Speech to the Gold Outlook Asia 2009 Conference
Hong Kong â€“ October 22, 2009
Iâ€™ve been asked to talk about the world economic and financial crisis â€“ and the implications for gold. In addition, I want to discuss important changes in the official sector and structural developments in the private investment sphere that have important implications for the price of gold over the next few years.
The place to begin, however, is with the U.S. and global macroeconomic situation â€“ past, present, and future.
This is an especially appropriate topic for an American economist since it has been, in large measure, Americaâ€™s economic policies over the past several decades that have landed us in todayâ€™s international economic predicament.
In my view, the root cause of the current world economic crisis has been decades of easy money, low interest rates, and a persistently expansionary monetary and fiscal policy by the United States â€“ aided and abetted by China and the other major Asian exporting nations. As a result, Americans have been on a buying binge in the global marketplace, buying things we often donâ€™t really need with money we donâ€™t really have.
And the rest of the world â€“ especially China and the other Asian economic powerhouses â€“ have been co-conspirators, lending us the money to satisfy our need for more things in order to promote economic growth and high employment in their own economies.
Now, however, many foreign lenders â€“ both private and official â€“ who have been financing Americaâ€™s budget and trade deficits are becoming increasingly uncomfortable pouring more and more good money after bad.
Hereâ€™s a quick lesson about the economic history of the late 20th and the early 21st centuries: Beginning in President Reaganâ€™s second term with the appointment of Alan Greenspan as Chairman of the U.S. Federal Reserve and continuing with Ben Bernanke at the helm of Americaâ€™s central bank, the Fed has pursued an expansionary, low interest-rate policy that has placed growth above all else.
During these years, every economic or financial-market crisis was met with injections of liquidity into the banks and financial markets with interest rate cuts often to negative inflation-adjusted rates of return.
The stock market crash of 1987, the Gulf War beginning in 1990, the Mexican Peso Crisis in 1994, the Asian Currency Crisis in 1997, the Long-Term Capital Management bankruptcy in 1998, the Internet Dot-Com Bubble in 2000, and the U.S. Housing Bubble that ended in 2007:
Each crisis was met with more money and lower interest rates â€“ a policy that came to be known as the â€śGreenspan Putâ€ť and more recently the â€śBernanke Putâ€ť because it assured many of the most reckless risk-takers they would not lose a red cent. Even if their investment and trading strategies went awry, the Fed was there to bail them out.
We never would have had the last stock market boom carry valuations to such heights without easy money.
We never would have had the U.S. housing boom without artificially low interest rates and without Fannie Mae and Freddie Mac promoting home ownership for everyone.
We never would have had the mortgage-backed securities debacle without easy money and low interest rates. And, no one â€“ especially foreign central banks â€“ would have bought these and other sub-prime securities if they thought they could lose their shirts.
A healthy vibrant economy needs to clean out the dead wood from time to time. Rather than allowing periodic recessions and bear markets to purge the excesses of each prior boom or bubble, the Fed stimulated the economy with massive doses of new credit, more liquidity, and lower interest rates. Neither the Fed nor the politicians in Washington wanted a recession â€“ and hardly anyone complained when the Fed just printed more money.
Not Over Yet
Today, we should not be fooled by signs the U.S. financial crisis is now over. The losses are still there . . . and still growing: Theyâ€™ve only been transferred from Wall Street and the private sector to the Federal Reserve and the U.S. Treasury.
And, donâ€™t be fooled that the recession in the United States is really over and things are getting back to normal. The U.S. economy is showing signs of life only because of massive injections of liquidity from the Fed, unprecedented fiscal stimulus by the U.S. Treasury, and inventory restocking.
Do you really think the economy will continue to grow if the Fed removes the intravenous feeding tube? Do you really think American consumers are in shape to start spending again â€“ with unemployment rising, household wealth diminishing, and continuing uncertainty about our economic future?
