Gold Outlook

Many in the market have become confused as to why, given the extent of financial crisis, gold isn’t at record highs and climbing. The answer seems to be that there is a rush to deleverage, hedge funds and commodity-basket funds are seeing high levels of redemptions and are therefore having to sell. Other institutions are having to raise money to support more illiquid assets and are therefore selling liquid assets such as gold, and some see the rise in the dollar as a sell signal for gold. However, whereas some institutions are selling, others are buying and there is also a rush of physical buying as the man on the street tries to diversify his wealth. Given that some top retail banks and some of the best known financial companies have gone bankrupt, this is not surprising.

The pervasive uncertainty and the risks the markets still face it seems highly likely that more gold will be bought as a safe haven. As a result gold may again achieve a fresh all-time high of over $1,000 an oz in the first half of 2009 on surging net investment demand from retail investors forecasts Gold Fields Mineral Services (GFMS), a London-based independent consultancy and research company. The yellow metal hit the historic high of $1,011 an oz on March 17, 2008 on sustained safe-haven buying support from investors and consumers and this is likely to be repeated.

ScottiaMocatta (part of Scotia Capital and a division of The Bank of Nova Scotia, is a global leader in precious metals trading and finance, with roots dating back to 1671.) reports that “as the financial crisis has unfolded and as some retail banks have failed, there has been a surge in physical interest in gold whether it be from ETFs or physical bars and coins. There are multiple reports of national mints selling out of gold coins and high premiums being paid for gold bars. In 2008, implied net investment is forecast to rise 95% to 378 tonnes, although overall investment in Gold and Gold products is likely to be considerably higher. Going forward, much will depend on how quickly confidence returns to the banking sector and on whether inflation is contained. Unfortunately, we think there is more turmoil ahead, which we expect will see demand for gold to continue to rise strongly.

Source: Scottia Mocatta, Precious Metals Forecast 2009

This view is echoed by investment bank Goldman Sachs who raised its forecast for the price of gold to $1,000 in the next three months from its previous forecast of $700 due to rising investor demand for safe-haven assets. The investment banks most recent report states that, "the gold price rally has been driven by surging demand for gold in all forms: physical gold, exchange-traded funds (ETFs), and futures contracts as investors seek 'a safe store of value' amid the financial distress and inflation risks."

Activity in the Exchange Traded Funds (EFT’s) for gold reflects that purchase have exceeded 1000 tonnes. The world's largest gold-backed exchange-traded fund, the SPDR Gold Trust, said it held a record of 859.49 tonnes of gold as of February 4, 2009 up 6.12 tonnes from February 2, 2009 alone. According to ScotiaMocatta investment companies are announcing the launch of new Gold funds to act as safe harbours from the turmoil in the financial markets. In addition, although the US and European fund managers may have diversified into commodities, there is huge potential for funds in Japan and Asia to follow suit.

Other traditional fundamentals influencing the gold market such as US dollar, geopolitical risk, oil prices, portfolio diversification, producer dehedging, European Central Bank and other official sales, and falling mine production have been overshadowed by the Western banking system in crisis but are still important.

• The Dollar

  ScottiaMocatta suggests that fundamentally the current circumstances, with gigantic bailouts and prospects for a severe economic slowdown, would suggest the dollar should be under pressure. However, the mechanics of the financial system with the dollar as the World’s reserve currency is causing various distortions that are creating demand for the dollar. The dollar is rising strongly, but this seems to be for mechanical reasons associated with the dollar being the World’s trading currency (when things are cashed in, it tends to be for dollars and with banks not lending freely, there is a technical shortage of dollars, hence the dollar is in strong demand), but these are not fundamental reasons. Given the dollar is the currency of the current financial system, in time the weakness in the system is likely to be reflected in the value of the dollar. If this happens, then gold is likely to rise in value as it is seen as the only quasi-currency not linked to any one government or tied into any one financial system. However, when these distortions have run their course, there may well be a sharp backlash – benefiting gold.

