Up, Up, and Away: The Bullish Case for Gold

The recent correction in precious metals prices and mining shares has led some investors, analysts, and financial journalists to conclude we’ve already seen the ultimate bull-market peaks in gold and silver.

I’m here today to tell you otherwise – but please don’t mistake me for a gold bug. Although, I believe quite strongly that its price will go much higher in the next few years, I don’t think there’s anything magical about the yellow metal.

The future price of gold is a function of past and prospective world economic, demographic, and political developments. My job for the next forty-five minutes is to briefly review some of these trends and developments – and let you come to your own conclusions.

Gold’s Bullish Building Blocks

There is no simple answer or single reason why gold has been moving from strength to strength for some ten years now. Here’s my list of eleven factors fueling gold’s ascent:

· First, U.S. Federal Reserve policy characterized by low or negative real interest rates and unprecedented central bank monetary creation.

· Second, the U.S. federal budget impasse, rising U.S. sovereign debt, and eroding U.S. creditworthiness.

· Third, the ongoing and expected future depreciation of the U.S. dollar in world currency markets.

· Fourth, accelerating global inflation – with high and rising agricultural and industrial commodity prices leading the way.

· Fifth, fear of sovereign debt defaults and bank failures in one or more of Europe’s “periphery” economies. These countries, despite tax increases and deep spending cuts, continue to see their debt ratings and ability to refinance both government and private-sector bank debt deteriorate. Moreover a widening economic schism across the continent calls into question the viability of Europe’s common currency, the euro.

· Sixth, the continuing civil war in Libya and political unrest across North Africa and the Middle East – and the threat to future oil supplies.

· Seventh, the growing affluence of the emerging-economy nations and the associated growth in gold demand – especially the two big population countries, China and India.

· Eighth, central bank buying by countries under-invested in gold and overexposed to U.S. dollars.

· Ninth, the development and maturation of new gold investment channels, especially gold exchange-traded funds, that make it easy for investors to buy physical metal.

· Tenth, the legitimization of gold as an investment class and the expansion of investor interest among retail and, importantly, institutional investors – including hedge funds, pensions, endowments, and insurance companies.

· Eleventh, no more than marginal growth in world gold-mine production for at least the next five years – while some of the gold-mining nations, including China and Russia, absorb more of their own production for domestic jewelry consumption, investment, and additions to central bank reserves.

Together these bullish factors are responsible for a growing gap between new mine supply and aggregate demand – a gap that can be closed only by much higher prices in the years ahead.

American Economics

Let’s look more closely at some of these bullish factors beginning at the epicenter of today’s world’s economic crisis – Washington D.C.

The U.S. economy still faces significant and painful adjustments in the years ahead following many years of profligacy, years in which our government sector and many private households simply spent more than we could afford, on things we didn’t need, with money we didn’t have.

Despite the rhetoric from Democrats and Republicans alike on the need to tackle the country’s deficit and rising debt, there is little evidence that meaningful and sufficient steps will be taken any time soon – that is, unless a run on the U.S. dollar forces “emergency” measures sooner rather than later.

The U.S. federal government came close to shutting down not too many weeks ago – and the rancor in Washington will likely pick up as we again approach the federal government’s debt ceiling and the 2012 federal budget debate gathers steam.

It is likely that continued discord in Washington will leave our central bank, the Federal Reserve, with the difficult, if not impossible, task of maintaining orderly U.S. and world financial markets in the face of diminishing willingness on the part of foreign central banks and institutional investors to continue funding America’s federal financing gap.

How the Fed maneuvers between rising inflationary pressures, on the one hand, and a sluggish economy with unacceptably low GDP growth and unacceptably high unemployment remains anyone’s guess.

So, even if the Fed discontinues its policy of quantitative easing with the expiration of QE2 this June, before long it may have to continue buying U.S. Treasury securities because foreign central banks and private investors will be unwilling to do so without much higher interest rates.

One thing is for sure: Without significant and meaningful U.S. fiscal reform the dollar’s role as the preeminent world currency and official reserve asset will likely continue to diminish.

The announcement a few weeks ago that the world’s largest bond fund, PIMCO, would no longer hold U.S. Treasury obligations may be a harbinger of things to come.

