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Gold: I’m Back But for How Long?
The article discusses the market performance of gold.
Lessons from History
If history holds any clues to the fate of gold, it would suggest that gold is vulnerable. During the last three economic expansions, gold has not only underperformed equities but has lost value in absolute terms. However, since the last recession ended (November 2001) in the USA, gold has soared 38% — outperforming major equity markets. While history shows that gold has been vulnerable during recent economic expansions, this was not the case in the 70s, when economic growth was accompanied by extreme inflation. While inflation may accelerate in the coming years, we do not expect a return of hyperinflation — and suggest that the last three expansions are a better benchmark for future gold prices than the expansions of the 70s.
History, however, is but one prism through which we view developments in the gold market. Fundamentals in the sector also indicate that weakness may lie ahead. In the sections below we take an in-depth look at the main factors affecting both the demand and supply of gold. Our conclusion is that demand may weaken at the same time as supply rebounds which will probably have a negative impact on the future value of gold and gold stocks.
Supply Continues to Grow
Central bank gold holdings are lying like the sword of Damokles on the gold price. In Greek myths, tyrant Dionsysios explained to the courtier Damokles the luck of an absolute ruler by placing a sword, hanging on a horse hair, above his throne. He wanted to demonstrate the fragile luck of a ruler as it can pass away any moment.
Perhaps we are a little bit dramatic in our comparison but there is an analogy. Central banks still hold large quantities of gold (26,000 tons or approximately 10 times the yearly mining production output) which could bring prices down on attempts to sell it. The Washington agreement between 15 major central banks has been put in place to reduce gold price distortions. (This is due to the fact that central banks are selling their huge gold reserve as the yellow metal’s ‘value backup’ function for central banks has been fading). We think that the Washington agreement expiring in September 2004 will be renewed in succession. Ernst Welteke, senior member of the ECB board, mentioned several times the advantages of a renewed gold agreement, pressuring other central banks to follow.
Although we think that there will be a renewal of the Washington agreement for another five years, we expect an increase in the selling quota from the current 400 to around 500 tonnes. Recent announcements from central banks (for example, Germany’s BUBA) to sell additional gold under the Washington agreement are a clear sign that the quota in the future will be significantly higher. Central banks that are not part of the agreement also tend to sell gold, with negative impact on the gold market. We estimate the central banks’ total selling volume to be around 600 tons for next year.
Expect production increase in gold supply from new mines. Many gold mines have been in operation for years, which lead to higher mining (extraction) costs as gold grades decrease. New mine exploration has been falling for several years due to low gold prices in the last decade. Since developing new mines takes years, recently rebounding exploration activity will affect supply in 2005/06. Markets are likely to look ahead to the supply increase from new mines.
Growing importance of gold scrap supply has a negative impact on gold. Gold scrap is extracted form industrial and consumer items no longer used (for example, old electronic equipment). Gold scrap has been tending up in recent months and estimated to reach 950 tons (or 26% of total world gold supply) in 2003 versus 835 tonnes last year. The ongoing high level of gold price should ensure that the scrap supply will be stable at 900 tons per annum.
The derivative gold market will be a drag on the gold price over the next few months. Short-term investors have been using derivatives to speculate from higher gold prices. Speculative positions reached peak levels in the third quarter of this year. We think that these positions are extreme and should reverse — bringing additional volumes of 100–125 tons on the market. On top of that, mining companies have reduced their short positions over the past two years in order to participate in rising gold prices. We believe that this de-hedging has overreached its summit, ie net producer supply (gold production plus net hedging activity) will now increase again.
Demand Looks Shaky
We expect demand for gold to weaken for two main reasons — fear and greed. We expect investors will show less fear and more greed over the coming quarters. Fear should diminish as the global economic recovery takes hold and currency volatility settles down. These factors have boosted demand for gold as investors looked for a safe haven.
The fall in these risks should reduce this safe haven demand. Greed is not really a fair way of characterising the flip side of the demand story. Economic improvement naturally leads investors to pursue opportunities to invest in growth. The conclusion is that investors are likely to reduce holdings in gold in order to invest in assets with more growth potential.
Stable USD exchange rates to major currencies for the medium term should not lead to higher gold demand. Non- USD investors should be aware of the facts that gold prices are negatively correlated with the USD exchange rate. Higher gold price generally goes along with a weaker USD. In such a situation, investors prefer the yellow metal as store value leading to an increase in gold demand. For the next 12 months we expect the USD to strengthen against the Euro (Forecasts: 1.10) and other currencies. This could have a negative impact on the gold price. Current high currency volatility should also come down as general insecurity vanishes, reducing the demand for gold.
As we still see no signs of inflation, the latest gold price development seems to be unjustified. We think that recent fears of upcoming inflation in the US helped to push gold prices up to current levels. Any gold price premium due to higher expected inflation should vanish, leading to negative gold returns. In the long run gold protects investors only partially against inflation. At the beginning of a higher inflation period, the gold price tends to overshoot, yielding investors high returns. Investors who try to jump on the bandwagon should be aware that gold quickly yields negative returns on signs of lower expected inflation. Negative real return on official interest rates around the globe have made gold an attractive investment class versus cash and money market funds. This attractiveness has in our view disappeared and should turn negative for gold as yields are expected to rise moderately over the next 12 months combined with still low inflation.
Low impact from rebounding gold consumption is the only positive driver for higher prices. On the demand side we expect that gold jewellery will increase in the east (India). The magnitude of demand is, however, slowed down by the current high gold price level. Western demand is generally less price but economic sensitive. Gold electronic demand should recover (+3% in 2004) from the tech slowdown. Even if we should see a more significant demand pickup in the electronics sector, impact would be small as electronic demand for gold only accounts for 10% of global gold demand.
We expect returns on gold for the next six to 12 months to be negative. Our price target for the next 12 months is 325–350 per ounce as we see additional supply coming on the market. Oversupply of gold for the next two years will be around 475 tons per annum. Investors could therefore reduce exposure to gold investments.
Gold Companies
Gold equities are leveraged plays on the gold price. Key to gold stocks is the long-term gold price which values their gold reserves, apart from production costs and gold reserve expansions. Gold stocks are obviously also influenced by the short-term gold price developments as those are taken as a guide to longer-term gold prices. As we are cautious on the gold price outlook medium-term, we have recently downgraded all gold stocks: Barrick Gold14 to Marketperform, and Newmont Mining2,5, AngloGold2,3,4 and Gold Fields Ltd to Underperform (Reduce). In an environment of moderating gold prices, we thus favour Barrick Gold, which will feel less negative impact due to its highest gold forward selling portfolio (ie gold price hedging) of around 17% of its gold reserves.
Investors can find more attractive opportunities within the Materials sector (which we rate overweight). We advise investors to focus on companies like International Paper16 and Smurfit Stone7,8 in the US and Arcelor2, BASF2,4 and Xstrata9 in Europe. These companies enjoy more growth opportunities and should benefit from the rebound in economic activity.
Disclosures:
Stefan R Meyer, Michael Kaimakliotis
and Dominic Schneider
UBS Wealth Management
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