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World Economic Trends and the Future Price of Gold

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I recently had the pleasure and privilege of speaking again this year at the China Gold & Precious Metals Summit in Shanghai and to several private seminars organized by clients elsewhere across China.  Here’s the text of my presentation:

First My Forecast

Forecasters, whether of the economy, or the stock market, or the gold price are frequently wrong . . . but we are never in doubt.  It is up to you - the investor - to listen, evaluate, doubt, and make your own decisions about gold’s future price and the role the metal might play in your own investment portfolio and personal savings plan.

With this warning, let me tell you my own forecast:

I have no doubt that gold will move up sharply in the years ahead, reaching heights that might lead some to label me a “gold bug.”  I believe that the price of gold will, over the course of this decade, reach a multiple of recently prevailing prices.

Prices of $3000, $4000, and even $5000 an ounce are very likely during the course of this long-lasting bull market, a bull market that still has years of life left to it.

Not withstanding the recent sharp price decline, I’d be very surprised to see gold dip into “three-digit” territory - that is below $1000 an ounce - ever again.

But, gold prices will remain extremely volatile - with big swings both up and down along a rising trend.  In fact, big corrections - such as the decline from the September 6th all-time record high near $1,924 an ounce to the recent low near $1,580 (a decline of nearly 20 percent) - will lead many investors, analysts, and pundits to declare the death of gold . . . or, at least, the death of the bull market we have enjoyed over the past dozen years.

Yet, historically, a gold-price decline of 20 percent is not so unusual.  At the time of the Lehman bankruptcy in 2008, gold fell by more than 20 percent and was slow to recover - but recover it did.  And, in the 1970s, gold corrected several times by 15 to 20 percent and once by considerably more - all in the midst of a great bull market.

Moreover, although the U.S. dollar-denominated price of gold is well off its historic high, when valued in most other currencies, the metal’s price remains near its record highs.

The future price of gold is a function of past and prospective world economic, demographic, and political developments.  My job for the next hour or so is to briefly review some of these developments and trends - so that you can come to your own “golden” conclusions.

Gold’s Bullish Building Blocks

Let me quickly list the gold’s bullish building blocks - and then, as time permits, I’ll discuss a few of these bullish factors, in somewhat more detail.  You will notice that many of these factors are interrelated - but it is easier, for the sake of this discussion, to think of them as separate and distinct.

  • The first bullish building block is past and prospective U.S. Federal Reserve monetary policy, characterized by low or negative real rates of interest and unprecedented central bank monetary creation.
  • Second, the U.S. federal government budget impasse, rising U.S. sovereign debt, and eroding U.S. creditworthiness.
  • The third bullish building block for gold is the expected future depreciation of the U.S. dollar in world currency markets . . . and the continuing decline in the dollar’s purchasing power for American consumers.
  • Fourth, the growing insolvency of some European nations - leading to the disintegration of Europe’s Monetary Union and the eventual abandonment of Europe’s common currency, the euro, by at least some of the EU member countries.
  • Fifth, the expected acceleration of global inflation - fueled by excessive monetary creation, world population growth, and changing diets in favor of more meat and protein . . . and led by persistently high and rising agricultural and industrial commodity prices from one country to the next.
  • The sixth bullish building block for gold is increasing political instability in the Middle East and North Africa . . . as authoritarian regimes are overthrown . . . but sectarian divisions in some countries prevent orderly transitions to democracy . . . with implications for world oil supplies and prices.  And then, of course, there is Iran - which remains an unpredictable “wild card.”
  • Seventh, the growing affluence of the “emerging-economy nations” and the associated growth in both jewelry and private investment and savings demand for gold - especially here in China - as well as India and other gold-friendly countries.
  • My eighth bullish building block - one that I believe is especially important to the long-term development of the gold market - is the affect this rising wealth is having on emerging-economy central banks . . . prompting some countries that are over-weighted in U.S. dollars and underweighted in gold to diversify their official reserves through the prudent acquisition of the yellow metal.
  • Ninth, the development and popularity of new gold investment vehicles and channels of distribution - especially gold exchange-traded funds - that facilitate physical gold investment by both retail and institutional investors.
  • Tenth, the legitimization of gold as an investment class and rising investor participation . . . together reflecting a growing appreciation of the benefits of including physical gold in a well-diversified portfolio . . . and the entry of new, large-scale, professional investors - including pensions, endowments, insurance companies, sovereign-wealth funds, and especially hedge funds.
  • Eleventh, the “stickiness” of much of the recent private sector and central bank gold demand.  This is shrinking the available “free float” in the world gold market . . . and it means that less metal will be available to gold-hungry buyers, except at increasingly higher prices.  Indeed, many of today’s new investors have no intention of ever selling, even at much higher prices.
  • And, twelfth in my catalog of bullish factors supporting a continuing long-term rise in the price of gold is the fact that world gold-mine production, although growing, will not keep pace with the expected growth in global gold demand.  Even a rash of new mine discoveries would take five to 10 years - or more - to contribute significantly to supply . . . and, meanwhile, existing resources are being depleted, nationalized by unfriendly governments who tend not to be good mine operators, or are simply mined out.