Although many economists, politicians, investors, and news reporters are beginning to talk about economic recovery in the United States, those that are seeing â€śgreen shootsâ€ť in my view are looking through â€śrose-coloredâ€ť eyeglasses . . . and there is significant risk of a â€śdouble-dipâ€ť recession with further contraction and a second down-leg in U.S. equity prices yet to come.
Indeed, much of the recent uptick in economic activity reflects the government stimulus programs, such as the â€ścash-for-clunkersâ€ť program that gave the U.S. auto industry a temporary boost.
While some of these programs help businesses and households in the short run, they are all adding to the Federal budget deficit . . . and, in the long run, will complicate the Federal Reserveâ€™s monetary policy dilemma.
We are in this mess today because America borrowed and spent too much, because we created too much credit, pumped out too much liquidity, and often kept interest rates too lowâ€“ and the rest of the world was willing to go along.
Now, the politicians and policy-makers are telling us the cure is more spending, more borrowing, bigger deficits, more credit, more liquidity and negative real interest rates.
How can this be? It was too much liquidity, too much credit, too much spending, and too much borrowing that created the economic crisis in the first place.
Yet, Americans are told by mainstream economists and politicians that the prescription is more of the same â€“ only in bigger doses.
Just look at the surging Federal budget deficit: Not many years ago, a deficit of two hundred or three hundred billion dollars was considered sufficient to elicit concern. Now, we expect annual deficits in the trillions for at least the next 10 years . . . and few are complaining.
I donâ€™t know what the prescription is . . . but I can tell you itâ€™s not more of the same. Would you tell a drug addict to cure his addiction with more heroin, only in bigger doses? Of course not!!
However, what I do know is that difficult times lie ahead â€“ not just for the United States but also for many of its creditors and trading partners. Large budget deficits call for increased taxation at home â€“ but tax increases are an anathema to Americans and there is only so much American voters will accept.
In lieu of actually paying down Americaâ€™s huge debts, we can expect currency debasement and higher rates of inflation to reduce the real value Americaâ€™s debts at home and abroad.
Hereâ€™s another indicator that the United States is headed into a period of higher inflation.
We have never in the economic history of the United States seen a period of rapid growth in money and credit nor an extended period of negative real interest rates that has not been followed by a declining dollar exchange rate abroad and a rising inflation rate at home.
A number of important foreign central banks â€“ especially China and the other Asian tigers â€“ are waking up to this situation.
They are seeking ways to diversify their reserve assets in order to minimize dollar-related risks â€“ and this will likely include acquiring proportionately more euro-denominated debt and more gold purchases by the official sector.
And, they will increasingly encourage their corporate sectors to invest in real assets around the world â€“ including mining and mineral resources â€“ so that they get something of intrinsic value for some of those depreciating dollars held by their central banks.
With higher inflation and a depreciating U.S. dollar, I think you can sense that Iâ€™m bullish on gold. Iâ€™ll have more to say about this later.
But first Iâ€™d like to briefly discuss five important gold-market trends: (1) the continuing slide in world gold mine production, (2) the surge in old gold scrap last year and early this year, (3) the fall of jewelry fabrication demand, (4) changing central bank attitudes with respect to gold, and (5) important developments in the gold investment arena.
Mine Production in Decline
Annual worldwide gold-mine production peaked in 2001 at 2,645 tons and has been falling gradually ever since. This downtrend is expected to continue at least for the next few years . . . and by 2011 it will likely have dwindled to less than 2,300 tons â€“ a decline of 14 percent over the 10-year period.
Over the long term, mine output is a reflection of price versus the rapidly rising cost of production and the increasing difficulty and expense in finding new deposits large enough to offset the loss of production from the ongoing depletion of existing mines.
In addition, increasingly stringent environmental regulations are adding to costs â€“ and unfriendly government attitudes toward mining or foreign ownership in some countries â€“ are discouraging exploration and development.
Importantly, the stock-market crash and continuing global economic crisis has slowed funding and retarded mine exploration and development in many countries.
