The end of the third quarter has seen, as usual, some extraordinary market moves. This time, much of the action has concentrated in the currency markets and, given the use of the dollar to denominate many physical assets, in the commodities.

Gold has been the chief beneficiary of these moves – especially throughout September. Yet those who see the root of the precipitous dollar decline in the Fed’s announcement of September 21 should look further back. In fact, Euro-dollar exchange rate outperformed dollar-denominated gold by 3.22% over the quarter and by 1.37% in September. The acceleration of dollar depreciation, measured in gold terms was therefore progressive and bolstered further by the expectation of QE2, rather than triggered by this.

Yet DXY shows a different picture. The trade-weighted dollar has lost 8.53% over the last quarter, with the bulk (4.65%) of the losses concentrated in September. The broader basket is, of course, broader mostly by the brim of the Japanese Yen, and the BOJ’s intervention in mid-September was the key factor precipitating capital flows into the Euro area. European gold investors, who now sit on 4 months of paper losses, have thus mostly Tokyo to thank for this, but should throw into the bunch of culprits also Mr Juergen Stark, Executive Member of ECB’s Board, who reassured the markets of the planned phase-out of unorthodox liquidity measures in Europe. Compare this to the Fed’s stance and the expected QE2 come November (and the similar plans by the Bank of England), and the mid-term picture for Euro appears resolutely rosy. Pity the European buy-and-hold gold investors. Pity the German exporters.

A longer term look at the correlation between Euro-gold and dollar-gold reveals some interesting changes. Over the last 5 years, the correlation has become much more volatile. Coefficient of determination is also falling progressively, with each subsequent year. Is this divergence foreshadowing the headline grabbing ‘currency wars’?

But the third quarter has seen some other extraordinary moves in the gold market – not necessarily associated with the forex. First, realized gold price volatility dropped in the last week of the quarter to a 5-year low – a wonderful opportunity to go long vol. Unusually, the record (dollar) prices continue to break all-time nominal highs just as the gold lease rates rebounded from the historical bottom. Although they remain in negative territory, it is remarkable that they have picked up at all – in the context of flat LIBOR and record high spot prices. Finally, the demand for protective put spreads for the end-of-the year have picked up significantly, reflecting fears of the sustainability of the current price ride.

Throughout all this, the forward contango has remained as boring as ever. We have seen a little bit of flattening over the month, even as the curve shifted in near parallel fashion, especially at the end of the “quiet” summer season.

On the equity side, the quarter gold medal goes to the often dismissed Hong Kong golds (up 26%). The Australian gold equities moved almost in synch and registered significant gains until a wave of healthy profit taking in mid-September swamped the market. London gold stocks reflected gold’s ambiguous moves in GBP terms and returned barely 1%. South African gold companies have suffered slightly negative returns during the quarter, as ZAR kept in step with the EUR, thus strengthening on a trade-weighted basis well beyond the long-term assumptions of both producers and analysts. Platinum stocks did even worse…

In the Western Hemisphere, this was the time to enjoy exploration and small-stock gains, with the renewed attention driven by drilling results, strong seasonality and investment conferences. GDXJ returned 26% over the quarter, followed by Tier II producers (24%) and large Canadian stocks (10%). Yet nothing could beat the silver producers, who registered a stellar quarter, with 31% return, almost twice the gains of the underlying metal. Interestingly, although silver stocks’ premium to silver has increased, the beta to the underlying has eased over the last year.

October is (almost) upon us. Hold on tight, because a near term correction is coming soon. It will not be too deep nor too damaging, but the combination of inauspicious Indian dates, Chinese holiday and overstretched dollar selling is begging for prudence.

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Tags: gold dollar correlation, gold equities, gold euro correlation, gold in third quarter, gold volatility

The conference season is upon us. The luckiest of us are now trekking to Denver, then onwards to Berlin and then to London. As it happens during yet another period of heightened interest in the gold market (as increasingly frequent calls from generalist and multi-strat – oriented friends testify), the collective cerebral power of pundits is weighing, yet again, the bullish and bearish arguments both from the cyclical and structural perspective.

It was not different this week at the Denver Gold Forum. 13 years after I joined this caucus for the first time, it was yet another opportunity to refresh the dusty capacity of face recognition. This was not too much of a test, as most of the gold market insiders look happy and youthful these days. Undoubtedly, happier and youthful-er than investors in many other sectors.

During the conference, the Denver Gold Group organized a “debate” in which two well-known commentators sparred verbally in what was an occasionally entertaining, but largely unsubstantiated exchange. As a result, I left the proceedings intellectually puckish, rather than fully satisfied.

