Speech to the 4th Annual China Gold & Precious Metals Summit
GOLD SITUATION & OUTLOOK:
How Monetary Policies, Investment Demand, Central Bank Interest, and Other Supply/Demand Factors Are Affecting the Market and the Metal’s Future Price
Shanghai, China — December 3, 2009
I’ve been asked to talk about the Gold Situation and Outlook - in particular how monetary and fiscal policies, private-sector investment demand, renewed central bank respect for gold, and other supply-demand factors are changing the market - and have important implications for the price of gold over the next few years.
The place to begin is with the U.S. and global macroeconomic situation - past, present, and future.
Easy Money is the Root
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 - aided and abetted by China and the other major Asian exporting nations.
As a result, Americans have for many years been on a buying binge in the global marketplace, buying things we often don’t really need with money we don’t really have.
Now, however, many foreign lenders - both private and official - who have been financing America’s Federal budget and trade deficits are becoming increasingly uncomfortable pouring more and more good money after bad.
For at least the past quarter century America’s central bank, the Federal Reserve, has generally pursued an expansionary, low interest-rate policy that has favored economic growth and high employment above price stability and a stable currency.
During these years, every economic or financial-market crisis was met with another injection of liquidity into the banks and financial markets with interest rate often pushed down below the inflation rate to negative real 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 - a policy that led many of the most reckless risk-takers to believe they could not lose. Even if their investment and trading strategies went awry, the U.S. Federal Reserve 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 - especially foreign central banks - would have bought these and other sub-prime securities if they thought their money was at serious risk.
Unfortunately, America’s lenders are now realizing the “full faith and credit” of the United States isn’t what it used to be.
A healthy vibrant economy needs to clean out the dead wood from time to time. Rather than allowing periodic recessions to purge the excesses of each prior boom or bubble, the Fed repeatedly stimulated the economy with massive doses of new credit, more liquidity, and lower interest rates. Neither the Fed nor the politicians in Washington - both Republicans and Democrats - wanted a recession - and hardly anyone complained when the Fed just printed more money.
America’s False Recovery
Today, we should not be fooled by signs the U.S. financial crisis is now over. The losses are still there . . . and still growing: They’ve only been transferred from Wall Street and the private sector to the Federal Reserve and the U.S. Treasury.
Neither should we 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 mostly because of massive injections of liquidity from the Fed, unprecedented fiscal stimulus by the U.S. Treasury, and inventory restocking.
No one really thinks the economy will continue to grow if the Fed removes the intravenous feeding tube. With unemployment rising, household wealth diminishing, and continuing uncertainty about our economic future, American consumers are in no shape to start spending again.
Although many are talking about economic recovery in the United States, those that are seeing “green shoots” in my view are looking through “rose-colored” eyeglasses . . . and there is significant risk of a “double-dip” recession with further contraction and another collapse in U.S. equity prices yet to come.
While some of the Federal stimulus programs help businesses and households in the short run, they are all adding to the Federal budget deficit . . . and, in the long run, will result in more monetary creation, more inflation, and a weaker U.S. dollar.
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 low- and our trading partners were willing to go along because it supported growth and employment in their own economies.
Defying common sense, the politicians and policy-makers in Washington are telling us the cure is more spending, more borrowing, bigger deficits, more credit, more liquidity and continued 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 - only in bigger doses.
Difficult Times Ahead
I don’t know what the prescription is . . . but I can tell you it’s not more of the same. Would you tell a heroin addict to cure his addiction with more heroin, only in bigger doses?
However, what I do know is that difficult times lie ahead - 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 - but tax increases are an anathema to Americans and there is only so much American voters will accept.
In lieu of actually paying down America’s huge debts, we can expect currency debasement and eventually higher rates of inflation to reduce the real value America’s debts at home and abroad.
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 - most notably the People’s Bank of China and the Reserve Bank of India - are waking up to this situation.
They are seeking ways to diversify their reserve assets in order to minimize dollar-related risks - and this includes acquiring proportionately more euro-denominated debt and more gold purchases by the official sector.
With this macroeconomic situation in mind, let’s take a quick look at five important gold-market developments: (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.
