Market commentators were as surprised as they were delighted to see the gold price hit $1,387 last month. But is the surge simply the result of fear in a financial crisis, and are the optimists justified in looking for further gains? Tomas Hirst reports.
I?n 1912 John Pierpont Morgan, the founder of the JP Morgan investment bank, gave the American Congress a stark warning: "Gold and silver are money. Everything else is credit". A century later, with the gold price soaring and foreign exchange volatility casting a shadow over markets, it seems that at least some people are revisiting old axioms.The problem is that while the price of bullion may have been stealing the headlines with record highs in recent months, relatively few column inches have been given over to the fundamentals underpinning it.In the present economic climate it is perhaps understandable to dismiss the rally in the gold price simply as evidence of growing fear in the market over the sustainability of the global economic recovery. The more recent and only slightly more nuanced argument is that the surge in the precious metal reflects uncertainty surrounding the expansion of the Federal Reserve's quantitative easing programme.
It is worth expanding upon these points to see the folly of such short-termist analysis.To view the price surge solely as a response to the effects of the subprime crisis is difficult to square with the performance history of the commodity. Using the monthly average figure, the price of gold has risen some 388% in dollar terms since its low of $260.48 in April 2001, according to the World Gold Council.By the start of 2007, however, the price had already surged to $629.42, or over 142% up from its 2001 low. While the pace of the rally increased significantly as the crisis hit, the momentum behind it was already well established before "subprime" entered common parlance and the bankruptcy of Lehman Brothers had been countenanced.This is not to cast doubt on the idea that the crisis was a factor behind the rapid upswing. There is a good reason why commentators were as surprised as they were excited to see gold hit $1,387 a troy ounce last month. What does not hold weight is the suggestion that the crisis was, on a simple analysis at any rate, the defining feature of a rally the origins of which stretch back into the tail of the dot-com bust. (article continues below)
In reality, given the breadth of the gold market and the divergent requirements of its participants, "investor fears" were never going to be a sufficient explanation for the continuing surge.
Indeed it is only by isolating the various strands of the marketplace that any kind of explanation can be reached and the prospects for the spot price can be brought into a broader perspective.
Supporters of the view that production fundamentals are driving the price can point to the fact that production of gold peaked in 2001 at 2,604 tonnes or 83.7m ounces. A basic understanding of supply/demand fundamentals would suggest that any fall in the supply of a commodity should result in an increase in price.
Adding to the fundamental case, there is strong evidence for chronic underinvestment in the industry over recent years, fuelled in the most part by the increasing cost of production. With so-called soft targets largely exhausted, miners are having to either drill deeper or move operations outside traditionally safe environments in search of new supply. Both scenarios entail significant additional cost.
"The rate of costs has increased to such an extent that it is only in the past year that exploration has looked cost effective," says Catherine Raw, a fund manager on the natural resources team at BlackRock. "As a typical mine takes between five and 10 years from the time drilling starts to full production we don't see much new supply hitting the market until at least 2012-2015."
Despite Raw's conviction, there have been signs that the trend is already in reverse. The Gold Survey 2010 released by GFMS, a precious metals consultancy, shows that gold mining production increased by 163 tonnes in 2009, or by 6.8% year-on-year. This was primarily because of significant production increases in Indonesia, China and Russia. In fact, all regions posted some growth except for America, where total cash cost of mining and extraction increased by an average of 3% to $478 an ounce.
Moreover, not all analysts agree that the falls in production necessarily mean that there will be an imminent shock on the supply side, however.
Juan Carlos Artigas, an investment research manager at the World Gold Council, says: "For the past nine years the level of mine supply has been lower than in 2001. On a tonnage basis it hasn't moved much over that period, although it increased a little in 2009 against 2008 levels."
There are several ways to read the increase in supply last year. To argue that the price was a key driver is part of the story, but given the lag in additional supply coming on stream, that appears only a partial answer. That the increases in mine production were particularly concentrated in developing markets indicates that, in the case of both producers and consumers of the precious metal, emerging trends on the demand side should not be overlooked.
In April, CPM, a metals research consultant, announced in its Gold Yearbook 2010 that in 2009, for the first time in 20 years, central banks turned from being net sellers of gold to net buyers. The report said that official gold demand resulted in net buying of 15.1m ounces (470 tonnes), the sector's first net addition since 1988.
Whether 2009 was in fact the first year of this trend is in doubt as it is difficult to gauge the accuracy of the statistics for global central bank transactions.
What there is little doubt about is the importance of the shift. Central bank gold activity represents the largest supply side component of the market, comprising nearly 13% of global supply through annual sales.
The report said: "Economic and financial trends, including currency market developments and intractable trade and debt imbalances, have led most central banks to reduce or stop selling gold. It seems most likely that central banks now will remain large net buyers of gold for the foreseeable future, for years to come."
Here is where the picture becomes more complicated. While the gold price rally began years before the financial crisis shook markets, the latter's longer-term consequences have affected the outlook for the global economy.
The prospect of reducing fiscal deficits against a backdrop of entrenched trade imbalances has led developed economies to cling to gold reserves as a relatively safe asset. On the other side of the equation, the extraordinary policy responses adopted by central banks in these markets have also helped to influence the behaviour of their emerging market counterparts, perhaps more than has so far been acknowledged.