Together these dozen bullish building blocks have resulted in a notional gap between world supply and aggregate demand - a gap that has been and will be closed only by high and rising prices in the years ahead.

American Economics

Let’s look more closely at some of these bullish factors . . . and let’s begin at the epicenter of the world’s economic earthquake - Washington D.C.

The U.S. economy still faces significant and painful consequences from its many years profligacy, years in which both the government and private sectors simply spent more than we could afford, on things we didn’t need, and, worst of all, with money we didn’t have.  Now we are paying the piper - and it will be years before the massive overhang of public and private debt is no longer a heavy burden on the economy.

As a result, the U.S. economy is in the midst of a persistent and prolonged recession - a long-lasting slowdown that is not fully reflected in the official government statistics, not fully recognized by the most-widely quoted mainstream economists, and not likely to go away anytime soon.

Despite a recent pickup in consumer spending, improving employment indicators, and wishful thinking from the White House and many economic forecasters, the U.S. economy remains in the midst of a persistent and prolonged recession or worse.

Normally, a recessionary economy would be countered by aggressive short-term fiscal stimulus - with more government spending and less taxation  - to give a temporary counter-recessionary boost to aggregate demand.

But fiscal policy is moving in the opposite direction - and is likely to continue in the wrong direction, making a lasting economic revival even less likely anytime soon.

The U.S. federal government came close to shutting down a few months ago when it bumped up against its mandated borrowing limit.  It is likely that we will see a replay sometime next year as federal borrowing again nears the debt ceiling and as the 2012 federal budget debate demonstrates Washington’s inability to put partisanship aside and deal sensibly with the country’s economic problems.

America’s inability to get its fiscal house in order will, sooner or later, result in a resumption of the U.S. dollar’s long-term downtrend . . . and renewed appreciation of the dollar-denominated gold price.

With America’s fiscal policy in disarray, it will again fall upon monetary policy and the Federal Reserve to counter recessionary business conditions - especially persistently high unemployment - without aggravating inflation expectations.

So far, the Fed’s key inflation indicator - the so-called “core” inflation rate (which excludes food and energy, as if these items are not part of every family’s budget) - has been subdued by a weak economy.  But, sooner or later, just as night follows day, years of unprecedented U.S. and global money-supply growth, must result in higher prices and accelerating inflation.

But, no matter how hard it tries, the Fed can’t succeed on its own.  Without significant and meaningful U.S. fiscal reform - with believable long-term spending and revenue targets - the dollar’s role as the preeminent official reserve asset will likely continue to diminish.

Even without well-conceived long-term fiscal reform, the austerity demanded by domestic and world financial markets (what some have called the “bond-market vigilantes”) will come in dribs and drabs - a tax increase here, a spending cut there - but however it comes it will impose significant fiscal drag on an already teetering economy.

To counter a deteriorating economy and offset the negative effects of fiscal tightening, the Federal Reserve, for all its talk to the contrary, will be compelled to step even harder on the monetary accelerator, with another round of quantitative easing very likely early next year - with implications for future inflation, the U.S. dollar exchange rate, and the price of gold.

In my view, any further weakening of business conditions in the United States will prove to be very bullish news for gold.  This is because the Fed is much more likely to pursue an aggressive “easy-money” monetary policy - by printing more money, more quickly, and in bigger quantities - than would be the case in an economy already on the road to recovery.

Although they would never say so, the Federal Reserve and U.S. Treasury may be quite happy to see a weaker dollar and somewhat higher price inflation.

Why? Because a few years of higher inflation, an invisible tax, would reduce the real value of America’s debt as a percentage of nominal GDP, and bring this ratio (the debt-to-GDP ratio) back down to historically acceptable norms.  And, right or wrong, conventional economic theory says a weaker dollar would stimulate the U.S. economy through an improving trade balance.

Across the Atlantic - Breaking Up Is Hard To Do

Meanwhile, as U.S. policymakers fiddle, a number of European countries with their economic backs to the wall - including Greece, Ireland, Portugal, Spain, and most recently Italy - are slashing government spending and raising taxes at great social and political cost, hoping to avoid insolvency and default on their sovereign debt.

Unfortunately, as in the United States, the fiscal restraint demanded of these countries is the wrong medicine - and is more likely to kill the patient than cure the disease.

Despite the best of intentions, government revenues are falling as these countries fall deeper and deeper into recession.  Instead of increasing access to credit, the financial situation of these countries continues to deteriorate . . . and capital markets are demanding higher interest rates to refinance maturing sovereign debt - so much so that the costs are becoming unbearable and are putting these countries deeper in the hole.

As we are just now beginning to see, there is only so much “belt tightening” that electorates in these countries will accept.  Sooner or later, newly elected governments will likely reverse course, opting for less austerity in favor of more stimulative fiscal initiatives.

Europe’s deteriorating economic performance is already forcing the European Central Bank to pursue more accommodative monetary policies.

The widening disparity between the stronger “core” economies (led by Germany and France) and the weaker “periphery” countries will further threaten the viability of Europe’s common currency, the euro.  Safe-haven capital flight from the questionable euro into both the U.S. dollar and gold has, thus far favored the dollar - masking the greenback’s inherent weakness and, counter intuitively, contributed to the yellow metal’s retreat from its early September peak.