Declining Mine Production
Annual worldwide gold-mine production peaked in 2001 at 2,645 tons and has been falling gradually ever since. Despite a brief uptick in global gold production this year, the long-term downtrend is expected to continue at least another few years . . . and by 2011 output will likely have dwindled to less than 2,300 tons - 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 - and unfriendly government attitudes toward mining or foreign ownership in some countries - are discouraging exploration and development.
Importantly, the continuing global economic crisis has slowed funding and retarded mine exploration and development in many countries, particularly for exploration and junior mining companies.
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 “big four” gold producing countries - South Africa, the United States, Canada, and Australia.
Interestingly, the locus of world gold-mine production is shifting from the previous “big four” to the emerging market nations - particularly China and Russia - both of which seem likely to hoard or consume most, if not all, of their gold-mine production, rather than sell it into the world market.
China became the world’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. As you know better than I, these policies are likely to continue . . . and China’s gold-mine production should 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 - and more can be expected as prices rise and access to financing improves - it will not be sufficient to reverse the downtrend in global gold-mine production for at least the next five years - 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.
Secondary Supply
Unlike “primary” output from mines, the recycling of old scrap - mostly from jewelry - sometimes reacts quickly to changes in the price of gold beyond certain levels that are seen by holders as attractive “selling” 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 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 had been running 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.
But this year, with prices over $1000, there has been a sea change in scrap flows. Apparently holders of old gold items began to think of $1000 an ounce as the new floor rather than the old ceiling. And it hasn’t been until quite recently, with gold well over $1,100 an ounce that scrap supplies have picked up - but secondary supply still remains well below the pace of a year ago.
Falling Jewelry
Let’s turn from old scrap - where old jewelry is a source of supply - to new 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 - and, since then, has been trending downward. Last year, global jewelry fabrication demand fell below 2000 tons . . . and this year, it could amount to less than 1,900 tons worldwide.
Much of the decline in jewelry offtake has occurred since 2001 and reflects the substantial rise in gold prices - both in U.S. dollar terms and in local currencies for many important geographic jewelry markets.
In more recent years, the poor economic environment has also hit jewelry demand, especially in the United States and Europe. In addition, and of importance to the near-term outlook, the steep decline in fabrication had been exaggerated by a reduction 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 - especially India and China - and supported also by some rebuilding of inventories . . . but this recovery will muted by the expected rise in the metal’s price over the next few years and by an on-going shift to lighter and lower karatage items in some markets.
While changes in gold’s commodity fundamentals are important, it is developments in the official sector and private investment arena that will have the greatest impact on the metal’s future price.
Official Sector Gold Policies
So, let’s turn our attention to the official sector - where momentous changes are underway.
I believe this past year will prove to be 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 has this year become 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 two percent of its reserve assets in gold and Russia now holds about six percent in gold.
Over the past three decades, beginning in the mid-1970s, gold has been under the threat of massive sales by the world’s gold-rich central banks and by the International Monetary Fund as well. In fact, up to now, the official sector has been a net seller of gold each and every year since 1989.
Over the past 20 years, net sales by the official sector have averaged over 400 tons a year, accounting for about 12 percent of total supply over the period. One can imagine that this additional supply of gold entering the market year after year must have had a considerable negative influence on the metal’s price.
Most of this metal came from a number of European central banks, some of whom simply thought they were over-weighted in gold relative to interest-bearing U.S. dollar securities . . . and some who saw gold as a “barbaric relic” to be disposed of in favor of modern financial instruments.
Large-scale European central bank gold sales now appear to have run their course. In part, this reflects a renewed respect for gold as a reserve asset and reliable store for value - and a loss of respect for the U.S dollar alternatives.
In hindsight, central banks that sold large quantities of gold in the past now look quite foolish. In addition, many central bankers are bullish on the metal and don’t want to sell an appreciating asset.
For sure, official sales - and the threat of more to come - have often contributed to negative sentiment in the marketplace with the price typically falling whenever one or another central bank announced a sales program.
But now, the opposite is true. Western central bank sales have run their course - and Eastern central banks, exemplified by China and India, with relatively low gold holdings appear eager to acquire more.
The expectation of central bank purchases is bolstering the market. Each announcement by one or another central bank - even a tiny country like Mauritius - encourages private investors and has been greeted with an advance in the metal’s price.