One explanation to the on-going decline in worldwide mine production is that prices in the past couple of decades simply have not been high enough to encourage exploration and development sufficient to replace the dwindling reserves in the historic â€śbig fourâ€ť gold producing countries â€“ South Africa, the United States, Canada, and Australia.
Interestingly, the locus of world gold-mine production is shifting from the â€śbig fourâ€ť to the emerging market nations â€“ particularly China, Russia, Indonesia, and Peru.
China became the worldâ€™s number one gold-producing country in 2007 aided by supportive government policies that continue to promote a rapid pace of mine development and rationalization of the industry. These policies are likely to continue . . . and, I expect, Chinaâ€™s gold mine production will continue to grow, both in absolute terms and as a proportion of total world output.
Although there is much exploration and development activity in a number of prospective regions around the world â€“ and more can be expected as prices rise and access to financing improves â€“ it will not be sufficient to reverse the downtrend in global gold-mine production for at least the next five years â€“ and likely longer.
Even if the price of gold rises substantially in the next few years sufficient to provoke a rush of exploration and mine development, for projects large enough to make a big difference, it usually takes five to ten years or longer to move from exploration to development and then to large-scale production.
The Rise of Secondary Supply
Unlike â€śprimaryâ€ť output from mines, the recycling of old scrap â€“ mostly from jewelry â€“ reacts quickly to changes in the price of gold beyond certain levels that are seen by holders as attractive â€śsellingâ€ť points.
Last year and earlier this year, as prices rose through the $900 and $1000 an ounce levels, holders of old gold jewelry in many countries around the world made a collective judgment that the price was too high. As a result, scrap supplies exploded, so much so that there was a flood of metal into the market, making the higher price levels unsustainable.
Scrap recycling, which on average runs about a thousand tons a year climbed to double that rate in the fourth quarter of 2008 and the first quarter of 2009.
In the past couple of years, the rise in jewelry scrap has also been a reflection of economic hardship, high unemployment, and a desperate need for cash by some holders of old gold jewelry.
With prices recently over $1000, it is encouraging to note that the responsiveness of scrap has been much more subdued compared to the previous episodes of gold moving over this psychologically important price level.
The Fall of Jewelry
Letâ€™s turn from old scrap â€“ where jewelry is a source of supply â€“ to jewelry fabrication, which until recent years has been a steady and reliable source of gold demand.
Gold jewelry fabrication demand reached an all-time in 1997 at 3,342 tons â€“ and, since then, has been trending downward. This year, I expect worldwide jewelry fabrication demand will total little more than 2,100 tons.
Much of the decline in jewelry offtake has occurred since 2001 and reflects the substantial rise in gold prices â€“ both in U.S. dollar terms and in local currencies for many important geographic jewelry markets.
With the continuing credit crisis and global recession, demand has also been hit hard by the collapse in retail sales, especially in the United States and Europe. In addition, and of importance to the near-term outlook, the steep decline in fabrication has been exaggerated by the running down of inventories on hand at manufacturers, distributors, and retailers.
In general, I expect a modest recovery in worldwide jewelry demand, reflecting an improving economic environment in some of the developing markets â€“ especially India and China â€“ and supported also by some rebuilding of inventories . . . but this recovery will muted by the expected rise in the metalâ€™s price over the next few years.
Official Sector Gold Policy
Letâ€™s turn our attention to the official sector. As many of you know, central banks and the IMF have been are a hot topic in the world of gold.
I believe this year is a key turning point in the modern history of gold as an official reserve asset. Central bank attitudes with respect to gold are becoming increasingly positive. After years of persistent net sales by central banks in the aggregate, the official sector is now becoming a net purchaser of gold from the market.
On average, the central banks of the world hold about 10 percent of their international reserves in gold . . . but there is great disparity from country to country and region to region.