• Dehedging

  At the start of the bull market for gold, which roughly coincided with the start of de-hedging, the total hedge book stood at 3,107 tonnes (99.9Moz). Seven years later it has already fallen to 515 tonnes (16.6Moz). As the hedge book shrinks, the level of de-hedging is likely to slow. ScotiaMocatta reports that the distribution of the hedge book now largely lies with two gold producers, who collectively held 403 tonnes of outstanding positions at the end of H1’08. There seems little interest in putting new outright hedges on, other than for some new projects.

• Central Bank Sales

  For the third year running, sales made under the Central Bank Gold Agreement (CBGA) have failed to reach the maximum amount of 500 tonnes allowed by the agreement. At present it looks as though sales in the final year of CBGA II that ends of 26th September 2009, could be as low as 250 tonnes.

• Central Bank diversification

  On average, central banks hold around 10 percent of their foreign exchange reserves in gold, with the US holding 78%, Germany and Italy around 67%. By contrast, China, Japan, Russia and Taiwan who also have large foreign reserves, hold only minimal amounts of gold. China holds 0.9% of its reserves in gold, Japan 2.1%, Russia 2.4% and Taiwan 4%. With a significant proportion of these reserves held in dollars, there must be considerable pressure for these central banks to diversify their dollar holdings. Indeed, the combination of the current financial crisis, a rise in the dollar and a pull back in the gold price may well provide an attractive incentive to find ways to diversify.

• Oil

  Oil and gold prices have been positively correlated for most of the bull run. Indeed, the turndown in oil prices in mid-July this year coincided with weaker gold prices too. At some stage, we would expect the correlation to break down as it would not be surprising to see oil continue to suffer, as the prospects for demand fall and the outlook for global growth slows, whereas gold’s safe-haven attributes are likely to support it and indeed boost it before too long.

• Supply

  The supply side of gold has rarely featured as an issue in the outlook for gold prices. For example, strikes in South Africa generally have no impact on prices, but the combination of various features of supply do now put gold supply in focus. Firstly, mine output continues to drop. In the first half of 2008 it was off 6% yoy, scrap supply fell 25% and Official sales were off a similar percentage. Some of the features leading to lower mine output are likely to be the temporary factors, such as power shortages in South Africa and parts of Australia, but the biggest impact was seen at Indonesia’s Grasberg operation where output fell 49 tonnes as low ore grades were encountered.

  Rising cash costs have also been a feature as these have risen rapidly in recent years. In 2005, World cash costs were estimated to be $271/oz, these rose to $317/oz in 2006, $395 in 2007 and were thought to be around $460/oz by the end of H1 2008. Lower fuel prices and a stronger dollar will no doubt see these fall now, but many of the other costs will stay high, including labour, royalties and other input costs. That said, mines may be able to increase their margins by electing to mine higher ore grades. One area that is likely to have a longer-term impact is the credit crunch, which could see lower spending or delays to new projects, exploration and expansions.

• Jewellery demand

  Demand from jewellery manufacturers has once again shown that it is price elastic, the threshold price now seems to have risen to around $800/oz. Up until March this year, the upward trend in the gold price eroded Gold jewellery demand. Fabricators have reduced the gold content of jewellery and have used other metals that offer better margins, such as silver, palladium and other non-precious metals. Interestingly, Goldman Sachs points out that "…in fact, this recent surge in gold ETF demand would more than offset a 20 percent decline in the fourth quarter global jewellery demand for gold." Ergo, the effect of lower demand from jewelry demand is buffeted by physical demand from ETF investment.

In summary, the global economic outlook is for more pain, uncertainty and fear. Given the financial shock and how deep and wide this is spreading, confidence is likely to take a long time to recover, especially confidence in financial markets and products with little intrinsic value. When the dust starts to settle, investors are unlikely to have much confidence in any assets, but money will need to be invested in something and assets with intrinsic value are likely to shine above paper assets, and in such an environment we feel gold will remain highly sought after.