With the GFMS figures out now, it has been confirmed what we suspected since October – global investment demand for gold outstripped jewelry demand for the first time in three decades. The traditional relationship between the price driver – the Comex trading, and price floor (determined by the physical demand) has been transformed by the success of the ETFs and increased interest in other gold investment products. In the first quarter of 2009, gold price advanced in synch with the strengthening dollar as record volumes of gold had to be stored to respond to the 13moz worth of new ETF demand. Then, in September, the gold option volatility skew suddenly flattened, the market went short gamma and – most unusually – never corrected after record increase in net long Comex positions. The goal posts of this market had shifted.


Investment demand is a game changer. Just witness the spectacular success of the new platinum ETFs in the United States since the beginning of 2010. In just two weeks, the market added the equivalent of 30% of last year’s global ETF demand… The picture for palladium is even more dramatic. There is little doubt that the autocatalyst and jewelry demand will have to respond to new price range and the PGM market may be testing how far the spread tolerance can go between the various market participants.


Platinum has a track record of taking some shine off gold. The market is about a tenth of the size of the gold market and the white metal lives a constructively schizophrenic life as an industrial and investment product at the same time. Although precious metals also tend to affect each other’s fortunes, an argument could be constructed on the basis of anecdotal evidence that the PGM ETF rush has led to some ‘gold fatigue’ among investors wobbling unsteadily into 2010.

But the clues to gold’s fortunes in 2010 have to be sought elsewhere. Yes, ultimately, gold market specific expectations will play the determining role – expectations surrounding central banks’ intentions, further growth of investment demand, recovery (or not) of Indian jewelry demand and the liquidity of the secondary market. Yet, I would argue that some of the main drivers of the gold market will come from the outside – determined by the broader risk perceptions, the shifts in the currency market, the anticipation surrounding relative interest rates and the bond market performance. Here is a short list of signals which may have consequences for the gold market.

1. Pay a close attention to the decisions surrounding the phase out of qualitative easing in the US. Although Bank of England has already begun to sell corporate bonds, the exact exit by the US monetary authorities remains uncertain. Any indication that the market could benefit from a significant drop in liquidity could be damaging to commodity market and to gold.

2. Watch the spread between US and Japanese 3-month Libor. Although carry trades are notoriously under-reported, there is little doubt that the spell of ultra-weak dollar since last summer correlated with the 3-month Libor falling below the levels of two classic funding currencies – JPY and CHF (Swiss National Bank has since intervened in the markets to weaken the currency). Any indication that the short end interest rates recover in the US could strengthen the dollar. And when it happens – while you may not necessarily be tempted to sell your gold jewelry or knock out your gold teeth just yet – you’d do well buying Japanese stocks.

3. Follow inflation-linked bonds. Any indication that US TIPS offer 2% or higher would mean a global recovery and possibly further inflationary pressures. How gold recovers will depend on market expectations for real rates going forward.

4. Further intervention by emerging markets in foreign exchange markets. Towards the end of 2009, emerging markets spent $150bn strengthening the dollar (and renminbi). Renewed bout of dollar buying would be gold-negative, ceteris paribus.

5. Treasury market balance in government budget deficit countries – not least in the US, UK, Japan and Euroland. The irony of 2010 is that the countries with the highest debt/GDP also enjoy the highest sovereign debt rating. But the demand for $4 trillions of new issuance from the G7 nations will depend on the appetite for other funds, velocity of money and inflation expectations. Any indication that Central Banks are reluctant to foot the bill could lead to rate spikes, affecting real interest rate – to which gold remains eminently sensitive.

These five signals are not mutually exclusive. It is also important to keep in mind that many of the arguments could function counter-intuitively. With 36% of investors based overseas, a US bond sell-off could initially be damaging for the dollar, yet the resulting increase in yields could dampen interest in commodities, including gold. On the other hand, an intervention by ECB to weaken the Euro (now less likely) could initially help the dollar, but the long-term effects would be liquidity-boosting – and therefore positive for risk assets and commodities.