The bear’s argument boiled down to a cautionary story centering on the sustainability of the investment binge. He countered the highly publicized view that gold remains “underinvested” if compared to other asset classes by pointing to the fact that all gold is homogenous while credit products are not. Therefore, in comparison to specific classes of, say, treasury, muni, corporate or other yielding assets, gold is no longer a tiny niche market awaiting discovery. More ominously, the gold market now depends fully on new and sustained flows of investment demand. The moment the growth of investment flows stops, there will be little, if anything at all, to stop a sudden slide of the gold price. Naturally, any hint of higher interest rates could provide such a signal (the debate was held a day before FOMC’s allusion to new asset purchases).

The bull then made his thesis, based on well-known macro observations (unresolved imbalances, lack of exit strategy from the liquidity binge, further liberalization of gold markets around the world, central banks’ attitude towards gold). There was little novelty to these arguments, widely shared among the audience.

The bear’s long-term vision was one of a re-invigorated US growth and central banks re-establishing credibility by linking today’s consumption with future consumption via a more realistic interest rate regime. This would raise the opportunity cost of holding gold and change price expectations of Indian traders, who would react by liquidating inventory. Eventually, other asset classes would return to favor.

On balance, I found the bear’s views more attractive. It is undeniable that no market ever moves in perpetuity in one direction – and nor should gold. It is also true that the underlying jewelry demand is fragile. However, one could have issue with the argument concerning the alternative asset classes. Most US and European investors are constrained in what they can purchase strategically with attractive cash flow profile. Farmable land, high risk private equity in frontier markets, scarce (illiquid) commodities, Renminbi-denominated bonds – may be available to some sovereign wealth funds and alternative vehicles, but will not address the concerns of the ageing baby boomers. Essentially, the post-2008 obsession with capital preservation leads to a binary market in put options – protection against deflation (hence the record-low yields) and against inflation (gold for most of us, copper for the Chinese).
As FOMC proved yet again this week (and BOJ last week), the fear of deflationary vortex entices monetary authorities to lean towards inflation risk. This is understandable for as long as bank reserves remain high and the entrenched output gap protects the developed economies against inflationary pressures. As I have argued on these pages previously, gold provides a good litmus test for what increasingly appears as a series of competitive currency debasements – either through direct intervention in the FX market, or through ultra-accommodative, unorthodox monetary loosening.

These underlying conditions are unlikely to go away any time soon. There is something fundamentally broken in the US job market, which, coupled with the staggering number of yet-to-be foreclosed properties feeds back into the consumption loop making a mockery out of “lagging indicator” from economic textbooks. Still, the short term indicators for the gold market are not encouraging. As the market is testing $1300/oz, much of the action is concentrated in the US dollar (and in Canadian dollar). Unlike last June, this month no other major currency has registered an all-time low against gold. The unhelpful exception is the Indian Rupee. Although one Swiss bank mentioned robust buying from India at $1270/oz, the record prices in local currency terms are unlikely to support the floor under the market as we are moving to a weaker seasonal period on the subcontinent. The impending holidays in East Asia and recovering lease rates are also mitigating against a stronger support for the prices. But the anticipation of a return to aggressive QE on Nov 3, the uncertain timing of AngloGold Ashanti’s hedge book buyback and political outliers (e.g. Beijing rocking – a Japanese – boat) could ensure that any such correction could be shallow and short-lived. Neither bull nor bear, and even broncos need some rest.

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Tags: alternative investments, Denver Gold Group, gold bear, gold bull, gold investment, Indian gold demand, monetary policy

As the record-setting gold market (and the very sympathetic gold equity market) are reminding us, we have now entered the seasonally friendly environment for the investors who patiently tread through two and half months of relatively uneventful lull.

The seasonal theme inevitably brings us back to the question of demand and Indian demand in particular. After all, late August to mid-September period is known to have brought positive returns in every year except the sadly memorable 2008. We have previously devoted these pages to the misunderstandings surrounding the changing nature of Indian demand seasonality. In light of the summertime reports heralding the alleged “end” to Indian infatuation with gold, it is worth reviewing the recent ebbs and flows in the context of the changing Rupee price of gold.

We have looked at the last three years, using the western (Gregorian) calendar. We do realize that many (though by no means all) of the gold purchasing patterns in India are related to the lunar calendar, but we have elected to reflect the fluctuating nature of Indian demand with respect to Western investors’ seasonal perceptions.

We delved into the demand patterns both from the perspective of the jewelry and investment market in India. We cross-checked these data with average intra-period Rupee price levels, price volatility and volume changes. The investment demand, dominated by retail bars, medallions and recently also small 24-carat coins (worth around $20 each) represents between 20% and 30% of the overall demand. The investment component peaked in 2007 – 2008 and has yet to recover to the levels prior to the massive dishoarding that occurred in early 2009. The circumstances of the first quarter of 2009 went well beyond the traditional “seasonality” and were associated with drop of incomes, mainly due to the sudden fall in exports and remittances.