Investor concern about U.S. government debt was further underscored last month by Standard & Poor’s surprise warning, issued on April 19^th, that America might lose its “triple-A” rating if it doesn’t act swiftly to address the federal deficit and reverse the growing mountain of federal debt.

Unfortunately, the fiscal austerity demanded by financial markets – whether in the form of spending cuts, tax increases, or some combination of the two – will, in the short run, act as a drag on the economy.

To counter the negative economic effects of fiscal tightening, the Federal Reserve, for all its rhetoric to the contrary, will be compelled to step even harder on the monetary accelerator. For this reason, I think we are likely to see another round of quantitative easing (QE3) with implications for future inflation, the U.S. dollar exchange rate, and the price of gold.

In fact, I think the Fed and U.S. Treasury are intentionally targeting a weaker dollar (to stimulate the domestic economy through the trade balance) just as they are targeting a higher inflation rate (to erode the real value of our debt as a percentage of nominal GDP).

The result will very likely be a replay of the 1970s – a decade of sub-par economic activity, high unemployment, rising world commodity prices (especially oil), double-digit inflation, and a booming gold market.

For now, at least, the U.S. dollar remains the number one world trade and official reserve currency only by default. There is simply nothing ready to take its place.

I believe we may move gradually toward a multi-currency system where an array of national currencies, possibly along with IMF Special Drawing Rights and maybe even gold, will function with much less dependence upon the U.S. dollar.

Interest Rates and Gold

A growing number of economists and Fed watchers believe the United States will start raising interest rates later this year or early in 2012. Whenever policy rates begin to rise, it will be too little, too late, to stem the upward march in the yellow metal’s price.

We have already seen the European Union, the United Kingdom, China, India, Brazil and a number of other major economies raise their own domestic interest rates in recent months. The prospect of more rate increases by these countries, joined by the United States, has some gold investors and analysts worried gold prices will turn south.

But, so far, in just about all of these economies, real “inflation-adjusted” interest rates remain quite negative – particularly if you allow for significant under-reporting of actual inflation rates in these countries. As long as nominal interest rates remain below actual inflation rates, there is no reason to believe that investor interest in precious metals will diminish . . . but there is every reason to believe that investors will want to hold more gold as their currencies continue to lose purchasing power.

Breaking Up Is Hard To Do

Meanwhile, several European countries with their backs to the wall (including Greece, Ireland, Portugal, and Spain) are slashing government spending so deeply that economic activity is shrinking, unemployment rates are rising, and many ordinary folds are rioting. Despite spending cuts and tax increases, government revenues are falling.

As a result, rather than improving their creditworthiness, the “periphery” countries will see their credit ratings marked down still further, forcing the European Central Bank to bail out its most?endangered members yet again by its own program of quantitative easing through the purchase and monetization of member?country sovereign debt.

Safe-haven capital flight from the questionable euro into both the U.S. dollar and gold will contribute to the metal’s expected appreciation and, at the same time, mask the greenback’s inherent weakness.

In my view, the only thing now holding the European single?currency monetary system together is the high cost – and seeming impossibility – of managing a break?up. Even if the euro somehow survives, its role as a second?string reserve asset has been badly damaged.

A tarnished euro, periodic funding crises, and fears of a euro break?up will benefit gold in the years ahead – even if the lion’s share of scared money and safe?haven demand find shelter in U.S. dollar financial markets.

To sum up the economic situation: I don’t think either the United States or European economies or currencies are heading toward total collapse. Instead, I think we’ll muddle through with several years of sub-par economic activity, painfully high unemployment, and high, but not hyper, inflation.

Food and Oil Lubricate the Gold Market

Accelerating global inflation is, to be sure, a monetary phenomenon, the result of unprecedented monetary creation by America’s central bank, the Federal Reserve, and most the central banks around the world. Simply put, we have had too much money chasing too few goods and services.

But there’s more to the story than just too much money. Commodity prices are rising because millions, if not trillions, of people living in China, India, and other emerging economy nations are enjoying unprecedented growth in national wealth and personal incomes.

Even if economic growth decelerates somewhat this year and next in these populous nations, as some economists now anticipate, they will nevertheless continue to pursue commodity-intensive infrastructure development (think steel, copper, aluminum, cement, etc.).