Any efforts to save the bankrupt periphery economies, as we have seen over and over again, will continue to be too little, too late . . . and, at best, will only postpone the ultimate day of reckoning.

What is missing is a shared sense of common statehood such as we enjoy in the United States.  Americans are, first and foremost, Americans - not New Yorkers, Floridians, or Californians.  But Germans are Germans and Greeks are Greeks.  They just don’t see themselves as Europeans first - and Germans just don’t see why they should work hard to bail out the Greeks or the Italians who, they say, don’t work hard enough, retire too early, and have it too easy.

Moreover, the disparity between inflation rates, economic productivity, and international competitiveness that separates the poorer periphery nations from the wealthier core economies is a gap that will prove too wide to bridge with a single currency.

Europe’s weaker economies are simply not competitive versus their stronger northern neighbors.  In the days before a single currency, countries could regain their competitiveness by depreciating their own currencies - but, with a single shared currency, this is no longer an option for individual members, each lacking their own currency and exchange?rate policy.

The only thing now holding the European single?currency monetary system together is the high cost of divorce - and the seeming impossibility of managing a break?up.

Even if the euro somehow survives, its role as a reserve asset has been badly damaged, further enhancing the appeal of gold to central bank reserve managers skeptical about accumulating more euro-denominated reserve assets.

A tarnished euro, periodic funding crises, and fears of a eurozone break?up will benefit gold in the months ahead - even if the lion’s share of scared money finds a safe haven and shelter from financial uncertainty in U.S Treasury securities and other dollar-denominated assets.

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

Chinese Liberalization Promotes Rising Demand

As a foreign visitor in China, I feel presumptuous talking to you about gold-market trends and developments in your own country.  But, no discussion of gold is complete without reporting on China’s importance and profound influence on the world market and the metal’s price.

As you know, private gold investment was banned and the local market was tightly controlled for more than five decades following the Communist Party victory and ascension to power in 1949.  Ever since the legalization of private gold investment and the gradual liberalization of the market beginning in 2002, China’s 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 market, its encouragement of private gold investment, and the development of new investment vehicles and channels of distribution.

Rapid growth in household incomes, an expanding middle class, and rising wealth have also been important, contributing to the growth in gold demand for jewelry as well as for personal savings and investment.

In recent years, China’s central bank, the People’s Bank of China, has also been a significant buyer.  Two and a half years ago - in April 2009 - the PBOC revealed it had bought some 454 tons of gold over the preceding six years, an average of about 75 tons per year.

Since then there has been no hard evidence of additional buying . . . but my guess is that your central bank continues to buy regularly from domestic mine production and scrap refinery output - perhaps as much as 50 to 100 tons per year.  For its part, the PBOC not long ago said it will “seek diversification in the management of reserve assets,” possibly implying their intention to accumulate gold without actually saying so.

As a result of China’s sizable appetite for gold, it has become a powerful driving force in the world gold market - and its influence on the future price of gold is likely to continue, if not grow, in the next few years reflecting demographics, economic growth, rising personal incomes, episodes of worrisome inflation, the continuing development of the domestic gold-market infrastructure, and, importantly, central bank reserve diversification.

Indian Demand Heats Up

China isn’t the only giant shaking up the world of gold.  India’s appetite for gold has also been hot like curry, reflecting - as in China - growth in household incomes, an expanding middle class, increasing national wealth, and, lately, worrisome inflation trends.  .

India has historically been a very price-sensitive market for precious metals.  Typically, gold demand falls as prices rise . . . and, at higher prices, owners of gold have usually been quick to take profits, cashing in their bangles and chains, so much so that Indian gold scrap has, at times, been an important source of supply to the world market.

But, in contrast to the historical experience, we are seeing much less price sensitivity of demand as Indian consumers have adjusted rather quickly to record high gold prices.  Even with the rupee-denominated price at or near all-time highs, Indians still seem to be fairly eager buyers, suggesting a psychological re-evaluation of long-term gold-price prospects among Indian jewelry buyers and investors.

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 a historical, cultural, and even religious affinity to gold as a traditional monetary medium for saving and investment.  And, like China and India, we have seen strong demand from both households and central banks in a number of these countries as well.

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 additions to central bank reserves.

Importantly, much of the gold bought by these countries will probably never come back to the world 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

For now, the U.S. dollar remains the number one world trade and official reserve currency by default.  There is simply nothing ready to take its place - certainly not Europe’s single currency, the euro.  That said, a recent survey of central-bank reserve managers predicted that the most significant change in their official reserve holdings in the next 10 years will be their intentional build up in gold.

I believe we are moving gradually toward a multi-currency system where an array of national currencies (including the Chinese yuan) - possibly along with IMF Special Drawing Rights and even gold - will together function as official reserve assets and settlement currencies with much less dependence upon the U.S. dollar.

Many central banks have taken a much more positive view of gold in recent years.   Indeed, the official sector has been a positive net buyer of gold for the past two or three years.  This follows some two decades in which the official sector was a net seller of gold to the market, reflecting mostly large-scale sales by European central banks that mistakenly thought gold was in descent as a legitimate reserve asset and sold at a mere fraction of today’s price.