Overall, as could be expected, Indian investment flows are inversely correlated to the Rupee prices of gold. No such inverse relationship can be detected in the case of the jewelry demand. Although the correlation is not statistically significant (0.16), it is nonetheless positive. The functional characteristics of the Indian demand ensures that the jewelry flows slow down, but do not reverse during the periods of high prices. Interestingly, this caps the potential for further increase in scrap supply. Again, the first quarter of 2009, which was marked by massive re-melting and volume-neutral jewelry exchanges, constitutes an outlier.

The old adage goes that in India it is the volatility of gold prices that counts, rather than the level of the gold prices itself. Even a cursory overview of the last 12 quarters bears out this popular thesis. Jewelry volumes have a negative -0.25 correlation to price swings in Rupee terms. Investment volumes seem to be less sensitive. The picture is again reversed if we compare the price volatility with inter-quarter changes in volumes. High volatility appears to have a strong negative correlation to changes in jewelry purchases (-0.5) and an even stronger negative relationship to the rate of change in investment flows (-0.62).

What does all this mean for the gold market in the near term? As we get closer to Pitru Paksha period, when many Hindus give Shraddh offerings to honor ancestors, the demand is bound to slacken a bit, as this two week period (starting late September) is considered inauspicious. This means that even lower levels of price volatility could dampen demand, especially in the South and West of the country. The “modernization” of India notwithstanding, it is prudent not to underestimate the traditional drivers of (and brakes on) the gold demand. For example, the second quarter this year saw a slight drop in both jewelry and investment purchases even despite the marketing efforts surrounding Akshiya Tritya festival. This slowdown could be associated with the addition of the extra month in the lunar calendar (Adhik Vaishak Maas), which is not considered auspicious for gold purchase (sweets are more commonly offered). Luckily for gold investors, Adhik Maas is added to the calendar only once every three years.

Beyond mid-October, as move towards the second wedding season, things will clear up again. This year in particular, the demand should be robust, thanks to plentiful monsoon. 70% of Indian gold demand is still rural-based and the growth of rural incomes in excess of local gold prices is critical for further demand. Only very high volatility of Rupee gold prices could snuff out this opportunity. Let us hope the gold prices do not accelerate too fast before Diwali on November 5.

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Tags: gold price volatility, gold seasonality, Indian investment demand, Indian jewelry demand, Rupee

Last week we briefly illustrated the complexity of the issues facing decisions of an investor in gold mining stocks.  Luckily, not all dilemmas are as intractable as the eternal notion of risk and the premium demanded for risk exposure.

In fact, many technical questions that can be asked are of binary nature.  This is not unlike the process of physical investment into a mining project.  The executives and the board have to first determine the strategic issues (open pit or underground, mill or leach pad, combinations thereof), followed by tactical pre-feasibility considerations (shaft or ramp, selective mining or bulk, mechanized or conventional) and operational decisions.  As the production rate and fleet size are determined and the cut-off grade is known, the investor may start to run her own numbers on the costs involved in the production.  These will differ for even comparable technologies depending on the location of the project.  Finally, the currency exposure has to be taken into account, as Brazil-focused miners have painfully experienced recently.

In the Western world, a successful small-scale gold project will have taken about two years from the discovery to reliable level of measured and indicated resources that could trigger bankable feasibility study.  A Chinese company would probably be able to halve this timeline.  For anyone else, it will be another two years before the commissioning of the mine and preliminary production.  An investor following an exploration story from the first discovery will have by then spent four years observing the company’s progress.

These four years can be a frustrating experience for anyone but the most ardent supporters of the mining entrepreneurs.  During this time, the development company undergoes several overlapping cycles and its market cap reacts accordingly.

First, we will have the 4 full cycles of previously discussed gold “monsoon” seasonality.  Chances are that they will affect significantly the market value of the company.  Secondly, as the company moves forward with the financing schedule, through a combination of bought deals and project financing, it may be subject to adverse (or beneficial) fluctuations in risk aversion and occasional liquidity clouds.  A bank-enforced decision to hedge a portion of future production could have lasting consequences for the company’s capital structure.  Finally, and most importantly, the company will be subject to a tsunami of investor interest around the time of the deposit’s discovery, but the influx of capital will subsequently peter out until the completion of the feasibility study.  How painful this process is will depend on where the feasibility takes place against the patterns of the financing and gold seasonality cycles.  Note that the seasonal consequences differ depending whether the project is located in deep Canadian north or in the Southern Andes.  Post-feasibility, the company is likely to get a boost from the announcement of construction.  Down the line, the project will be valued on the basis of future cash flows (rather than call optionality) and will fall in line with high-growth competitors.

From this point on, comparables can be run with existing projects of established companies.  The grades, continuity of the orebody, contaminants and their impact on processing, the tonnage, the dilution (how much unwanted stuff is mined), the recovery (how much desired stuff is left in the ground), changes to stripping ratio and flexibility, prospects for further resource upgrade and resource-to-reserve conversion, brownfields potential, mining, milling and G&A costs, fleet and circuit optimization initiatives, depreciation, taxes and voila!  A meaningful relative value comparison is possible, with applicable sensitivity analysis.