The major Euro-zone nations together hold about 55 percent of their assets in gold. In contrast, the Asian nations, as a group, hold only about two percent of their reserves in gold. Based on recent published statistics, China has about 1.9 percent of its reserve assets in gold and Russia holds about 4.3 percent in gold.
For the past three decades, beginning in the mid-1970s, gold has been under the threat of massive sales by the worldâ€™s gold-rich central banks and by the International Monetary Fund as well. In fact, the official sector has been a net seller of gold each and every year since 1989.
At times, official sales â€“ and the threat of more to come â€“ have contributed to negative sentiment in the marketplace with the price typically falling whenever one or another central bank announced a sales program.
This was seen most dramatically in 1999 when, much to its recent embarrassment, the Bank of England sold over half its official gold reserves at an average price of about $275 an ounce. So much for central bankers making smart decisions!!
A number of other European central banks â€“ among them Switzerland, France, Italy, Spain, Portugal, and the Netherlands â€“ followed Britain, together selling about 3900 tons in total over the next 10 years.
Realizing that their gold sales were having a considerable disruptive affect on the market and the metalâ€™s price, the European central banks announced in September 1999 their agreement to limit future gold sales to no more than 400 tons per year over the next five-year period.
This was followed by a second Gold Agreement in 2004, which limited sales by the European signatory nations to 500 tons per year for another five years.
And, just recently, the European Central Bank announced a third Agreement that caps the groupâ€™s aggregate sales once again to 400 tons per year for the next five years.
All of this may prove to be irrelevant because the European central banks have not been inclined to sell much gold this past year â€“ and my guess is that they will not sell much at all during the next few years.
For one thing, many central bankers are bullish on the metal and donâ€™t want to sell an appreciating asset.
Moreover, central banks that have sold large quantities of gold in the past now look quite foolish as the metalâ€™s price has moved higher and the value of their U.S. dollar reserves has declined.
European central bank sales in this final year of the second Central Bank Gold Agreement, which ended last week, will probably total about 150 tons versus the 500 tons allowed.
I believe the decline in gold sales by the European central banks reflects a renewed respect for the yellow metal as a reserve asset and reliable store of value.
The International Monetary Fund has also made news with its plans to sell 403.3 tons of gold to support lending to the poorest countries. IMF strategists have suggested sales might occur gradually over two or three years. Others believe all 403 tons may be sold â€śoff the marketâ€ť directly to one or a few central banks â€“ with China, Russia, India, Brazil, and the Gulf states mentioned as possible buyers.
Importantly, the new Central Bank Gold Agreement incorporates these sales by the IMF, even though the Fund is not a signatory. In other words, total sales by the European central banks and the IMF cannot exceed 400 tons per year â€“ unless some of the IMF metal is transferred â€śoff the marketâ€ť to one or more central banks.
To a large extent, gold sales by the IMF are already anticipated and factored into the current price. However, direct sales â€“ off the market â€“ to one or more central banks would be confirmation that central bank attitudes are shifting in favor of gold and would likely have a positive affect on the metalâ€™s price.
The big news of the past year has been announcements from both China and Russia that they have been buying gold from their domestic mine production â€“ importantly demonstrating that large central banks can gradually buy gold without disrupting the market.
This past April, China told the world it had purchased 454 tons since 2003, bringing its total official holdings to 1,054 tons â€“ still less than two percent of its total official reserves.
I believe China continues to buy gold from domestic production at a rate of at least 75 tons a year â€“ but gold purchases this year have not yet been transferred to the central bank accounts and have not yet been reported as official reserves.
Russia, like China, has also been buying gold for official reserves from its own domestic mine production. Prime Minister Putin has said that Russia should hold 10 percent of its official reserves in gold versus the 4.3 percent that it held at the end of July. Recent statistics indicate the country has added nearly 50 tons to its official reserves during the first seven months of the year.
The Expansion of Investment
While changes in goldâ€™s commodity fundamentals are important, it is developments in the investment arena that will have the greatest impact on the metalâ€™s price.