And, similarly, slower growth or not, millions of households in these countries will have the means to buy more commodity-intensive consumer goods than ever before.

As a result, high and rising food and agriculture prices are under pressure from a healthy rise in personal consumption in these nations. People with a few more yuan or rupees in their pockets are now eating better, eating more, and eating more grain-intensive “meaty” western-style diets.

So, high and rising global food prices are, in part, a monetary phenomenon . . . and, in part, they are demand driven as millions of consumers eat better – but, in recent years, there is still more to the rise in food prices.

Agricultural inflation is also a consequence of weather-related problems in some of the planet’s most important grain-, corn-, and rice-producing regions: Too much rain, or too little, combined with record heat waves in some places, has taken a big bite out of food production. Now, dryness and weather-related planting delays are threatening poor harvests again in the 2011-2012 crop year.

Many climatologists claim agricultural supply problems, as we have seen repeatedly in recent years, are a symptom of global warming – and are likely to continue, if not worsen, in the future.

High food prices also have had a profound indirect affect on world inflation: Indeed, the high cost of food has been politically destabilizing in some of the countries where food accounts for a big share of household budgets. Remember, earlier this year, high food prices were credited with triggering rioting, unrest, and revolution – first in Tunisia, then in Egypt.

In turn, conflict and political uncertainty has affected world oil markets – and, as we all know, pushed the price of oil (and other energy products) much higher with immediate consequences for inflation everywhere.

Many oil analysts had been warning that oil prices would be heading much higher even before the outbreak of political unrest and revolution in North Africa and the Mideast, due to the growth in demand for oil from both the emerging economies, namely China and India again, and from some of the oil-producing nations themselves.

So, it looks like households around the world – in the United States, Europe, India, China, Latin America, and Africa – will have to endure rising prices for food, energy, and other commodities for a host of complicated reasons beginning with but not limited to excessive monetary growth from one country to the next. Whatever its cause, accelerating global inflation spells higher gold prices ahead.

Chinese Liberalization Promotes Rising Demand

Let’s turn our attention to China: This country has already had – and will continue to have – a profound influence on the world gold market and the metal’s price.

Private gold investment was banned and the market was tightly controlled for more than five decades following the Communist Party takeover in 1949. Ever since the legalization of gold investment and the gradual liberalization of the market beginning in 2002, the Chinese appetite for gold has been growing by leaps and bounds.

Much of the growth in China’s gold demand over the past few years has been a result of the government’s liberalization of the domestic gold market, its encouragement of private gold investment, and the development of new investment vehicles and channels of distribution.

As a result, China has become a powerful driving force in the world gold market – and this trend is likely to continue, if not accelerate, in the next few years reflecting demographics, strong economic growth, rising personal incomes, worrisome inflation, and the continuing development and maturation of the gold-market infrastructure.

China’s first gold exchange-traded fund (a hybrid that invests in overseas gold ETFs) was launched this past December and was quickly fully subscribed. I anticipate Chinese-listed gold exchange-traded products – and other new channels of gold investment – will grow rapidly in the next few years with a significant and lasting effect on the world gold market and the U.S. dollar gold price.

China – Continuing Growth Despite Monetary Tightening

The recent and prospective monetary tightening by China’s central bank, the People’s Bank of China (the PBOC), will not – in my opinion – diminish the country’s growing appetite for gold jewelry and investment.

PBOC policy actions – raising interest rates, adjusting bank reserve requirements, and allowing some gradual appreciation in China’s currency, the yuan – are in response to super-strong economic activity and uncomfortably high domestic price inflation.

But, real interest rates in China (that is after adjustment for inflation) are actually falling . . . and have become more stimulative and supportive of gold. Moreover, Chinese monetary authorities would like to see more, not less, private gold investment, hoping to reduce speculative investment in real estate and the stock market.

At most, Chinese authorities are trying to cool a hot economy and slow the annual rate of GDP growth from around ten percent to a more sustainable pace around seven percent. I have long argued that the country’s long-term bullish influence on the world gold market would continue as long as China’s economy continues to chug along at a moderate rate – with or without worrisome rates of consumer price inflation.

If inflation accelerates, as it has recently, led by rising food and commodity prices, that’s just icing on the cake, boosting gold demand still more.

