Gold rebound of no surprise
The rebound in gold is no surprise – the only surprise was the initial sell-off.
With all of the ongoing doom and gloom in financial markets, it’s important to maintain some perspective and take a look at the facts.
At the moment market sentiment and headlines continue to be dominated by Greece and other parts of Europe.
The truth is that this is pretty much the same story that we’ve been exposed to for the better part of the past four years – no better, no worse.
Greece has always been likely to default on its debts, with the likely scenario (even championed in some quarters as the best solution for Greece) to withdraw from the EU and revert back to its traditional currency – the Drachma.
Journalists have been writing the same story about Greece and Europe for the past few years, but the reality is that nothing will change overnight.
What we do know is that the world’s population is continuing to grow – hitting 7 billion late last year – and at current rates will reach 10 billion by 2050.
All of these people need to be fed, housed and clothed, in turn generating huge demand for raw materials – both hard commodities and soft commodities alike.
As they become more affluent, they will demand more of the everyday items we take for granted.
The resource boom therefore isn’t over.
Commodity markets are being driven by emotion and sentiment, not long-term reality.
Most commodities are getting harder to locate and more expensive to produce, with all sorts of enhanced political risks no matter where you go in the world.
With money being pumped into the world’s economic system, the inevitable questions that follow are how and when all of this ‘free money’ will be repaid.
The answers aren’t particularly palatable – either mammoth inflation or debilitating deflation.
A massive outbreak of inflation will occur once economic recovery eventually reasserts itself as a result of the massive money-printing that’s taken place since 2008.
This brings us to gold, which should benefit strongly form an eventual inflationary outbreak.
China’s gold demand has hit a record during 2012, driven by investor concerns over inflation and property market curbs.
China remained the world’s top gold consumer, beating historical leader India.
Will the Chinese love affair with gold continue? Well, it’s hard to see things changing as its citizens grow wealthier.
In the near-term, investment demand will most likely depend on price expectations and the relative performance of other assets such as property and the domestic stock market.
But ongoing inflationary expectations should continue to drive Chinese gold buying.
The World Gold Council anticipates the trend of net central bank buying to continue during 2012 as the main driving factors remain in place – some countries are seeking to diversify their foreign reserves, whilst others try to increase gold holdings to maintain the ratio of gold to their foreign reserves.
Interestingly, if you’d listened to many market watchers over the past six months, you’d have been convinced that the gold market was on the verge of collapse – prices were predicted to plunge to US$1,400 or even US$1,200.
Many pundits believed gold’s relatively lacklustre recent price performance meant the more-than-a-decade-long bull market in gold was over.
As always you have to take a step back and understand gold to put its price fall into its proper perspective.
Whilst gold did fall rapidly from an all-time high of US$1,920 per ounce to a low of US$1,531 per ounce during the second half of 2011, the price predictably stabilized around US$1,600 per ounce, which is the metal’s long-term trend-line. This is clear in the price chart below.
The important thing about the recent price correction and that following the GFC during late 2008 is that gold has been sold because it is a profitable asset.
It’s been used to fund losses on declining assets elsewhere in investors’ portfolios, like equities.
This means that gold has undergone a large degree of forced selling. Remember this fact when listening to the experts talking about gold not responding to crises as it supposedly should.
What about the supply side?
According to the WGC Gold, gold miners will need to achieve a price of $3,000 per ounce in five years’ time simply to stay afloat.
The reason is the rising cost of producing gold. Rising labour costs, surging oil prices and higher rates of taxation are eating into the margins of precious metals miners, which in turn raises the cut-off bar in terms of new projects.
Total average operating costs for the gold industry are estimated at somewhere around $1,500 per ounce, factoring in ongoing exploration expenditure for reserve replacement, as well as depreciation and amortization.
For many companies operating in a high gold price environment, this doesn’t leave a lot of room for robust profitability.
Continuing strong demand combined with major supply-side factors are the reasons why I remain convinced of major upside with respect to the gold price.
I have confidence that the price can comfortably reach the US$2,000 per ounce mark within the next 12 months and push higher.