Just looking at the recent official data actually reported by central banks and published by the International Monetary Fund, the official sector bought 148.4 tons, net of sales, in the third quarter alone . . . and, based on year-to-date data, it looks like net official purchases may total 450 to 500 tons - or more if we include a guess of unreported purchases by China and possibly others, including purchases by sovereign wealth funds that may be buying surreptitiously on behalf of their country’s central banks.

Following many years of net annual sales in the 400 to 500 ton range, the official sector became a net buyer of gold in 2009.  This is a “game changer” for the gold market.  Instead of supplying hundreds of tons, year in and year out, central banks are now buying at what seems to be a net rate of 400 to 500 tons per year - representing a swing in the annual supply/demand balance of 800 to 1000 tons a year.

I don’t think most market observers and participants fully appreciate just how significant this has been - and will continue to be - for the world gold market.

In addition to China, the list of countries that have bought gold in the past few years is itself growing with new, surprising names joining the club - names like:

?        Russia - which has been the most outspoken and one of biggest buyers of gold in recent years making monthly purchases from its domestic mining and scrap refining at a rate of about five tons a month . . . and has more than doubled its gold reserves over the past four years.

?        India - which made a strong pro-gold statement, buying 200 tons directly from the International Monetary Fund at the start of the IMF ’s gold-sales program a couple of years ago.

?        South Korea - which last summer announced the purchase of 25 tons, its first purchase since 1998 when it collected and resold gold jewelry donated by patriotic citizens to help the country through a period of economic emergency,

?        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 continues to buy on the sly . . . along with some of the other oil producers that, like the Saudis, are over-weighted in U.S. dollar assets and grossly underweighted in gold,

?        Thailand - which bought nearly 40 tons so far this year,

?        Mexico - has been the biggest buyer so far in 2011 at some 100 tons,

?        In addition to Mexico, other Latin American buyers include Bolivia (which recently bought seven tons following a similar purchase in December 2010), Colombia, and Venezuela (which not only bought some gold this year, but also repatriated much of its gold held abroad in Bank of England vaults),

?        Bangladesh and Mauritius - which also bought gold from the IMF gold sales program,

Meanwhile, gold sales by the European central banks have dwindled to practically nothing, only enough to supply their bullion and commemorative coin programs.

Keep in mind that aggregate central bank gold purchases probably exceed the official data by a wide margin.  The People’s Bank of China, the Saudi Arabian Monetary Authority, and other central banks with large U.S. dollar-denominated official reserve assets have an incentive to buy gold discretely and surreptitiously - simply because the announcement of their buying programs would likely boost the yellow metal’s price and raise these central bank’s acquisition costs.

As we saw in September, after prices took a tumble, official demand responded positively.  Central banks, in the aggregate, are bargain hunters, what we call “scale-down buyers.”

But the reverse is not true:  We don’t see central bank profit-taking when prices move sharply higher.

Importantly, much of the gold bought by central banks has been bought for the long term - and will likely be held not just for a few days or months or even a few years . . . but for decades or longer, even at much higher prices.

As a result, central banks are now creating an upside bias to the market and are reducing the “free-float” available to meet future demand, even at much higher prices.  As a consequence, we can expect less downside volatility - and a more sustainable bull market with much higher prices in the years to come.

Rising Participation

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 around the world “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.

Contributing to increasing participation 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 swift appreciation in the metal’s price.  But, ETFs have also contributed to downside volatility - like the sharp correction we have suffered through in recent months.

Another interesting vehicle that is raising participation, because of its appeal to some investors, is the internet purchase or trading platforms -offered by some gold retailers as well as a variety of financial-service firms - that gives buyers or retail traders direct and immediate access to the market.

These 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

With these bullish building blocks in mind, let me reiterate my personal forecast of the future price of gold:

I believe gold’s fortunes remain very bright.  To begin with, gold’s key price drivers remain supportive - and most, if not all, will continue to support the rising price for at least a few more years.

Although gold-price volatility - and occasional big declines in the metal’s price - will lead many to prematurely proclaim the death of gold, I believe the bull market has plenty of life in it.  My advice to gold investors is to use these sell offs, when they occur, as opportunities for scale-down buying.

In my view, it is only a matter of time before we see gold break through the $2,000 an ounce level.   Notwithstanding the recent sharp price decline, I wouldn’t be surprised to see gold at this level during the first half of next year . . . followed by $3,000, $4,000, and possibly even $5,000 (or still higher) in the middle to late years of this decade.

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Gold and the Economy: Don’t Be Fooled

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After reaching a new record high of $1,430.95 last Tuesday, December 7th, gold fell back quite precipitously, mostly on profit taking by institutional traders and speculators in “paper” derivative markets.  By week’s end, the metal traded as low as $1,372 to register a loss of nearly $60, about four percent, from the all-time high.

Economic news in the United States (of improving cyclical indicators and initial reactions to the President’s deal with Congressional Republicans on tax policy and unemployment benefits), in Europe (of some agreement within the Eurozone on funding Irish debt), and in China (on monetary tightening by the central bank) appeared to trigger last week’s gold-selling spree.

But, physical demand remained firm in key consuming markets, particularly India and China.  And, we heard that “bargain hunting” from the official sector, central banks and sovereign wealth funds, has also appeared to support the market at prices under $1,390.