Indian Demand Heats Up

China isn’t the only giant shaking up the world of gold. India’s appetite for gold is also hot like curry.

As in China, economic growth has been strong with GDP rising smartly – and inflation has been heating up as well.

India has historically been a very price-sensitive market for precious metals. Typically, buying interest falls as prices rise . . . and, at higher prices, India women are known to take profits, cashing in their bangles and chains, so much so that Indian gold scrap can, at times, be an important source of supply to the world market.

In contrast to the historical experience, we are now seeing much less price sensitivity of demand as Indian consumers have adjusted quite quickly to record high gold prices. Even at recently prevailing prices in the $1400 to $1500 an ounce range, Indians still seem eager buyers – suggesting a psychological re-evaluation of gold-price prospects.

As in many other countries, Indian gold investment is benefitting from securitization and the growth in gold exchange-traded funds. First introduced in 2007, there are now 10 gold ETFs with physical gold held on behalf of investors totaling more than half a million ounces (about 15.5 tons) when I last checked a few months ago – and holdings will likely grow as more mainstream stock-market investors participate.

India and China are very important markets for gold, in part, reflecting their huge populations and growing wealth. But there are many other countries across Asia and the Mideast that share an historical, cultural, and even religious affinity to gold as a traditional monetary medium for saving and investment. Even gold jewelry in many of these countries is purchased for its investment characteristics, as a symbol of wealth and social status, and as an amulet or talisman bringing good fortune to its owner.

Longer term, as many of these countries prosper and as their share of global income and wealth continues to increase, they will demand a growing share of the world’s above-ground stock of gold for jewelry, for investment, and for central bank reserves.

Importantly, much of the gold bought by these countries will probably never come back to the market, at least not for many years to come and only at much higher price levels or if political and economic developments prompt distress sales, something we will not likely see in the next few years.

Central Banks Buying More

Central banks collectively have taken a much more positive view of gold in recent years.

Just last week, it came to light that Mexico’s central bank, the Banco de Mexico, purchased some 93.3 tons this past February and March. That’s about 3.5 percent of annual world gold-mine output worth more than $4 billion at recently prevailing prices.

After net sales of roughly 400 to 500 tons a year over the prior decade, the official sector (including central banks, the International Monetary Fund, and sovereign wealth funds) became a net buyer of gold in 2009.

Net official purchases may have totaled as much as 100 to 200 tons in each of the past two years, even allowing for the IMF’s 403 ton gold sales program, which ended some months ago.

Last year, net official purchases continued as a number of central banks, principally in Asia, added to their official reserves while sales by European central banks were minimal – and have now virtually ceased except for some small reductions for domestic gold coin programs.

Officially published data on central bank gold transactions are not to be believed as some countries buy gold surreptitiously, choosing not to report purchases . . . and data on sovereign wealth funds are, for the most part, unreported. So, it’s not possible to get an exact reckoning of net annual purchases or sales by the official sector.

China, for example, announced two years ago that its central bank had purchased 454 tons in the prior six years – but it chose not to report these purchases until April 2009. Some observers, myself included, believe that China continues to buy significant quantities on a regular basis, possibly 100 tons or more annually, probably all of which comes from domestic mine production.

Saudi Arabia also added significant quantities of gold – 180 tons, in fact – to its official holdings over the past few years – but did not report these purchases until last June. It is likely that the Saudi Arabia Monetary Authority also continues to buy . . . along with some of the other oil producers with dollar-heavy, gold-underweighted official reserves.

The People’s Bank of China, the PBOC, and other central banks have an incentive to buy gold discretely and surreptitiously – simply because the announcement and acknowledgment of their buying programs would likely affect the yellow metal’s price and raise these central bank’s acquisition costs.

What we do know is that the list of countries that have bought gold since the beginning of 2009 continues to grow. China, Russia, India, Saudi Arabia, and now Mexico have been the biggest buyers. Other gold-buying countries include Kazakhstan, Sri Lanka, Mauritius, Venezuela, Bolivia, the Philippines, Thailand, and Bangladesh. Even the Ukraine and Tajikistan central banks have added small amounts to their official reserves in the past year.