Why Central Banks Hold Gold
So why do central banks hold gold . . . and why are some now buying more?
- First, gold brings a degree of economic security. It is the only monetary or financial asset (apart from silver) that is not another’s liability and, therefore, makes it free from counterparty risk. It cannot be undermined or devalued by inflation in a reserve currency nation, nor can it be repudiated or defaulted upon for any reason by another country or institution.
- Second, gold provides protection against unexpected events. It provides “catastrophe insurance” in case of war, high (or hyper-) inflation, or internal political upheaval - because it is always liquid and universally accepted as a means of payment.
- Third, gold creates confidence. Although no currency in circulation today is backed by or convertible into gold, central bank gold holdings may instill a degree of confidence in a country’s currency.
- Fourth, gold serves as a great diversifier. Just as private investors may own gold as a portfolio diversifier, so do central banks. Since the metal’s price tends to be uncorrelated - or sometimes inversely correlated - with a central bank’s foreign currency holdings, inclusion of gold tends to reduce the volatility of a nation’s reserve assets.
- Fifth, gold offers physical security. Where appropriately located, gold cannot become subject to exchange controls or seizure by a hostile government.
- Sixth, gold may lend prestige. A significant gold position - or a significant addition to a country’s gold reserves - may bring with it a degree of international prestige and recognition in the family of nations. (For example, India’s recent acquisition made a powerful statement to the world that they are no longer a third-world economy but a leading nation in the world economy.)
- Seventh, some countries with domestic gold mine production, large current account surpluses, and growing foreign currency reserves might prefer to purchase its own domestic output, paying producers in its own currency, rather than sell its production into the world market for yet more unwanted foreign currency reserves.
- Eighth, geopolitical posturing: It is quite likely that central bankers here in China as well as in Russia have increased their official gold reserves, rather than accumulate still-more dollars, as a tacit declaration of economic independence, and as a warning that they are no longer playing by the old rules favoring the United States.
Who’s Buying
The International Monetary Fund has also made news, moving forward with its plans to sell 403.3 tons of gold to restore its own financial position and support lending to the poorest countries.
IMF strategists had suggested that sales might occur gradually over two or three years - so they must have been taken aback by India’s purchase of 200 tons. Mauritius was next, buying two tons from the IMF and then Sri Lanka’s bought 10 tons from the IMF, this on top of another 5.3 tons purchased earlier in the year in the world market.
Most observers believe the remaining balance - 191.3 tons - will be sold “off the market” directly to central banks wishing to augment their official gold holdings. Some think China will be the next big buyer but India is rumored to want more and other countries -Russia, Brazil, and the Gulf states - are also mentioned as possible buyers.
To a large extent, gold sales by the IMF had been already anticipated and factored into the current price. However, direct sales - off the market - are providing confirmation that central bank attitudes are shifting in favor of gold and each announcement has had a strong positive affect on private investor interest and, consequently, on the metal’s price.
Other 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 - importantly demonstrating that some large central banks can gradually buy gold without disrupting the market.
Some of you who attended this conference last year may recall my advice to the People’s Bank of China to buy gold from domestic gold mine production. This past April, it was revealed that they had been doing so since 2003, buying 454 tons, bringing its total official holdings to 1,054 tons - still less than two percent of its total official reserves.
I believe China continues to buy gold from domestic production at a rate of maybe 75 tons a year - but China’s official 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. Its central bank has revealed the purchase of 15.6 tons in October, bringing its total holdings to just over 606 tons - about 4.7 percent of total reserves. We can anticipate continued purchases as Russia strives to reach its 10 percent target.
A number of countries are calling for a new international reserve asset based on a basket of currencies with an enhanced role for gold. This seems highly unlikely anytime soon - but as long as it is being discussed and remains even a distant possibility, central banks are more likely to hoard their existing gold stocks . . . and some countries with uncomfortably large dollar-denominated holdings will probably buy more, either from their own domestic production or, when conditions allow, in the open market.
The Expansion of Investment
Investor interest in gold is also changing in a number of important ways with potential price implications that are not fully appreciated or recognized. Developments in key geographic markets along with new investment vehicles are making gold more accessible and more mainstream to more investors around the world - and the result is a permanent upward shift in the demand curve so that much higher prices will be the norm rather than a temporary cyclical episode.