Already, the introduction and growing popularity of gold exchange-traded funds (ETFs) is having a profound influence on the gold market.
Gold ETFs are gold-backed stock-market securities representing ownership in a trust designed to track the ups and downs of the metalâ€™s price. Despite some rumors to the contrary, certainly the major gold ETFs representing the lionâ€™s share of the market are backed 100 percent by physical bullion held in depositories on behalf of ETF investors.
Importantly, gold ETFs are bought, sold, and trade just like equities on a stock exchange â€“ and they avoid the tax, storage, and other difficulties sometimes associated with owning physical gold.
By facilitating gold investment and ownership they have brought significant numbers of new participants to the market â€“ not just individuals but hedge funds, pension funds, and other institutional investors.
So much so that bullion held in depositories on behalf of ETF investors now total some 1,729 tons, more than the central banks of either Switzerland or China â€“ a remarkable feat considering gold ETFs have been around only about six years and got off to a slow start.
Iâ€™ve already mentioned Chinaâ€™s central bank interest in gold. Just recently, China has gone one step further by encouraging private citizens to buy gold and silver investment â€“ and will be making investment bars available through the domestic banking system.
To put this into perspective, imagine that just one percent of Chinaâ€™s population each buys one ounce of gold next year â€“ thatâ€™s 13 million ounces (or about 404 tons) of new demand, coincidentally about the same amount the IMF will now be selling.
The Future Price of Gold
The future price of gold â€“ at least over the long term â€“ has less to do with mine production, secondary supply, jewelry fabrication or any of the other â€ścommodityâ€ť fundamentals of gold supply and demand . . . and most to do with goldâ€™s appeal as a financial and monetary asset â€“ an asset held as a savings medium, store of value, portfolio diversifier, and insurance policy by individuals, investment institutions, and central banks alike.
As I discussed earlier, real interest rates are a reliable indicator of Federal Reserve monetary policy â€“ and it is monetary policy and money-supply growth that ultimately affects the dollar, inflation, and gold.
The historical data show that the U.S. dollar gold price is inversely related to the real (or inflation adjusted) rate of return on U.S. Treasury securities.
Not surprisingly, the current bull market for gold that began in 2001 (with gold near $255 an ounce) has, for the most part, been a period of negative or low real interest rates.
In fact, in the years of market-determined gold prices (since August 1971 when President Nixon closed the gold window) each and every time the real inflation-adjusted three-month U.S. Treasury bill rate fell below zero, the U.S. dollar gold price rose over the subsequent 12-month period.
The great bull market for gold in the late 1970s culminating in the 1980 high near $875 an ounce was also a period of negative real interest rates in the United States. And, goldâ€™s run up in late 2007 and early 2008 â€“ an advance that saw the price rise briefly over $1,030 an ounce â€“ was again a period of negative real interest rates.
Today, real â€śinflation-adjustedâ€ť interest rates across a range of maturities are again negative . . . so, if history is a guide, we can expect the price of gold to continue moving higher over the next year.
As my clients know, I am â€śextremely optimisticâ€ť on the gold-price outlook â€” but, unlike many other bullish analysts, I believe the metalâ€™s ascent will take several years to reach its next long-term cyclical peak.
In the meantime â€“ partly because of the activity of ETF investors and partly because the price sensitivity of secondary supply and jewelry fabrication in this difficult economic environment â€“ we can expect high volatility and a difficult climb, with sharp reversals along the way that will, at times, cause some observers to wonder if the market has already topped out.
Ultimately, thanks to the extremely expansionary monetary policy â€“ and with a little help from ETF investors, central banks, and new or evolving geographic markets â€“ like China and India â€“ gold will most likely climb into the US$2000 to $3000 range â€“ and it could go even higher given the right confluence of economic and political developments . . . or if a late-cycle mania produces a final hyperbolic bubble before the gold-price cycle moves into its next bear-market phase.