If all these considerations are adequately factored in, and the investor remains sanguine about the prospects for the gold market, then the last hurdle is the build-up of a sufficiently diversified portfolio.  The difficulty with shorting many of the new names and the unavailability of traded options means that the portfolio will have a strong long bias and possibly some unsystematic risk included.  There are time-tested ways to steepen the security market line leading from the risk-free level: combine the subportfolio of tier II tickers with large companies (which are cheaper to short), spread the risk geographically, ride the wave of the market value cycle (mentioned above), include gold companies domiciled in markets with low correlation to the dominant (North American) gold equity market.

Such a portfolio requires active management, which, of course, incurs some costs.  However, it offers a valuable enhancement for portfolios dominated by directional gold positions.

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Tags: active gold portfolio management, cost assessment, gold stock market cyclicality, project development timelines

The gold miners’ season is upon us.  Out of the summer doldrums and through the usually disappointing (for most) margin squeeze reported after the second quarter.  As we are eagerly awaiting the annual gold stock party (and, at the same time, the annual Denver Gold Group’s show), it may be helpful for the readers to understand in what way investment in gold mining companies differs from investment in physical gold.

It is well-known that gold prices are fairly stationary.  Over long time, they represent a form of insurance, whose price is the non-existing yield (if we forget for the moment the return that could in theory be earned by lending bullion at rock-bottom lease rates).  Gold mining companies are not like that.  They do not “hold” gold – they sell it.  They currently dig out gold at an average cash cost of $490/oz and, depending on the total cost, pocket the difference with the spot price or some combination of spot and forward sales.

A self-respecting gold investor should hold a portfolio combining the insurance value of gold or gold-backed instrument, a position in companies that sell gold for a good profit and a sub-portfolio for derivative trades enabling her/him to benefit from changes to the volatility of the metal.  The problem is that the three subportfolios require very different skills and time horizons.  Physical gold requires a long-term macro vision (and wealth to preserve in the first place).  Investment in gold mining equities – long or short – requires a level of knowledge of the complex industry which can only be gained by actually working there; a privilege few of us mortals will have.  Finally, dynamic option trading requires both experience and a fairly good orientation in what other large derivative desks are doing.

We shall focus here on the second element of such an ideal portfolio – investment in gold mining companies.  Four years ago, during the height of private equity activity, someone made an interesting observation that unlike oil and gas industry, mining attracted very little in way of leveraged long-term investment.  In many scarce commodities – from lithium to uranium – it is theoretically possible to take a controlling position in an early stage company against the future offtake of the product (assuming that the private equity firm is appropriately positioned further down the value chain).  But in gold, the intermediary bullion banks have been in the business for decades and the product is never “scarce” by any conventional measure.  In addition, the complex knowledge necessary to analyze a mining investment is a hurdle that few non-operating companies undertake.  Those who can do this, are successful royalty businesses.

Why is it so difficult to switch from analyzing, say, retail or machinery sectors to analyzing mining?  There is one underlying conceptual difference.  Your clothing stores and your factories will be differentiated by the product they churn out.  But the process of a factory based in Mexico or in China may be exactly the same.  In mining, the opposite is true.  The product is essentially an undifferentiated commodity, with specific qualities and standards determined by decade-long interaction between producers and users.  But it is the process of obtaining this commodity that differs in every single operation.  The combination of geology, metallurgy and engineering makes each and every one mine a unique operation.  In order to understand the process fully, nothing replaces the actual visit to the site.  And the sites tend to be off-the-beaten track.  As my former boss would quip – “God had a sense of humor when he decided where to put gold”.  From the Arctic Circle to breath-taking heights of 12000 ft and equally suffocating depths underground, from deep jungles to parched deserts, gold just does not happen to be easily accessible.

The 19^th and early 20^th century gold rushes in California, Alaska, Australia, Brazil and South Africa show that God’s sense of humor was somewhat less acerbic at that time.  But much of the easily accessible land has now been scoured for prospectivity, a process that accelerated in the 1980s.  Parts of Australia and Nevada are now drilled out like Swiss cheese.  No wonder that the most prospective gold and copper porphyry-rich Tethyan belt snakes through Burma, Tibet, parts of Afghanistan and Iran, and into Pakistan, where Barrick & Antofagasta’s Reko Diq project is located.  In addition to the challenges posed by the difficult terrain, it is the above-ground factors in these countries that have considerably raised the operating risk.  Such an adverse environment requires the deposit be highly prospective – either rich in grades (which is preferable), or very large.  In the latter case, the operation may incur high development cost or extend way into the future, making the value of the project highly vulnerable to discount rates used to value the cash flows.  The question how to reflect the risk of low-frequency but high-impact events is a huge topic with bankers insisting on somewhat arbitrary adjustments to the discount rate, and operators seeking to reflect the hazards directly in the cash flow profile.  Either way, the shareholders purchase the associated risk, most often with little knowledge of the applicable probability distribution for the potentially damaging events.