Despite last week’s news and knee-jerk gold-price retreat, economic trends and prospects in the United States, Europe, and China will actually support rising prices in the year ahead and give us confidence that gold will soon be trading above $1,500 an ounce — less than five percent above its week-ago record high and about seven percent above the current price of $1,398 (at the time of writing).

U.S. Monetary and Fiscal Policy — Pro-Gold

Don’t be fooled by the recent spate of positive U.S. economic indicators and rising optimism among many mainstream economists about America’s growth prospects and predictions of economic acceleration in 2011.

Instead, continued economic weakness and recession-like, if not outright recessionary business conditions, mean that the Federal Reserve will keep the pedal to the metal for some time to come.  And, as in the past year, continuing aggressive quantitative easing will push gold prices higher.

Last week’s rise in long-term yields are credited by some analysts and observers for taking the wind out of gold’s sails.  But, in our view, higher long-term yields are no threat to gold, as higher yields reflect rising inflation expectations and diminishing confidence in the U.S. dollar, particularly among some overseas holders of U.S. Treasury debt.

Don’t be fooled that Congressional passage of much-debated legislation to retain rather than raise current tax rates and extend unemployment benefits to millions of long-term idled workers will provide sufficient stimulus to keep the American economy above water — and relieve the need for further “gold-positive” Federal Reserve monetary stimulus.

Instead, expectations that passage of this economic policy package will result in substantially bigger U.S. Federal budget deficits for years to come are already raising medium- and long-term interest rates.

Much, if not all, of the presumed stimulus arising from passage of these policies, however noble, will be offset by higher bond yields.

Indeed, Washington’s inside-the-beltway economists and most of their private-sector colleagues have not accounted for the economic drag arising from higher yields, drag that will require still-more monetary stimulus from the Federal Reserve.  So, what at first glance appears to be a negative for gold will, over time, prove to be yet another plus for the metal.

Europe — More Sovereign Risk Ahead

Don’t be fooled that Europe’s financial crisis has been solved by the recent bailouts extended to the Irish and promised to other overly indebted Eurozone countries.

Excessive fiscal restraint across the continent is socially, politically, and economically untenable and unsustainable.  Why? Because spending cuts and tax increases will hurt personal incomes and corporate profits — diminishing tax revenues and harming the creditworthiness of some Eurozone member nations, quite the opposite of the intended consequence.

Sooner or later, the unintended result will be renewed fears of the euro’s demise as the zone’s common currency and renewed capital flight into both gold and the U.S. dollar, the latter as the least vulnerable of the two tarnished currency’s.

China — Growth Assured Despite Monetary Tightening

Don’t be fooled that the recent and prospective monetary tightening by China’s central bank, the People’s Bank of China (the PBOC), will diminish the country’s growing appetite for gold jewelry and investment.

PBOC policy actions — raising interest rates and some bank reserve requirements — are in response to super-strong economic activity and accelerating domestic price inflation.  But, real interest rates (after adjustment for inflation) are actually falling . . . and are more, not less stimulative.

At most, Chinese authorities are trying to cool a hot economy and slow the annual rate of GDP growth from over ten percent to a more sustainable pace around seven percent.  We have long argued that the country’s long-term bullish influence on the world gold market would continue so long as the economy  — and, with it, personal income growth — continue 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.

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.  This maturation of the gold market continues apace — as evidenced by the forthcoming launch of gold exchange-traded funds in that country.

While news of monetary policy tightening by the People’s Bank of China may trigger some short-term selling, China’s long-term gold demand is likely to grow rapidly in the months and years ahead  . . . and is likely to have a powerful influence on the future world price of gold.

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ASIA TRIP REPORT: Positive Signals for Gold

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I’m just back from nearly three weeks in Beijing, Shanghai, Hong Kong, Singapore, Malaysia, and Vietnam where I met with gold dealers, brokers, bankers, analysts, and leading gold-industry officials.

Take-Home Message — Very Positive

The take-home message is very positive for gold:  Virtually everyone I asked expects gold consumption across the region — both jewelry and investment — to continue rising for years to come.

And, there was also strong agreement that China’s central bank, the People’s Bank of China (the PBOC) would continue its own buying program well into the decade if not beyond.

Many analysts and market participants in the West have difficulty imagining gold sustaining past gains let alone registering significant price advances for years to come.  But this is not the consensus view across much of Asia!

For gold investment demand and jewelry consumption to grow in China and elsewhere in the region to continue growing and to continue supporting a rising world gold price requires only moderate growth in economic activity and household income in China and neighboring countries.  Inflation fears or financial market uncertainties are not required, although their presence (as in Vietnam) will only encourage more savings-related demand. Read the rest of this article »

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Why I’m Pessimistic on the Economy . . . and Optimistic on Gold

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The following rather lengthy post is the full text of my June 9th speech, unabridged and unedited, to the Mines and Money Conference in Beijing, China:

To begin with my conclusions, I believe we will continue to see gold generate lofty returns for years to come.  By year-end, I expect we will see gold hit $1500 an ounce — and sometime in the next few years $2000 seems very likely . . . with $3000 or higher quite possible.  And, in my mind, these are quite conservative forecasts.

