Tags: gold equities, gold seasonality, gold swaps

Amid the return of global uncertainty and market volatility, the end of the second quarter of this year has seen off the 7th straight 3-month gain in gold prices. Indeed, no other asset class can compete with gold’s current “for all seasons” performance.

Yet lurking behind the gloss, there is a disturbing sign of global asset underperformance, increasingly shrouded in murky tales of impending deflation. It is a global picture of cash being hoarded by the private sector – companies and households alike. Most of these funds find their way back into the Treasury market of the perceived “safe” (read: sufficiently liquid) countries. Whenever the shift of capital into sovereign debt crosses a currency divide, the returns on gold holdings by local investors are heavily affected. And while gold notched up in the last quarter an impressive 22% in Euro, 16% in Canadian dollars (hitting an all-time high on the last day of June), and nearly 12% in USD, it only yielded pale 4% for Japanese investors.

European investors were the supposed winners in this global rush to capital preservation. Their 22% gain in gold largely reflected the loss of Euro’s purchasing power. A trade-weighted Euro lost 9% this quarter. And while it ceded 22% of its value to gold, it also fell against the Yen (11%), US dollar (9%), Swiss Franc (7%), and the pound – inexplicably buoyed by the market’s infatuation with UK’s new budget. Only the commodity currencies, spooked by the unexpectedly softer Chinese data have lost more ground than the common currency. In particular, the Aussie dollar has been penalized by the capital flight back to Japan.

In response to China’s sobering PMI numbers, the commodity rout has been widespread. Over the quarter, zinc has lost 25% of its value, iron ore 24%, lead 19%, copper 16%. Many of these metals are important buy-products of gold producing companies and can seriously affect the mines’ cost structure. As for oil, the correlation to gold has turned negative and the oft-watched gold/oil ratio hit record spreads twice during the quarter.

But while bullion and gold ETFs offer some solace to those who see debt monetization as an inevitable outcome of the current strains in developed world’s public finances, the mainstream investor is suffering from poor equity returns and scrams headlong into the Treasury market. Increasingly signaling serious deflation risks, the 10-year US Treasury yield dipped below 3%, bringing the returns to 4% over the quarter.

Not surprisingly, a crater has opened underneath the global equity market. In the flight from risk, global equities (MSCI world) returned negative 13.5% this quarter, while S&P500 has lost 10.9%. By comparison, the gold stocks’ performance has been stellar, yet in absolute terms it has been all but.

In fact, as the gold price continues to advance across all currencies and the commodity currencies are now suffering from China jitters, the returns on gold mining stocks have been trailing, yet again, the bullion’s gains. In a mean-reverting industrial commodity, such a yawning discount to NAV would presage a sudden collapse of the value of the underlying commodity (as was the case with many commodities two years ago). Are gold stocks now sending a warning shot?

In fact, the performance of global gold stocks varied widely. Asian equity markets are a depressing spectacle these days. Hong Kongers in particular are happy to swap their wealth into a bet on an IPO of one Chinese bank. Hong Kong market has lost 6.5% over the quarter and its gold stocks returned “only” 11.25%. Australian gold companies enjoyed somewhat of a late rally in June, leading to a 12.6% return. In North America, gold mining companies compare favorably to the broader market: GDX index returned 17%, HUI index 16%. The biggest winners were South African miners, with 17.9% return (most of which occurred in April – May) and London-listed gold stocks with an impressive 20.69% vs only 13% gains for bullion denominated in the British Pounds. London is one market which continues to favor gold equities over ETFs – a fact certainly not lost on the executives of the nascent Kazakhgold/Polyus giant.

All this means that the global equity sell-off has affected the performance of gold stocks even though the companies’ top line, cost of capital, inflation pressures and currency movements have all conspired towards higher margins. Indeed, since gold stabilized after hitting the most recent all-time high in USD terms (June 18), North American gold stocks have slipped around 3%. At the same time, exploration stocks, as measured by GDXJ index, have tumbled 9.2% and returned a relatively paltry 8% over the quarter. Not surprisingly, most exploration-focused gold funds registered a loss.

It is hard to imagine that the monetary and fiscal authorities would stand idle if the global economy began to slide into deep deflation, a scenario which may not bode well for the gold market. Yet many of the gold stocks are now attracting multiples more akin to industrial sectors dependent on the robustness of global demand. The outcome is binary. Either they are becoming a dangerous value trap, or should be treated as a tremendous opportunity should the current deflationary scare ease.

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Tags: gold and currencies, gold exploration stocks, gold quarterly performance, gold stocks