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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 19th,
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
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