At the crux of my bullish outlook is this:  History demonstrates time and again that excessive government spending, rapid money supply growth, and negative real interest rates are always accompanied or followed by rising gold prices.

And these are precisely the conditions that have characterized the U.S. and European economies for the past few years . . . and why gold prices have been and will continue to trend higher.

But even with “gold-neutral” macroeconomic policies in the older industrialized nations, there are good, solid reasons to expect much higher gold prices for years to come.

Just so you know where I’m going, let me quickly list the top nine bullish factors that support this forecast — and then, in turn, discuss some of these bull points in more detail.

  • First, as I just mentioned, inflationary U.S. monetary and fiscal policies — past, present, and future — along with the coming second dip in the U.S. business cycle.
  • Second, Europe’s intractable sovereign debt crisis, which has greatly undermined the euro’s appeal as an official reserve asset . . . and is pushing the European Central Bank to pursue inflationary monetary policies.
  • Third, moderate, well-managed rates of economic growth in the “gold-friendly” newly industrialized or emerging economies . . . especially, and most importantly, in China and India.
  • Fourth, continuing — if not growing — interest by the official sector, principally the central banks of a number of newly industrialized or emerging nations to diversify official reserve assets.
  • Fifth, rising private-sector investment demand in the “western” older industrialized nations reflecting fear of inflation, currency depreciation, and a loss of confidence in governments to deal effectively with today’s economic challenges.
  • Sixth, rising long-term saving and investment demand for gold from India, China, and other gold-friendly nations enjoying healthy growth in household incomes — growth that is likely to continue for the next several years.
  • Seventh, the continuing maturation of what I call the “gold-investment infrastructure” — in other words the development of new gold investment products and channels of distribution in many important geographic markets.
  • Eighth, the continuing long-term downtrend in world gold-mine production for at least the next five to ten years or longer.
  • Ninth, the relatively small size of the world gold market compared to other capital markets — such as equities or currencies — so that even small shifts in portfolio preferences away from currencies, or equities, or real estate, for example, may have little price effect on these big markets but will have a relatively large, indeed profound, effect on gold.

Let’s look at some of these bullish factors more closely . . . beginning with the U.S. economy.

Despite relatively favorable data on retail sales, industrial production, and consumer prices over the past half year or longer, I believe the economic statistics will soon indicate a renewed cyclical downturn, an end to the recovery seen by most business and government economists along with rising price pressures.

What I see down the road for the United States and Europe is an extended period of stagflation — much like the 1970s, with below par business activity and continuing high unemployment along with above par price inflation led by rising prices for oil and other key commodities.

Stripping away the contribution to GDP growth resulting from the temporary federal stimulus programs (like the just-expired tax benefit to first-time home buyers) and the positive effect of inventory accumulation during the fourth quarter of 2009 and the first half of this year, leaves a gloomy picture of an economy that is dead in the water.

As Washington’s stimulus programs wind down — and with the inventory cycle not longer contributing to growth in Gross Domestic Product — the U.S. economy will stall . . . and, very possibly, sink back into recession.

In addition, there are other good reasons to fear a renewed business downturn and years of sluggish growth with higher inflation.

The United States economy depends on consumer spending — spending that typically accounts for about 65 to 70 percent of Gross Domestic Product.  But, American consumers are in no shape, mentally or fiscally, to continue spending at the pace of the past decade or two.  Here’s why:

Savings rates are rising as consumers spend less and save more to rebuild household balance sheets after years of excessive borrowing . . . and, as a precaution in uncertain economic times.  To be sure, high unemployment, the increasing duration of unemployment, and fear of future unemployment is enough for many households to cut back.

In addition, the declining value of household assets — including home prices and retirement savings invested in stocks and mutual funds is also discouraging consumer spending — something we economists call the “wealth effect.”

Consumer spending will soon take another hit when the tax cuts enacted nearly ten years ago under the Bush Administration, tax cuts that favored upper income brackets, expire later this year.

It’s not just consumers who are spending less:  State and local public-sector budgets are also in crisis across American.  With most states and cities legally prohibited from operating in deficit, falling tax revenues are beginning to trigger public-spending restraint — including layoffs, reduced benefits to workers and retirees, cuts in social programs, and so on.

Next we have the continuing squeeze on small- and medium-size businesses resulting from the reluctance of banks to offer credit and financing to this important segment of the economy.  Small- and medium-size businesses are the engine of economic growth and expanding employment — but they are dependent on lines of credit from America’s banks to run their businesses.  And, many banks have been and continue to be reluctant or unable to lend to this important sector of the economy.

And, let’s not forget the impact of Europe’s sovereign debt crisis — which is pushing a good part of the continent into recession or sluggish growth.  Just as in America, heightened uncertainty is causing consumers and businesses to curtail spending and investment . . . while attempts at fiscal restraint in some countries will cut directly into spending by households and businesses.

Europe’s downturn — aided by the fall in the euro against the dollar — will soon, and for some time to come, reduce the contribution to U.S. economic activity from America’s international trade.

You may be asking: “What does all this have to do with gold?”  Well, a lot, actually!

Disappointing U.S. economic activity will have serious detrimental consequences for the Federal budget deficit, for Treasury funding requirements, and for the U.S. dollar — all of which will benefit gold.