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Tags: ETF, FX, GFMS, gold price drivers, interest rates, Libor, platinum, Treasury market

In the years since the vertigo-inducing success of gold ETFs – currently accounting for around 40moz of gold investment – the question of the continued relevance of gold equities has been raised on several occasions. As the platinum market is now bracing for the potentially game-changing effects of introducing a new platinum ETF on New York market, the issues of comparable risk, leverage, beta and relative merits of ETF vs. equity investments in the precious metals space are resurfacing again.
Arguably, the platinum market has always suffered from equity under-representation. The production of this metal is highly concentrated in the hands of 3-4 miners, the largest of which has only a limited free float. This relative paucity of investment vehicles may not be unique to PGM space, but can hardly be compared to the wealth of choice offered to a global gold investor. The geography of gold equities largely reflects the geological ubiquity of the product. The question remains, however, whether the equity market served with highly liquid gold ETFs is large enough to accommodate hundreds of producing, near-producing and exploring gold companies.

If recent capital-raising offers any clues, then the answer to this last question is an emphatic “yes”. In 2009, gold companies raised an unprecedented $18.5bn in financing for exploration, expansions and operations. This number dwarfs the previous record (in 2007), but has not prevented gold stocks from outperforming the commodity, for the first time in 5 years. While in 2009 gold notched a respectable 25% increase in dollar terms, gold equities ran up between 44% (HUI index) and 39% (GDX index). This was a far cry from 2008, when the extreme deterioration in the liquidity conditions reduced annual return on gold equities to negative 31%. Over the same period, gold held relatively well, becoming a rare asset above the water, albeit only at 3% annual return.

In fact, the high-beta characteristics of most gold equities are usually reflected in negative returns for the indices whenever gold fails to achieve at least a double digit return. Such conditions occur with surprising regularity, at about 4 year intervals (2000, 2004, 2008). However, since the advent of the ETFs in the middle of the last decade, it was not until last year that the gold equities benefitted from the tsunami of liquidity, offering returns above those ‘guaranteed’ by the underlying commodity.

Where do these precedents leave gold stocks for 2010? The good news is that after two years of liquidity-driven trading, fundamental analysis may finally come back in fashion. The bad news is that the investors must now do their homework properly, rather than hoping for momentum trading and another bandwagon liquidity event.
From this perspective, gold stocks that offer potentially attractive returns fall into two categories. On the one hand, there are stocks with very comfortable operating margins, owing to favorable cost environment. While they may not be the cheapest equities on near term multiples to cash flow, they offer attractive returns on equity in the months to come. The exposure to this group is not riskless, as most of them (e.g. Alamos, Kingsgate) are one-mine wonders, and should only be considered in the context of a larger, diversified gold portfolio.

On the other hand, there are stocks characterized by considerable growth in cash flow per share. Large expected volume increases offset somewhat these companies’ slightly higher costs. Despite the promise of significant earnings increases, their multiples are low, both in terms of EV/Ebitda and price to cash flow. Here, the most typical examples are Great Basin Gold and Jaguar Mining. The relative undervaluation of both stocks may owe something to the market’s nervousness regarding the structurally overvalued operating currencies – South African Rand and Brazilian Real, respectively. In 2009, the US dollar may have lost only 4% to Euro, but the greenback continues to wobble in relation to emerging market (and especially commodity-exporting) currencies, whose movements now determine most of the changes to the value of trade-weighted dollar (DXY).

Betting on the former group would align an investor with the dominating theme in the equity market today – disciplined growth. The latter group, on the other hand, falls into “contrarian value” category, which enjoyed an enormous success in broader equity markets since March 2009. Interestingly however, neither of the two stocks mentioned above have benefited from this run.

Astonishingly, the same applies to gold companies with significant copper by-products, despite the fact that the red metal outpaced gold five times over the period, keeping the lid on production cost creep. But should China become serious about reining the credit binge, copper prices may suffer soon, exposing these gold-copper producers to even higher discount. It is as if the gold equity market was alone in anticipating such a turnaround for several months now.

The above opinion does not represent investment advice and is not subject to FINRA or NYSE rules.

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Tags: copper, ETF, gold stocks