Just recently, the gold price has moved above its 50-day and 100-day moving averages, which is another indication of potential strength for the metal and an additional reason to believe that gold may be an attractive entry point.
For many newer investors with little grasp of human and financial history, gold remains somewhat of a pretty-to-look-at but rather useless relic.
This is unfortunate because gold’s value lies not in its capacity to generate some form of short-term income or dividend.
Beyond its value as jewellery and an industrial input, gold’s value lies in not entirely measurable factors, not least of which is its use as a form of investment insurance policy.
Those with little knowledge of history will find it difficult to get their minds around this.
After all, it was our own esteemed Treasurer Peter Costello that sold off our gold reserves more than a decade ago.
The decision to sell 167 tonnes of the bank’s reserves (at around US$300 per ounce) cost the nation around $6 billion, based on today’s price of around US$1,600 per ounce.
A board paper recommending the decision to sell conceded that gold served as “insurance against a breakdown in the international financial system”, but it then dismissed the need for holding this valuable asset.
In my view gold’s historical role as a store of value and its safe-haven status in tough economic times should see a special place reserved for the yellow metal in any new financial architecture contemplated in the wake of the Global Financial Crisis.
This could take the form of either a return to a fully-fledged gold standard or to a gold exchange standard as prevailed in the world’s financial system prior to 1971.
At the very least, gold could provide at least a partial anchor for the modern day financial system, where investors have grown increasingly wary of national currencies.
The US dollar has well and truly lost its lustre, as decades of flagrant spending and growing debt have weakened the foundations of the currency’s stability.
The ongoing trend of emerging markets ‘decoupling’ from (or outperforming) mature economies should lead to a refocusing of the world’s economic and financial geography.
What this effectively means is that the overall size of the US economy will shrink relative to other economies, with the world gradually reverting to a situation that prevailed prior to World War I, when the first wave of globalization took place.
During the 19th century and right up to WWI, the gold standard effectively provided the foundation for the expansion of international trade and international financial relations.
At this time, none of the world’s larger economies was typically dominant, even with their colonial empires.
During this period in history that was characterised by intense rivalries amongst the major powers, the anchor for the world’s monetary relationships was gold.
After WWI and especially after WWII, an economic landscape evolved that was unusual from an historical standpoint.
Europe underwent reconstruction from the devastating effects of the war; the US became the dominant economy in global trade and investment relations with the Soviet Union; and after WWII China elected to pursue a closed-door policy in international economic relations, whilst India pursued a protectionist model of economic development.
As a result, the US dollar became the international currency for payments and reserves, mainly due to its peg to the price of gold until 1971, the size of the nation’s financial markets, and its overwhelming size and military strength.
There’s an intriguing and rather prophetic insight known as the ‘Triffin Dilemma’, which was postulated during the 1960s by Robert Triffin and which figured prominently in international monetary policy discussions right after WWII.
The theory suggests that a country issuing the reserve currency (in this case the USA) is bound to run an ever-escalating current account deficit, as world trade and payments increase in order to allow reserve accumulation.
However, when the size of this current account becomes too large, the country accumulates an unsustainable external debt due to the burden of its debt service.
The US was thus able to obtain an unfair advantage, enabling it to pay for its imports with its own currency.
This situation was able to be side-stepped as long as the US economy grew at least as fast as the world global average and had no serious rival on the world stage.
However, the global financial crisis, which originated in the US has severely shaken confidence in its banks, financial institutions and markets, which along with the emergence of China and India, has reignited these dormant worries.
Fiscal irresponsibility has further raised the spectre of a scenario in which the international role of the dollar has suddenly come into question.
The US cannot continue to run a current account deficit without jeopardizing the stability of the world economy.
In the future, with the shift of the world’s economic epicentre further to the East and the growing importance of emerging markets, it will be increasingly difficult for the US to back the role of the dollar as the main medium of exchange and transactions in world trade and international capital markets.
Gold on the other hand has historically represented a hedge against traumatic events such as inflation outbursts and financial crises and I believe it has a major and vital role to play in the world’s economic future.
Gavin Wendt is the founder of MineLife, publisher of the MineLife Weekly Resource Report