This “double-dip” scenario of renewed recession or merely slower than expected activity means:

First, the Federal Reserve, America’s central bank, will maintain near-zero interest rates for longer than most market participants generally anticipate.

Second, future U.S. Federal budget deficits will be significantly bigger than now expected as projected tax revenues fall short.  This will erode confidence in the dollar among those central banks and institutional investors who have traditionally bought our debt and financed our deficit — leading to higher medium- to long-term interest rates in the United States.

Third, even more pressure on the Fed to monetize a growing share of Treasury debt.

All of this will produce more inflation — and more demand for gold.

In the interests of time, I’m going to skip over a more detailed discussion of the European sovereign debt crisis — except to highlight three brief points:

First, the crisis has created fear and uncertainty about the future viability of Europe’s common currency, the euro.

Second, it has created and fear and uncertainty that some of Europe’s biggest banks, banks that have invested heavily in now-questionable sovereign debt, will be pushed to insolvency or require government bailouts.

Third, the euro — which had increasingly been viewed by central bank reserve managers a legitimate diversifier to reduce dollar dependence — has suddenly been tarnished and discredited as viable alternative reserve asset.

Together, these fears and uncertainties have touched off a gold rush of demand for physical gold investment products — small bars, bullion coins, and gold exchange-traded funds — by private investors, not only in Europe, but around the world.

This brings me to the official sector — and the increasing interest among some central banks to hold gold as a reserve asset, dollar alternative, portfolio diversifier, and investment asset.

Even before the euro’s sudden and surprising demise, some central bankers began to take a fresh look at the yellow metal . . . and, last year, a few countries even began adding to their official reserves.

After two decades of selling, at an average annual rate of some 400 tons per year, the official sector became a net buyer of gold in 2009, adding more than 425 tons to total official-sector holdings.  I believe the official sector continues to be an important net buyer of gold — and could easily add another 150 to 300 tons or possibly more this year with sizeable net purchases continuing for years to come.

As you know, last year the People’s Bank of China (PBOC) announced that it had purchase 454 tons of gold from domestic mine production since 2003 . . . but it did not include these acquisitions in its official reserve accounts until last April.

I believe that China continues to buy gold discretely from domestic mine production — but chooses to hold this metal “off the books” so to speak as periodic announcements of PBOC purchases and inclusion of this metal in its official reserve accounts would probably result in higher world market prices making subsequent purchases that much more expensive.

In contrast, Russia and recently Kazakhstan have bought gold from their own domestic mines — but unlike China have chosen to publicize their purchases each month, perhaps as a matter of prestige or to improve their appearance of creditworthiness in world financial markets, something that China and the PBOC need not consider.

Last year, India bought 200 tons “off the market” directly from the International Monetary Fund, which has a one-off program to sell 403 tons over several years to fund its own operating expenses and benefit its poorest members.  Sri Lanka and Mauritius also purchased small amounts last year from the IMF.  All three, like Russia, announced their purchases to benefit from the publicity and prestige that comes with owning gold . . . and, in the case of India, perhaps to make a statement that they’ve arrived as a big-league economic power.

The IMF has some 152.8 tons remaining to be sold under the existing program, having announced sales into the market this year of 38.5 tons through April.  Quite possibly some or all of this gold found its way into the vaults of one or another central bank preferring anonymity.  In any event, this metal was easily absorbed into the market without detrimental effect on the price.

In another twist, the China Investment Corporation, China’s largest sovereign wealth fund, announced purchases early this year of about 4.5 tons.  While not a central bank, it is likely that the investment had the blessing of the PBOC.  Interestingly, the CIC purchased this gold via the SPDR Gold Trust, the NYSE-listed gold ETF.

At the very least, even if a one-time isolated purchase, it further signals China’s very positive “pro-gold” official attitude . . . and gives private investors greater confidence to buy gold for their own saving and investment programs.

Another very important factor — one that has been especially apparent in recent weeks and months has been rising private-sector investment demand for gold from across the old industrialized world.

Private investors in the United States and Europe, both individuals and institutions, are buying more gold reflecting the same concerns and fears that are driving central banks to accumulate the metal.

They are increasingly concerned about the huge deficits and debt of governments on both sides of the Atlantic . . . and that accelerating inflation and depreciating currencies will eat away at their other savings and investments.

Just as the European sovereign debt crisis has gathered steam, we’ve seen a substantial rise in physical investment demand across Europe — from Germany, Switzerland, France, the United Kingdom and other countries — like the United States.  And, just as we’ve seen on earlier price advances, mints (like the United States Mint, the Austrian Mint, and others; refineries (that manufacture small investment bars); and precious metals dealers report very strong demand from retail investors, so much so that premiums on small bars and coins have risen in recent weeks.

Importantly, as in earlier big advances in this gold bull market, these are mostly long-term investors — and their purchases, unlike those of traders and speculators, are not likely to return to the market anytime soon.

Similarly — and perhaps even more important to the long-term outlook for gold — we have seen rising long-term investment demand from India, China, and other newly industrialized nations.

