Original Post
BY: Daniel Gschwend
Why not start with the most important question. Is it already too late to buy precious metals or commodities in general?
Not at all. Gold and metals generally have very long cycles; ups and downs tend to be for typically 15 to 20 year periods. We are now seven-eight years into the cycle. So depending on which way you look at it, you could be in the one-third or a mid-cycle. In nominal terms (at $900 odd dollars an ounce now) the previous high was $850 in the 1980s. If you take into account inflation then the equivalent price of that now is over $ 2,300. So if you look at where you are in a cycle then it also in some sense reaffirms the direction in which or the potential to where gold can go.
After over 20 years of a persistent bear market in commodities, we have entered a new bull market in 2001 which has still a long way to go. Typically, a bull market peaks with a new high in real terms – which means currently over $ 2,300 per ounce for gold. It’s the same situation for other precious metals such as silver, platinum or palladium.
What else speaks for gold from an investor’s point of view?
The other couple of things that really make a difference to gold are that it is counter cyclical to the US dollar. So, if you expect the US dollar to weaken, then gold moves the other way and appreciates. Gold is also a store of value and therefore is valuable in times of geopolitical stress or calamities in markets or during times of inflation (because of inflation gold price goes up).
You’ve got multiple drivers for why gold is technically a good investment. We are seeing a lot of the above playing out now. Central banks around the world are worried about inflation. There is a lot of financial stress in the system and still some huge time bombs have not been deactivated, such as all the derivatives that may fail and ignite some kind of chain reaction in the financial system.
All these factors make a good case for the gold price to look very attractive. Overall, gold is a good diversifier with reasonably good returns over a long period of time and low correlation to other asset classes.
Are commodities such as precious metals really their own asset class?
If you define an asset class as an independent investment vehicle with its own characteristics, such as bonds, stocks or real estate, than yes. Commodities have unique attributes – no matter if we speak about agriculture, metals or energy – commodities usually rise in times of distinct inflation. Gold has even the tendency to rise in times of deflation since it is more or less the last resort to preserve value.
Commodities have been rediscovered by investors. I’m absolutely not surprised that we have seen such a strong price rally lately. In an environment in which we have negative real interest rates, inflation pressure and depreciation in stocks and real estate because of exaggerations supported by artificially low interest rates and lots of leverage – commodities just have to shine. As for gold, gold is not only a commodity, it is also money – in situations such as today, investors are seeking protection against an overall asset meltdown and buy gold.
What about inflation, is gold really a hedge against inflation?
Gold’s role as a hedge against inflation is unparalleled, though for much of the last 20 years it was challenged in the West on the basis that it wasn’t working. What was being overlooked, of course, was that in Europe and North America at that point inflation had been brought under control and gold was not, at that time, needed as an inflation hedge. In other countries where inflation was running much higher (or out of control – Turkey was a particular case in point), it was doing its job perfectly well.
With the markets now increasingly concerned about inflationary trends, gold has posted its credentials once more. While inflation is nowhere near the levels of the early 1980s (in the first quarter of 1980, inflation in the United States was 14%), inflationary expectations combined with an unprepossessing growth outlook have reinforced gold’s defensive qualities. Only when inflation is really a threat does gold work as a hedge.
What are the main drivers of higher metal prices in the future?
Low inventories in virtually all metals with growing demand and sluggish or even diminishing supply. Investors have not really understood how severe the supply situation actually is. There is only talk about how much a possible US recession or global economic growth slowdown will affect demand.
Demand will remain strong since this cycle has been activated because of structural changes in many developing countries. There are hundreds of millions of people entering the middle class. Entire cities, power plants, streets have to be built – those changes will transform these countries and until all these infrastructure projects – which are not being postponed because of higher copper prices and so forth – are achieved, demand will remain very strong. Unless there is no more supply coming online prices will rise.
But supply is the problem. By way of example: South Africa has a major power problem which probably cannot be solved until 2012 – and SA is still the no. 2 gold producer in the world. Platinum and palladium prices have skyrocketed because of this power disruption and will very likely remain high.
Aside from disruptions because of strikes and maintenance at operations running at or close to capacity, increasing government demands for higher royalties and profit taxes or greater stakes in projects are hampering development in many areas.
Another floor to lower gold prices is rising production costs if gold corrects to 650 $ per ounce many mines would have to shut down. The lack of skilled labour force, particularly geologists, will keep the wages high and also support even higher gold prices. Supply and cost pressure are probably even more important than demand concerns.
While the price of gold has risen very strongly in the recent months, don’t you expect slower demand because of higher prices?
Not really. Higher prices will of course affect jewellery demand negatively at least in the western countries. It’s the opposite in developing countries such as India or China – in these countries we see hundreds of millions of people being able to buy some kind of luxury goods or jewellery for the first time ever. The net effect on jewellery demand will very likely be positive.
Investment demand is growing fast and is not at all affected by the higher prices. It’s actually the opposite. There is some kind of paradigm shift going on in the financial world towards real assets and away from inflated paper assets. Overall we will see very strong demand from jewellery and the industrial and investment side for the years to come.
You mentioned China, how much do you attribute to the China factor?
I believe China is a major factor in the equation of higher prices in the future. But it is not only China, it is the entire Asian region which is experiencing a major structural shift accompanied by strong economic growth. Strong and growing demand is the main driver out of Asia.
As for China, figures from the World Gold Council showed sales of gold jewellery in China hit a record high of 302.2 tons in 2007, up 34 percent on the previous year. China has now overtaken the United States to become the world’s second largest buyer of gold jewellery after India. But behind the remarkable growth lies a deep Chinese traditional appreciation of the precious metal as a hedge against social and economic risks.