This is just one example of the complexity involved in the decision to invest in a mining venture.  Even though the rewards can be considerably higher than in the case of defensive holding of physical gold, the homework concerning the intangible notions of risk takes a bullion-hoarding investor way out of his comfort zone in the Swiss vault.

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Tags: gold vs gold miners, ideal gold portfolio, risk assessment, unerexplored ground

Coming out of the recessionary cost-cutting and post-recessionary restocking, US and European stocks offered a slew of expectation-busting results in the second quarter. But the positive earnings surprises (for the former) and revenues surprises (for the latter) did little to avert the outflow of funds from the equity market. A theory of ageing baby boomers caring less about return on capital and more on capital preservation (the popular pun refers to return OF capital) is gaining traction, keeping pace with the inflow of funds into the seemingly bottomless bond market. Safe heaven bonds are selling like hot cakes and only the Japanese Ministry of Finance is allowing more products to mature than to be sold. This week again, the yields on the Japanese, German and US government bonds have dredged record depths.

The stock market apathy is now being countered by feverish M&A activity. The last two weeks have seen an unprecedented onslaught of announcements targeting a variety of companies: Potash, McAfee, NedBank, 3Par Inc, International Power, Cairn India, Dana Petroleum, New Alliance and Sphere Minerals (which controls attractive iron ore assets in Mauretania). With the exception of Kinross’s advances in West Africa (and the earlier Newcrest-Lihir tie-up), the gold mining industry has been remarkably quiet on this front. This relative inertia continues despite the much higher level of fragmentation than in the case of more M&A-prone potash or iron ore industry. Why has the gold industry been so quiet? The answer is threefold.

The first part of the answer lies in the structure of the gold mining industry. Three out of top 10 gold mining companies are domiciled in South Africa. After Pretoria’s initial green light to Anglo American, Billiton and several others to establish Plc structures in the UK, the process of internationalization of South African resource companies stalled. The last significant acquisitions made overseas by SA gold mining firms were executed in 2001. The liquidity and fungibility of their shares made it extremely difficult to compete for Australian assets and practically impossible to enter a contest for North American assets. The legislation favoring ownership by historically disadvantaged South Africans, first leaked in 2002, further depressed any interest in South African producers as potential targets of corporate activity. Several years later, the botched approach by Harmony to take out Gold Fields offered the final nail in the coffin. Short of resuscitating the idea of intra-South African consolidation (or rather asset rationalization), there is little chance of the three giants to play a decisive role in the global consolidation of the industry.

The second part of the answer has to be sought in the relative valuation of gold mining stocks. The CEO of Yamana has recently complained that the undervaluation of large mining stocks vis-à-vis their smaller competitors lies behind the slow pace of consolidation. It is true that when a tier I company does venture out, the allegations of ‘overpayment’ abound. Kinross’s CEO is still facing a tough battle with many reluctant shareholders over the purchase of Red Back. Both gentlemen have investment banking background and Yamana’s boss seems to be correct in his assessment. Currently North America’s large gold stocks trade at around 13x next year’s cash flow, 21x forward earnings, 7x EV/Ebitda and around 1.4x NAV. By comparison, the 2nd tier producers, where most growth is expected, trade at 16x cash flow, 23x PE, 9x EV/Ebitda and around 1.7x NAV. And that despite the largest companies having the free cash flow yield twice the size of the second group’s. Essentially, that would mean that large companies – many of which were built on successful acquisitions in the past – are bound to destroy value if they embark on costly acquisitions among the 2nd tier producers. But that does not rule out some activity on the part of 2nd tier producers targeting small and emerging gold miners.

Here lies the third reason behind the slow progress in consolidation. Even if we put aside the Chinese and Russian producers, the universe of potential takeout targets runs close to three digits. Monitoring this universe requires dedicated teams for both desktop overview and on-site due diligence. Many of the 2nd tier producers lack the adequate corporate structure to focus on any targets that are not known already – through geography, personal contact or other privileged leads. Investment bankers will not find a $150m-$300m deal attractive enough to dish out a detailed proposal. Essentially, the industry lacks vehicles facilitating the deal flow beyond the most obvious targets (Lihir was one of them). Canadian banks may have the best information about their actual and prospective clients, but it is the prospective acquirer which will eventually have to do all the time-consuming homework. The signature of confidentiality and standstill agreements with the target will invariably divert resources from the key development work that 2nd tier miners depend on. Those which may potentially have such resources at their disposal (ElDorado? Agnico-Eagle?) possess plenty of in-house growth projects in the near term, or are busy integrating recently acquired assets. In addition, while tier 1 companies may more easily deploy resources from other operations to increase efficiency gains from the target’s assets, smaller acquirers usually find the post-merger acquisition just as challenging as the ongoing process of monitoring the available universe of potentially attractive targets.