Meanwhile, in recent days, it has been suggested by senior German officials that Portugal ought to sell some of its official gold holdings to ease its difficult debt problems. Should such a sale take place it is very likely that a number of other central banks would quickly line up as potential buyers, with Germany’s Bundesbank and the European Central Bank probably at the front of the line.

Recent year gold sales by the IMF have demonstrated that large-scale official sales need not disrupt the market – and that central banks underweighted in gold are willing buyers when given the opportunity to make off-market purchases.

Increasingly, many investors – both retail and institutional – are looking at these official-sector gold purchases and concluding they, too, should be diversifying their savings and investments with some physical gold.

Rising Participation

A few weeks ago, a big headline in the Wall Street Journal proclaimed “World is Bitten by the Gold Bug.” Gold bears seem to think that suddenly everyone has gone mad buying gold – and, because so many piled so quickly and recklessly into gold, they argue we have already seen the top and the metal will just as quickly lose value as investors shed their holdings.

Even though more people than ever before are buying gold, participation by both retail and institutional investors in the United States and many other countries remains very low. Moreover, many investors already holding gold remain underweighted with less than optimal and prudent holdings.

I expect participation rates will rise in the months and years ahead as more savers and investors “catch the gold bug” and begin to see the virtues of gold as a reliable store of value and insurance policy against an assortment of risks to their economic and financial wellbeing.

Of great importance to the future price of gold has been the introduction and growing popularity of gold exchange-traded funds (ETFs) from one country to the next. Gold ETFs are gold-backed stock-market securities that track the ups and downs of the metal’s price and represent an ownership interest in actual bullion held on behalf of fund investors. As stock-market securities they attract investors for whom direct ownership of bars or coins may be too cumbersome . . . and ETFs allow some institutional investors prohibited from owning physical commodities or futures contracts a legal loophole, if you will, through which they have bought many tons of metal.

On a cautionary note, gold exchange-traded funds not only allow investors to easily and quickly accumulate gold . . . these ETFs also allow investors to easily and quickly shed their gold holdings. At times, this has contributed to upside volatility with occasional swift appreciation in the metal’s price. But, ETFs have also contributed to downside volatility – like the sharp correction we saw just last week.

Developments in key geographic markets along with new more convenient investment vehicles are making gold more accessible and more mainstream to more investors around the world – and the result, in economist-speak, is a permanent upward shift in the demand curve such that the future long-term average price, stripped of cyclicality, will be much higher than the average price over the past decade or two.

My Gold Price Forecast

I see the clock ticking, so let me say something very briefly about world gold mine output and wrap up with my gold-price expectations.:

While production has increased in the past couple of years, growth in total ounces produced will continue to be modest for the next few years, maybe 1.5 to 2.0 percent annually – and total world mine production will continue to fall far short of the expected growth in jewelry, investment, and central bank demand for at least the next five years or longer.

Well, now that we’ve circumnavigated the world of gold and accounted for the key trends and developments, what can we say about the metal’s price prospects?

I believe gold’s fortunes remain very bright. To begin with, gold’s key price drivers all remain supportive . . . and there are so many of them, so many reasons to expect the long-term trend will continue upward for at least another few years.

What’s more, recent market activity – from a technical or chartist perspective – rather than signaling an end to gold’s decade-long advance, strengthens the case for a snap-back in the metal’s price with new all-time highs in the months ahead.

It’s sometimes said that forecasting is particularly difficult, especially when it’s about the future – and this is even more so when it comes to forecasting the future price of gold. It’s more an intuitive art than an exact science . . . although many an analyst and economist would have you believe otherwise.

That said, it’s my hopefully well-informed opinion that the price of gold will very likely hit $1700 an ounce by the end of this year – and I wouldn’t be at all surprised to see it even higher.

At the same time, gold prices are likely to remain volatile registering big short-term swings both up and, as we saw last week, down. Sizable intermittent price declines may lead some investors, and more than a few journalists, to question the bull market’s staying power. I can only warn you not to get prematurely caught in a bear trap.

Looking further out, I believe we are likely to see gold at $2000 an ounce in the next year, and possibly $3000 or even $5000 an ounce before the gold-price cycle moves into reverse in the middle or later years of this decade.

Jeffrey Nichols

 NicholsonGold.com