Interestingly, so far Chinese consumers are not deterred by rising prices. Rather, they increasingly view gold as not only a means to protect wealth but also as an efficient part of their investment portfolio. The World Gold Council said investment demand for gold at the retail level amounted to 23.9 tons in 2007, a rise of 60 percent compared with 2006.
There is a lot of wealth being created in Asian countries, and India and China have just woken up. Because of the strong economic growth and a appreciating Yuan vs US $ this also makes gold and other commodities traded in US $ cheaper for the Chinese – this is also valid for all other countries with appreciating currencies vs the US $.
There is a lot of talk about central banks or the IMF, aren’t they selling gold, and won’t they keep the prices under control?
Yes, they kept the prices from rising even more, but not under control. Under the current Central Bank Gold Agreement II act, central banks are allowed to sell up to 500 tons of gold per year until the year 2009. Interestingly, even though the price of gold has risen, the maximum quota of 500 tons per year has not been exhausted fully. Some of the participant banks didn’t sell at all or only a fraction. The effect has been minimal – without these sales gold would have risen even more.
As for the IMF, it might sell some of its gold holdings – something around 400 to 500 tons. This news is known and the gold market has not reacted at all. I expect this gold will be sold off market and will be happily absorbed by some institutional investors or central banks in the Asian region.
How about the central banks with huge US $ assets, how will they act in the future?
In contrast to the central banks in the western countries, they will be net buyers of gold very soon. Gold is the only real hedge against a depreciating US $. Since central banks in China, India, Russia or Japan hold huge amounts of their overall reserves in US $ it would be wise to protect these assets against depreciation and also do some more asset diversification. Just imagine, China has over 1,000 billion of US $ reserves and only holds less than 2% in gold – countries such as Germany hold over 60%, France over 55%, Switzerland over 40% or the USA over 75% in gold.
Since paper money is only a derivative to gold – which represents real value – central banks are under a lot of pressure to reallocate some paper assets into gold to preserve their wealth. Let’s play some numbers: if China (1.2%), India (4.1%), Japan (1.8%) and Russia (3.0%) decided to extend their gold holdings to a still very conservative interest of 10% of their overall monetary reserves, they would have to buy over 9,000 tons of gold which is more than 4 years of current worldwide gold production.
There has been a lot of talk about hedge funds buying gold and pushing prices ahead of their fundamentals, what’s your view on this?
There is indeed some speculative momentum in the market, also driven by hedge funds. But more importantly is the realization that gold has again become its own asset class. This has brought many deep pocket players into a comparably small market. Most of these new market players are active on gold futures traded on the COMEX or in ETFs (Exchange Traded Funds). If you look at some of the data, the amount of gold ETFs in the world in October 2003, just 4.5 years ago, was fractional at less than 20 tons of gold. Now it is over 800 tons.
Most of the investors who come into gold ETFs are in the US or the more developed pockets. If you look at the data provided in the weekly Commitments of Trades Report (future & option positions in gold) you will see that long positions in futures held by large speculators are more or less at all time highs. Some analysts see this as a contrarian indicator, but so far the positions remained high and were even growing. Hedge funds and other deep pocket players are very confidant and so am I because of very favorable fundamentals for precious metals.
What’s the role of pension funds and other institutional investors in this commodity bull market?
They actually play a very important and very prospective role. Calpers, the largest US pension fund with around 240 billion $ in assets, decided this February to boost its commodity investments up to 3% of its assets. That’s a 16-fold increase since it started to invest in commodities which was as recently as last year.
There are a lot of very powerful institutional investors entering the commodity sector and this trend has just started. This view is also confirmed by a survey conducted by Barclays Capital published last December. About half of the 150 money managers aimed to expand commodities to more than 10 percent of their total assets. These investors are the so-called deep pocket players, they have a long term strategy and they buy because of very strong fundamentals. Is it wrong for a private investor to do the same? I’d say no. Commodities should be an integral part of everybody’s asset allocation.
Since metal prices have done well, how about mining shares?
Since 2001, when the bull market started, the AMEX Gold Bugs Index (HUI) was at around 35 and is now at 400. In other words, mining shares outperformed metal prices and all other conventional asset classes greatly. Mining shares have a leverage to metal prices since profit margins are rising faster than the underlying spot prices.
In the last few months, this mechanism didn’t work because costs were rising rapidly and neutralized higher revenues. Right now, mining shares vs metal spot prices are at or close to historically low levels and offer a great buying opportunity. Even though spot prices are up, many shares are sharply down because of the sub prime aftershocks which lead to very high credit spreads and huge risk aversion towards all stocks. As an example, junior mining stocks are currently trading relatively lower than when the bull market started in 2001.
We at our fund are taking advantage of this market anomaly and have invested around 30% in the junior market and the remainder in intermediate and senior producers. This strategy was very tough in the last months but should work out very favorably in the near future once the appetite for mining shares returns.
This sounds like you are growing more optimistic about mining shares in the near future?
Absolutely. Right now there are great buying opportunities in this sector. Fundamentals are strong, but shares are trading with discounts to their NPVs. Nobody can tell you when the market will wake up the next time, but it will wake up.
Historically, moves in the mining sector were always very fast. From an investor’s point of view – diversification is everything.
Buy some physical gold and hold some stocks – either directly or by a fund investment – this strategy should work out perfectly for the next many years. For investors who don’t like to buy a fund, they could buy BHP Billiton (BHP) for base metal and oil exposure and Barrick Gold (ABX) for precious metal exposure. Both stocks are very representative for the mining sector.
Disclosure: Article was originally written for the ‘Precious Metal & Mining Investment Outlook Conference’ in Hong Kong, June 2008. The author is fund manager at a mining & metals fund. The author’s view reflects explicitly his personal opinion. The fund has a position in BHP Billiton and Barrick Gold.
