The future of gold

Commodities and precious metals in particular have had a wild ride in the last 24 months. Last September, gold hit a nominal all time high of US$1,921 a troy ounce (although it was lower in real terms than a peak in 1980. Since then it has declined markedly to about US$1,600. What’s behind its movements and what can business and investors expect in the coming months? On June 20 in Vancouver and June 22 in Toronto, Business without Borders hosted a special event on precious metals, featuring Leo Abruzzese, global forecasting director of the Economist Intelligence Unit, and James Steel, precious-metals analyst for HSBC Bank USA. They offered a number of explanations about gold’s behaviour, ranging from the state of the world’s economy, the popularity of President Obama and even the behaviour of Indian monsoons.

Photo: Jose Luis Pelaez

The foundation for understanding precious metals’ outlook is the performance of the global economy. Abruzzese said that the three main engines of the global economy—North America, Europe and China—face a difficult year. “The reason we’re talking about a pretty uncertain year this year, and even going into 2013, is that Europe is already in a recession. When you have a US$15 trillion economy that’s contracting, that’s going to be an anchor globally.”

And while China has had what Abruzzese called “a great run” in the last 22 years it too is slowing down. “China’s economy as recently as a few years ago would grow by 11% or 12% a year. This year it might do 8%.”

Finally there is the United States, which is not in recession but neither is it booming. “So given all of that it’s really hard to find a strong engine that’s really going to pull up global growth this year, although again there’s some prospects of things perhaps getting a little bit better: central banks are loosening interest rates in emerging markets and commodity performers such as Australia. “Policy makers,” Abruzzese said, “are looking for ways to boost the economy a little bit, but overall fairly tepid conditions [predominate].”

A PROBABLE SCENARIO FOR EUROPE

The Economist Intelligence Unit expects a slow crawl out of Europe’s current malaise. “Slowly, very slowly, very painfully, the Europeans are beginning to pull their act together. But we attach about a 30% probability that we could see another global recession, because if Europe does implode, make no mistake about it, it will affect everybody, it will put the U.S. into a recession, it will put Canada into a recession as well.”

The very viability of the European economy could be thrown in doubt, Abruzzese said. “Think about this as a business person. Your contracts are denominated in euros, you’re getting paid in euros, you’re invoicing in euros, what happens if you wake up one morning and suddenly don’t have the euro anymore. Do you want to get paid in Greek drachmas or Italian lira again? Are we going to start making distinctions between Italian euros and German euros? You can see where things could start breaking down in a hurry.”

One problem Abruzzese noted was the interconnectedness of global banking and how a crisis in one of the world’s economic engines can infect international financial institutions. “There are hardly any global banks anymore that are not intimately connected. Banking is the mechanism that moves everything up in good times, and it’s the mechanism that potentially pulls things down when you have a crisis.’

THE EFFECT ON GOLD PRICES

How does all this affect the price of gold? For gold bugs it’s perversely good news. Abruzzese said that if the economy were to take off at a time when there is a lot of liquidity in world markets, the price of gold would probably plunge, something he said investors should worry about. The problem, he said, is that while Europe has the tools to resolve the current sovereign debt crisis there is a political gulf with Germany on one side and everyone else on the other. With its surpluses and the size of its economy, Germany’s agreement to work on the crisis is essential. Without movement from Berlin the European economy will only worsen.

There are several factors that make up the price of gold, Abruzzese said. One is jewelry, which accounts for 50% of global gold demand, and most of the remainder is consumed for investment. Jewelry consumption was flat last year after demand in India collapsed owing to declining consumer confidence in government policy and a slowing economy. India is traditionally the biggest consumer of jewelry gold.

The supply-demand balance for gold remains tight. Supply of new gold entering the market is barely sufficient to meet demand, which is being further stoked by a return to gold buying by central banks. For two decades beginning in 1988, central banks such as the Bank of Canada reduced their gold holdings. But now, with global economic uncertainty, many of them are turning away from U.S. dollars, whose value continues to decay. In the absence of another truly global currency the banks are repurchasing gold.

A SAFE HAVEN?

James Steel, HSBC gold analyst, said that gold is the only commodity to serve as a currency and that it “has kept its currency-like status for 5,000 years.” Since the economic crisis began rumbling in 2007 gold has out-performed all other asset classes, he said, until this year.

Steel suggested that gold has been behaving independent of other asset classes. Unlike so-called “risk-on” investments such as equities or emerging-market currencies, and unlike so-called “risk-off” ones such as U.S. Treasurys or German bonds, gold has been cutting its own path throughout the crisis. “Since the crisis started gold has neither acted like a risk-on asset or a risk-off asset, it’s actually been neutral, and that makes it very valuable as a portfolio diversifier. That’s one of the things that I discuss with hedge funds: if they’re looking for portfolio diversification it’s very hard to beat gold right now.”

Why is gold relatively stable compared to other commodities? Steel said that exchange-traded funds’ holdings of gold are now far bigger than those traditionally traded via the Commodity Exchange, Inc., a division of the New York Mercantile Exchange (COMEX). ETF holdings have grown to four times the size of COMEX’s. “It’s an enormous amount of gold,” he said. “ETFs really have dominated the traffic.”

What’s significant is that unlike the speculative traffic which flows in and out of COMEX, ETFs get very little liquidation, so they are steadying the price of gold. “Why is this type of investment solid? It’s because of the investor profile,” Steel said. “A lot of retail people in ETFs have high net worth, a lot of them are holding it for inheritance, and so this gold could be held for a generation or more. We have a lot of pension funds in the ETFs, they also have a very long-term time horizon. They’re not worried about gold going down $50 or $100. They’re going to keep it there for twenty years.”

Another influence on gold’s price, Steel said, is Americans’ approval of their president. “Two [of the] most popular presidents in the post-Bretton Woods period have been [Bill] Clinton and Ronald Reagan, and in both cases the gold market collapsed. What we have for Obama is very interesting. You see the peak of his popularity was the day he assumed office, and that has been the low of the gold price. Ever since then his popularity has slid, and when it broke critical levels of 40% the gold market took off. A third more temporary influence is the more colourful: the Indian monsoon season. Two-thirds of gold in India is purchased in the agricultural regions. When  the monsoon is good it results in a good crop and rural income for farmers who, Steel says, “are closer to a jeweller than they are to a bank, so they tend to keep their wealth in gold. When the monsoon is bad you don’t get a lot of gold-buying.”

But while Indian gold consumption has been flagging in recent years China’s consumption has been rising. “This is a function of income,” Steel said. “Based on the demographics alone and rising income we think that the jewellry market will probably continue to get bigger [in China].” Could desperate European nations sell gold stocks or issue gold-backed bonds? Leo Abruzzese says the optics of such a move would be disastrous. “At that point they’re basically selling family jewelry, which means they’re a goner. When you see that happen, look for that country to be out of the eurozone a few months afterward. It’s not going to save them.”

Steel offered a final long-term prognosis and one rooted in the physical. In 1970 it took one tonne of rock to yield an ounce of gold; today it takes 2.5 tonnes. And this decline is happening around the world. “There’s no Saudi Arabia of gold,” he said. “Ore grades are dropping around the world,” he said. As well, young people are not taking up mining as a profession—50% of mining engineers are over the age of 54. “We don’t have enough engineers, we don’t have enough geologists, we don’t have enough geoscientists.”