Already, the introduction and growing popularity of gold exchange-traded funds (ETFs) are 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 metal’s price.
Importantly, gold ETFs are bought, sold, and trade just like equities on a stock exchange - and they avoid the tax, storage, and other difficulties sometimes associated with owning physical gold in some national markets.
Gold bars and coins have long been considered an unconventional investment choice by most Americans - but gold ETFs are now becoming a very conventional choice for many investors worried about the long-term value of the dollar, the overvaluation of equities, and the prospects for future inflation.
By facilitating gold investment and ownership they have brought significant numbers of new participants to the market - not just individuals but hedge funds, pension funds, and other institutional investors some of whom are prohibited from investing in physical commodities or futures contracts but can and are investing in gold ETFs.
Today, gold held in depositories on behalf of ETF investors totals close to 1,750 tons, more than the central banks of either Switzerland or China - a remarkable feat considering gold ETFs have been around only about six years and got off to a slow start.
I’ve already mentioned China’s central bank interest in gold. As many of you know much better than I, the Chinese government has recently gone one step further by encouraging private citizens to buy and hold gold - and gold investment bars, bullion coins, and other gold-backed vehicles are now available through the domestic banking system as well as at many jewelry retailers and department stores.
I’m told that investor participation in gold is expanding, prompted in part by booming real estate and equity markets and by rising inflation expectations. Future announcements of central bank additions to the country’s official gold reserves will probably encourage more private buying as well. Given the vast number of potential buyers along with the expected growth in personal income and wealth, I believe Chinese gold demand has the potential to push prices much higher in the next few years.
With some gradual appreciation of the yuan against the U.S. dollar in the years ahead, the local-currency price of gold may not rise quite as dramatically as the U.S. dollar denominated price - but gold’s future appreciation will still be quite satisfying to Chinese investors and long-term savers.
The Future Price of Gold
The future price of gold - at least over the long term - has less to do with mine production, secondary supply, jewelry fabrication or any of the other “commodity” fundamentals of gold supply and demand . . . and most to do with gold’s appeal as a financial and monetary asset - 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 - and it is monetary policy and money-supply growth that ultimately affects the dollar, inflation, and the U.S. dollar denominated 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 a period of negative real interest rates in the United States. Similarly, the stunning gold-price rallies in late 2007 and early 2008 - and again this year - were preceded by periods of negative real interest rates.
Today, real “inflation-adjusted” interest rates on short-term Treasury bills are even more negative . . . so, if history is a guide, we can expect the price of gold to continue moving higher over the next year.
No Bubble for Gold
There has been much talk lately about asset bubbles in various markets caused by traders and fund managers borrowing U.S. dollars at low interest rates to invest in what they expect will be higher yielding equity, real estate, and commodity markets around the world. This inflation in some asset markets far above their fundamental values is complicating economic policy in many countries. History suggests that buying mania - whether Dutch tulips, U.S. equities, or real estate here in Shanghai - inevitably end leaving much economic carnage in their wake.
Although gold is surely benefitting - along with other markets - from speculation with cheap money, the surging gold price is anything but a bubble. It’s built on the same monetary fundamentals and other factors that have supported a rising gold price in the past - easy money, low real interest rates, unbridled growth in U.S. Federal debt, diminishing faith in the U.S. dollar, rising geopolitical tensions, and global economic policy discord.
As my clients know, I am “extremely optimistic” on the gold-price outlook - but, unlike many other bullish analysts, I believe the metal’s ascent will take several years to reach its next long-term cyclical peak.
In the meantime - partly because of the activity of ETF investors, partly because the price sensitivity of secondary supply and jewelry fabrication in this difficult economic environment, and partly because steep declines in other markets may briefly pull gold lower - we can expect high volatility and, at times, a difficult climb, with sharp reversals along the way that will may cause some observers to wonder if the market has already topped out.
Ultimately, thanks to the extremely expansionary U.S. monetary policy - and with help from ETF investors, central banks, and new or evolving geographic markets - like China and India - I believe gold could climb into the US$2,000 to $3,000 range in the next few years - and possibly much higher if a serious crisis of confidence triggers a massive flight from the U.S. dollar.