The occasionally optimistic pronouncements about the overdue nature of gold mining consolidation are destined to remain just that – optimistic. The fragmentation of gold’s primary supply is a combination of historical legacy and the comparatively high-value, yet low tonnage nature of the majority of the relatively isolated deposits with few operational synergies. This does not mean that interesting targets are not there – in West Africa, in the Andes, in North America’s northeast or in Southwestern Pacific. But the process will be as slow as it has been in the past – regardless of the bouts of M&A fever in other sectors.

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Tags: asset rationalization, consolidation, corrpoare activity, fragmentation of gold mining industry, gold mining M&A

Last week we reflected on what lessons, if any, the Japanese experience with deflation carries for gold investors elsewhere. A tentative conclusion was that the value of Japanese Yen mattered probably more for Japanese gold investors than the domestic decline in prices. And while the recurrent deflation has certainly influenced the wide-spread preference for long-term holdings of JGBs, the evidence for gold has to be sought in more selective statistics of bar hoarding, coin purchases and gold accumulation plans. A look into these historical data reveals just how astute the daily readers of Nikkei Shimbun are…

Let us step back to the onset of the first yen-carry trade, in 1996. After a record year for gold investment in Japan (1995 was punctuated by the Kobe earthquake and 18-year low prices in JPY terms) the investment demand nearly halved to 57t. The following two years saw a combination of profit taking and bursts of demand towards the end of each calendar year. In 1999, the Yen strengthened and deflation began, but overseas gold also hit a low of $275/oz. Investment demand in Japan picked up 16%, but this was a short-lived phenomenon, despite deepening deflation and further strength in the Yen.

Carry trades resumed in 2001. Between terrorism, Argentina’s default, Enron and a collapse of Daiei supermarket chain, Japanese investors increased somewhat the purchase of gold for investment purposes (this was the time when yellow jewelry barely sold in Japan). In early 2002 – against the background of weakening Yen and stronger gold prices, Mrs Watanabe rushed to purchase gold to protect the household against reduced government insurance for time deposits. Investment in gold hit 95t – an amount never registered again. At that time, bullion would change hands at around Y1400/g.

The subsequent three years of deflation saw a recovering economy, buoyed by exports and aggressive (and ultimately futile) attempts to weaken the Yen. Interest in gold depended on a variety of factors, ranging from the health of the banking sector, the performance of the local stock market and the JPY exchange rates.

The shock came in 2006, after the deflationary period was over. The carry-trade driven depreciation of the Yen sent the prices fast above Y1500/g and Mrs Watanabe began to take profits. That year, the Japanese disinvested a net amount of nearly 43t. With equally weak Yen the year later – and gold continuing to gain strength (crossing Y2600/g), 2007 saw a further 32% growth in net disinvestment. This process continued until JPY reversed the course in the wake of Lehman’s collapse towards the end of 2008. The return of deflation and a stronger Yen (a veritable ‘Hauch des Lebens’ for the otherwise embattled uncovered interest rate parity) coincided in 2009 with further dishoarding, albeit at a much slower pace.

This short summary of the recent history in Japanese gold investment reveals Mrs Watanabe’s uncanny sensitivity to the fluctuations of real values (rather than nominal prices). It is all the more surprising because it is, a priori, impossible to gauge the exchange rate reaction to changes in monetary aggregates. For example, a reduction in money supply should, ceteris paribus, lead to an increase in nominal exchange rates – and (depending on interest rates) a possible increase in real exchange rates. However, as the velocity of money is reduced, deflation sets in, and deflation means a decrease in real exchange rates.

Despite the multifactor complexity of these phenomena, the wisdom of (ageing) Japanese crowds got it right. Naturally, the gold investment demand exhibited a very high (negative) correlation to gold prices expressed in Japanese Yen (based on annual average prices). No surprises here. However, given gold’s relentless gains during the last decade, the nominal exchange rate (JPY/USD as a proxy) offers little guidance (barely 34% correlation to gold prices in Japanese Yen). The value of the Japanese Yen vs USD does not correlate with the gold investment demand in Japan at all.

It is by looking at JP Morgan’s broad Yen index (real effective exchange rate), that an astonishing picture unfolds. First, gold confirms its role as a “reality” check on the actual value of the currency (an argument made on these pages previously). JP Morgan’s JPY index and gold in JPY correlate at 55%. And Mrs Watanabe beats even that. Her gold purchases since 1996 correlated at 63% with the real effective value of the Japanese currency!