In particular, the perception that many countries were undertaking competitive devaluation of their currencies has stoked concerns. Some fear quantitative easing could be used as a tool to manipulate the foreign exchange value of a currency to increase trade competitiveness and this has encouraged policymakers in developing markets to look at diversifying central bank holdings. Gold is progressively being regarded as a core portfolio diversifier to sit alongside baskets of foreign currencies to protect balance sheets against a shock in any one currency.
"Developing markets have been buying gold for the last decade but the big change now is that Europe is not selling anymore," says Raw. "The key thing is not that developing markets have fallen in love with gold but that they've fallen out of love with other currencies."
With the Federal Reserve set to undertake as much as $600 billion (£2371 billion) of additional quantitative easing, many central banks with high exposure to the dollar have taken the opportunity to reduce the possible risk. In July, South Korea gave a strong hint that it would buy gold for the first time in 11 years.
An official from the Bank of Korea was quoted as saying that the bank had "closely watched central banks in other nations and trends in the global gold market" in formulating its plan to manage the country's foreign exchange reserves, the sixth largest reserve pool in the world.
Although to an extent the statement is anecdotal, the possibility of a major economy reversing its stance on gold would surely be supportive to the value of the commodity. It is, at the very least, an example that highlights the general tone of uncertainty in global markets towards further monetary easing and the growing wariness of central banks towards one another.
Central banks, however, are not the only demand-side pressure that the gold market has been receiving over the past decade. Having only shifted from the supply to the demand side of the equation in the past couple of years, they were hardly in a position to be supportive to gold prices earlier in the new millennium.
At the start of last decade, jewellery made up about 80% of total demand for gold. Last year investment demand matched jewellery demand at about 35-40% of the market, illustrating the extent to which it is seizing the position of jewellery as the key driver of spot prices.
Much of this rise has been attributed to the advent of Exchange Traded Funds (ETFs), which have allowed investors to gain exposure to the physical commodity without having to take delivery of it. In effect it has allowed those outside the high-net-worth bracket to buy and sell gold much as though they would any other asset.
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GFMS figures suggest that net world investment in gold almost doubled in 2009 to more than 1,900 tonnes, with an approximate value of $60 billion. ETFs showed a 617-tonne increase between December 31, 2008 and December 31, 2009, as retail investment surged to more than 400 tonnes from less than 50 tonnes in 2007.
Raw says that physically backed ETFs can have influence over the spot price as they remove supply from the market. Given the pace of growth in demand for these products, the price moves could be sizeable.
While there can be little doubt about the increasing scale of the market, the extent to which these types of products have an impact on long-term prices has been brought into question.
Joshua Crumb, an analyst at Goldman Sachs investment bank, produced a report last month suggesting that any impression ETFs make on the spot price of a commodity is likely to be short-lived.
"Ultimately, we don't believe that these products will impact the market beyond the short term," he wrote. "Specifically, even if an ETF were to buy sufficient material to drive a market into shortage, it would then shift the forward curve into backwardation and there would be an arbitrage to sell the storage-paying ETF and buy lower- priced futures, thus releasing the material right back into the market to ease the shortage. We believe such a product would have to assume a large degree of irrational investor bias to ultimately disrupt the market and create significant 'new demand'."
Given the attacks on the Efficient-market Hypothesis in recent years, behavioural economists might suggest that factoring irrational behaviour into an investment model is fundamental to its success.
Furthermore, in current market conditions there is also an argument that gold ETFs are not being used as strategic short-term investments but as part of a broader portfolio diversification push. Daniel Wills, a senior analyst at ETF Securities, says that while the physical holdings in his firm's products have not had a strong correlation to the spot price, this does not necessarily mean that investments of this type are short-term in nature.
"While the trend for both spot prices and gold ETF/ETC holdings has been up, holding accumulation has not necessarily been closely associated with spot price movements," he says. "This suggests a significant uptake from long- term strategic investors over an extended period, possibly mirroring the broader move towards investors looking at alternative asset classes such as commodities for portfolio diversification."
Even these notes of caution have failed to dampen the enthusiasm of the gold bugs. They will often point to 1980 when the price peaked at $850 an ounce - or about $2,250 in inflation-adjusted terms - as evidence that the current price could still be far from its ceiling.
Of course, the statistics ignore the fact that the 1980 peak came as a direct consequence of a period of high inflation caused by strong oil prices, Soviet intervention in Afghanistan and the impact of the Iranian revolution, which prompted investors to move wholesale into the metal. It also preceded a sharp drop in value, with gold sliding from $850 to $260 an ounce over the next two decades.
That is not to make a case for a similar scenario this time, only to point out the inappropriateness of the comparison. As suggested above, there are a number of technical as well as macroeconomic and political factors that have contributed to the present rally.
So what could stall the seemingly inexorable rise of gold to new record highs? There is some irony from an investment perspective that a global recovery with strongly trending equity markets and robust economic growth could derail the performance of an asset. But this has invariably proved to be the case with gold as the properties of the metal as a safe haven become outweighed by the prospects of greater gains elsewhere.
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