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