More granular data (e.g. on a quarterly basis) would be necessary to refute alternative hypotheses. Yet even at this high-level, the short review illustrates how attuned Japanese investors are to the real purchasing power of their currency. Rather than offloading gold at the first sight of positive real interest rates, they continued to hoard the metal and then sold a third of these holdings once the economy crept out of deflation. Remarkably, latent inflation fears never dented their resolve.

Watanabe-san! Atama ga sagarimasu!

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Tags: deflation and gold, exchange rates and gold, gold demand in Japan, Japanese gold investment, real and nominal values

The spectre is haunting America. The spectre of deflation.

With no apologies to 19th century’s dialectical materialism, I have chosen the quote to describe the increasingly uneasy feeling US monetary authorities express regarding the mid-term prospects of America’s economy. With the vocally dissenting exception of Kansas City’s Thomas Hoenig, the Fed has once again expressed this week its relative malaise vis-à-vis the slowing growth. Bernanke & Co also showed how limited the DIY toolbox is to counter the Japanese scenario. The markets reacted accordingly.

Yet the oft-quoted “Japanese scenario”, or “defure jidai” (era of deflation) is poorly understood. There is now considerable interest in the mechanism of Japan’s recurrent deflation and gold investors should heed some of these lessons as well.

First, it is important to stress that Japan has not been mired in deflation without interruption for two decades since the collapse of the property bubble. Rather, there have been two distinct periods of deflation – the first one during 1999-2005 (following the banking crisis of 1997-98) and the second one in 2009-10 (triggered by the global recession).

Secondly, deflation alters investors’ behavior. Deflation is particularly damaging to debtors, who, in the context of falling real incomes and prices, must make interest and amortization payments in nominal amounts. No wonder that Japan’s corporations focused on debt minimization rather than profit maximization. Private investment stalled and marginal efficiency of capital collapsed. But the debt repayment obsession continued even at near 0% rates during the periods of positive CPI, as in the mid-1990s. Japanese investment behavior durably changed because investors believed that the pre-1989 asset prices were “wrong”.

It is impossible to understand what role gold has played in such an environment without tracking the performance of the Japanese Yen. The Japanese love story with gold was a short but boisterous affair. Despite the country’s efforts to diversify energy imports after 1973, the second oil shock triggered a major panic in Japan. In January of 1980, gold hit JPY6495/g. By the time deflation set in nineteen years later, the combination of a strong Yen and uncoordinated sales from central banks brought the prices to JPY917/g. For a deflation-gripped Japanese household, whose cash tomorrow was worth more than cash today, gold offered just another route from riches back to rags.

It’s from this low point that a more interesting story unfolds. Between 1996-98, during the first spell of carry trades (when the Yen lost 25% of its value), gold remained flat at around JPY1400/g. The second period of carry trades – between 2001-08 – saw the reversal of fortunes. Now the Yen barely diverged from the mean of 114 to the dollar, while gold gained 230% in Yen terms. Despite spells of interest registered by Tanaka Kikinzoku, most gold buying during this period occurred overseas. The most recent period of a stronger Yen has seen much more modest gains of about 4.6%. Remarkably, Japan – with little domestic gold mining – has now become a gold exporter! In other words, the first bout of deflation in Japan was accompanied by gold’s gains, while the second one has so far sent mixed messages – in line with gold’s significant volatility in JPY terms.

In fact, the fluctuations of the Yen exchange rates matter more for a deflation-bruised Japanese investor than the relative value of assets and liabilities exacerbated by the recurrent liquidity trap. The reason behind the limits of the Japanese experience lies in the asymmetry of the global exchange rates. The Yen is a structurally strong currency. The Hondas and Toyotas sell for dollars and euros (ah, yes, and the renminbi), which then have to exchanged into the Yen – boosting the demand for the Japanese currency. US and European corporations do not have the equivalent need to sell Yen proceeds from the current account (i.e. trade account and proceeds from overseas investments). Instead, the solutions to weaken the Yen were periodically sought in the capital account. Although Mr “Yen” Sakakibara’s efforts to weaken the currency were first spurned by Larry Summers, Japan’s ultra-low interest rates offered the global markets a cheap way to finance investments elsewhere. These carry trades were there to stay until all hell broke loose in 2008. But as 2009 showed us, the low US Libor reduced the attractiveness of the Yen as a funding currency. At the same time, the demographically challenged Japanese corporations have now moved to build and control vast swathes of Chinese industrial capacity, thus reducing the dependence on the weak Yen. All this will limit Japanese appetite for gold, even if the current rebound in industrial production does not immediately warrant a durable escape from deflation.