Gold has historically been a preferred medium of savings in India, China, and many of the other Asian countries.  As incomes rise, as more people enter the middle class, and the numbers of truly wealthy increase, it is only natural to see some of this money flow into gold.

Both India and China, because of their huge populations and the movement of millions of people each year from poverty to middle class, and from rural areas to the cities, have tremendous potential in terms of the volume of gold investment that will be purchased in future years.

For gold savings and investment demand in these countries to grow requires only moderate growth in personal income.  Inflation or financial market uncertainties are not required, though their presence may encourage even more savings-related demand.

I believe the economic outlook for in these countries is propitious for gold. Cautious measures to counter excessive speculation (in real estate or equities, for example), prevent overheating, restrain inflation and will keep these economies growing at moderate rates that will benefit gold demand in the years ahead.

Let’s take a closer look at each of these countries so important to the very bullish long-term outlook for gold.

As long as I can remember, Indian gold demand has always been extremely price sensitive — with rising prices quickly restraining purchases and often evoking a return flow of old scrap as holders of gold seek to take profits.  As a result, the ebb and flow of India gold interest has often had a significant effect on the world market — stopping strong rallies when Indians think the price is too high and establishing floors when they think prices have fallen enough.

But, importantly, we’ve seen the Indian gold buyer adjust to higher and higher price levels.  A year ago, reflecting India restraint, the world market had difficulty moving higher when prices neared $1000 an ounce.  Today, Indians are still buying at $1200 an ounce.  I see this behavior continuing — but at higher and higher price levels over the next few years.

But it’s not just prices that matter to the Indian gold buyer.  Indian demand is now picking up and momentum improving thanks to the country’s strong economic recovery, growth in personal incomes, and — as I’ll explain later — new distribution channels that are gradually “westernizing” India’s gold market.

Last year, in 2009, gold demand was hurt, not just by resistance to rising prices, but from poor monsoons, low crop yields, and greatly diminished demand from the gold-friendly agrarian sector for whom gold has always been a traditional form of personal saving.

Now, weather forecasters (who have a much better track record than even the best gold forecaster) are predicting good monsoons and more than adequate rainfall this summer, with abundant harvests this fall, and healthy gains in personal income . . . some of which will, as it always does, find its way into gold jewelry and investment products.

What can we say about China?

After more than five decades of prohibiting private gold investment, China’s government legalized private gold investment only some three years ago . . . and today private gold investment is not just legal, it is encouraged and endorsed.

Five decades of pent-up and unrealized gold demand, the development of gold spot and futures markets, the evolution of a national gold-investment distribution system through banks and other retail outlets, the growing Chinese middle and rise in wealth across the population, inflation anxieties, and the country’s long-standing cultural affinity to gold assures that China will have an increasingly important influence on global gold supply and demand trends — and a powerful positive effect on the metal’s price for years to come . . . and this doesn’t even take into account the on-going “official” or “government-related” purchases that I’ve already mentioned.

We also see some very important institutional and structural developments occurring in the world of gold.  New gold investment products and channels of distribution are making gold more readily accessible to more investors, both individuals and institutions, in more markets around the world.

For example, gold exchange-traded funds, that allow investors to purchase gold via an equity-like vehicle, were introduced only six years ago.  Now there are more than 18 such funds traded on many stock exchanges around the world — and a new gold ETF is just now being launched in Japan.  Since their introduction, the total quantity of gold held on behalf of ETF investors has grown to more than 1900 tons.  This is more than is held by the central banks of all but four countries.

Another example:  In China, private gold investment was legalized only three years ago after five decades of proscription.  Now, not only is gold investment legal, it is encouraged by the central government.  Five national banks have been authorized to trade gold and make gold investment products — small wafers, bars, coins, passbook programs and accumulation plans — available across China.  In addition to these banks, physical gold is also available to investors at stand-alone gold investment retail shops and at department stores.

Similarly, in India, we are seeing the introduction of new products in the past few years, including a gold ETF traded on the Mumbai Stock Exchange, as well as online physical investment products offered online by a number of financial service firms.  Beginning in September the postal service there will begin selling small coin-like medallions at post offices in rural agrarian communities where there is great interest in gold but a paucity of banks and financial firms for savers to purchase the metal.

These new products, distribution channels, and other advances in the gold investment infrastructure are resulting in a permanent upward shift in the demand curve for gold — so that the average price of gold, stripping away the big cyclical swings, will in future years be much higher than most of us would now imagine possible.

Well, I think I’ve already talked too long but I do want to make a point about declining world gold-mine production.

Global gold-mine production has been in a downtrend for decades.  Despite a small uptick last year and possibly again this year, the fall in world mine output will continue for at least for the next five years . . . and probably for years longer.

The ebb in mine production reflects many factors, including the depletion of existing deposits, the continuing drop in ore grades, the decline in operating depths at many mines, the rise in energy and labor costs, the expense and time required to meet increasingly restrictive environmental regulations, unfriendly government attitudes toward foreign investment in some gold-producing countries, and the lack of financing available to many gold-mining exploration and development companies.

Even if the expected leap in the price of gold triggers much more exploration and development . . . and even if new significant economic deposits are discovered . . . it can take five to ten years or longer to bring a large discovery into sizable production.

So there you have it, my reasons and analysis behind my positive outlook for gold.

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