Deflation happens when saved money is not (productively) invested. Low interest rates in a weak economy, lack of credit growth, excess corporate savings, overcapacity – all these themes echo from Marunouchi to Wall Street. Yet, it is impossible to gauge whether the usually optimistic American extroverts will ever consider the pre-2007 house prices “wrong”. In the meantime, what matters more is the relative performance of the currencies. The currencies benefiting from risk aversion (the Yen, the Swissie) and from Asian growth engine (again the Yen, the Taiwanese dollar, the Won, the Aussie) are not friends of local gold investors, especially in a deflationary setting. On the other hand, the US dollar and the Euro are structurally weak, even though the dollar’s vast fixed income market will periodically make it the destination of risk-fleeing capital. European and American investors have thus little choice but continue to add to their gold holdings to offset the competitive erosion of their currencies’ value. For as long as the continued pressure on the labor markets does not derail the global trade, this recurrent weakness of Euro and Dollar should help counter the deflationary pressure.

Finally, it is worth remembering that investment in economically inert gold is, ceteris paribus, deflationary. Luckily, with barely $350bn of equity gold available worldwide and about a $1 trillion in private vaults, the global deflationary risk of flight into gold is a doomsday scenario better shelved with the Mayan calendars.

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Tags: gold and deflation, Japanese deflation and gold, JPY and gold, Yen and deflation

If you trade copper, aluminum or tin, or Australian iron ore equities, then every muttering of a Chinese official may make or break your day. You follow religiously the spread between Shanghai and LME prices and plough through the construction numbers in Anhui. But now the country that gave us a suite of graceful oxymorons – from “agrarian communism” to capitalism without capital markets – is encroaching on the sanity of gold investors as well.

How should it be otherwise? When you already own eight apartments in Wenzhou, three ambitious mistresses and a gleaming black Buick with a chauffeur, what else is there to impress your peers than a solid gold toilet, in the aptly gaudy style known from Hong Kong exhibits or the recent Shanghai Expo. For the rest of us math majors, the equation goes: “more solid gold toilets – better for the gold market”. Then multiply it by 1.3bn and you attain nirvana.

The attractiveness of gold toilets has as much to do with the delicate tastes of the ‘xinfu’ (nouveaux riches), as it has with the paucity of gold investment products in China. Not surprisingly, this week’s announcement about the widening of gold trading in China has created quite a stir, helping gold test the elusive $1200/oz level again.

China’s reform of the internal gold market has been painstakingly slow. Although the government monopoly was broken in 2001 and Shanghai Gold Exchange opened a year later, for the first four years SGE served exclusively the jewelry market. Only in 2006 were individual investors put on a “trial method” to trade 100kg bars. It took two more years for CSRC to treat favorably the application to open up the futures market. Nearly 7m gold futures were traded on Shanghai Gold Exchange in 2009. This has been a helpful development for Chinese gold producers, who are not allowed to export gold mined in China. Yet some of the gold mined in China finds its way through bank swaps into Hong Kong market. The announced launch of Hong Kong Mercantile Exchange and its gold futures contract represents a (healthy) competitive threat to SGE. SGE could counter this partly by allowing in foreign participants on the exchange, but any such allusions are, for the time being, a matter of bureaucrats’ “opinion”, not policy.

Meanwhile, in the absence of ETF products, most individuals on the mainland rely on popular coins (golden pandas and Olympic coins) and bars. In fact, China is now the world’s fourth largest market in terms of coin and bar hoarding.

The PBOC’s announcement called for better financing services to facilitate Chinese banks’ hedging overseas. It is impossible to divorce such statements from the problem of the closed China’s capital account and the tortoise-like internationalization of the renminbi. PBOC faces an unsolvable dilemma. Further boost to renminbi’s global role would mean progressive loss of control over its value. On the other hand, readiness for such a move would require a comprehensive plan over how to grow the economy of a post-mercantilist China. There does not seem to be such a plan at the moment. As a result, only 1% of China’s international trade is settled in renminbi and only 4 (four !) renminbi bonds have been issued by non-residents. Open cross-border trading of gold is as distant a future for Chinese investors as is renminbi’s full convertibility.

For all this skepticism, the decision to modernize China’s gold investment market should be applauded. Investment demand represents 18% of overall gold offtake in China and the potential for growth remains significant. Neighboring countries such as Korea and Taiwan have a per capita consumption nearly four times the Chinese level. This contrast is comparable to the overall differences in terms of GDP per capita. Should China continue to grow faster than the rest of East Asia, its gold demand will grow accordingly.

But even if ETFs and other investment products outweigh the importance of golden toilets, China will, in foreseeable future, remain predominantly a gold jewelry market. Whereas the global jewelry consumption now accounts for roughly half of the total demand, Chinese appetite for jewelry ensures that as much as 78% of all gold sold appears in ornamental form.

This brings us back to one of the key considerations of a self-respecting gold investor. China’s jewelry market exhibits a strong seasonality of its own, with most purchases made in September, November and January. In the near term, the recognition of the impact of these flows holds much more importance than any exegesis of PBOC’s mutterings.

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Tags: China gold market, Chinese gold demand, PBOC, renminbi, seasonality, Shanghai Gold Exchange