The rally in gold has become increasingly fuelled by the depreciating U.S. dollar, or, more accurately, is following the trend in the euro. However, it is important to note that this relationship is more self-fulfilling than fundamental in nature.
In our view, both the global environment (financial and geopolitical) and gold market specific developments (producer de-hedging and gold investment promotion) have tended to reinforce the euro-gold relationship by attracting and maintaining broader investor interest in gold. New entrants to the gold market have found that the euro is a dependable trading tool and so have further strengthened this relationship.
Gold has also clearly benefited from the wider investment trend towards commodities as a whole, though this has been a more unique experience for other commodities. In our view, a lot of “gold-positive” news is priced in at current levels.
We believe gold will ride the final leg of this rally to a fresh peak in the first half of 2004 but remain vulnerable to the withdrawal of support from speculative investors. Over the course of 2004, the risks are biased to the downside, such as the potential for dollar recovery, poor physical demand, disappointing levels of buying by long-term investors, a slowdown in de-hedging and stronger financial markets.
Inflation may well become the next “great hope” for higher gold prices but is unlikely to affect prices in 2004.
Key market themes
The key to sustaining, let alone continuing, the bull run in gold is the success, or otherwise, of the industry’s attempt to revive broader investor interest.
A disproportionately large amount of buying in gold has been from short-term speculators using systems-based trading. This dominance is evident in the massive increase in long positions on the Comex and also in the extraordinarily high correlation of gold with the euro.
As 2004 began, there was a further buying surge, which we believe was the result of money inflows into commodity trading advisors (CTAs) following strong performance in recent years — this, is in addition to buying commodities as an asset class more generally. The danger with such a reliance on this group is that they will reverse their positions should the underlying trend fail. This has not happened yet, but a fall in prices below a key level such as US$390 per oz. could be the catalyst for a mass rush for the exit.
A reversal in the euro is the obvious catalyst. The potential for intervention to prevent further appreciation of the euro (above 1.30 for example) is now a topic of regular discussion across the financial newswires. Ironically, gold could weaken even if the U.S. dollar continues to weaken against other currencies (that is, should the Asian currencies be allowed to appreciate), as the market has become fixated by the euro-gold relationship rather than with the U.S. dollar itself. It is, therefore, extremely important that speculators are either joined or replaced by longer-term investors.
The arguments for such a holding — portfolio diversification, an inflationary and/or U.S. dollar hedge — are far from new. More recently, we have seen prominent investment bank strategists, such as Barton Biggs at Morgan Stanley, advocating a 5% allocation in gold.
However, actual investment buying has been modest so far. The principal excuse for this has been the difficulty most funds face when trading in gold. But the World Gold Council-sponsored Gold Bullion Securities initiative is addressing this with exchange-traded gold funds in which one share equals one tenth of an ounce of gold. This began in Australia in March 2003 and opened in the U.K. in the following December. So far, more than 30 tonnes of gold have been bought as a result. The big hope is that a listing in the U.S., currently under review, will see an even more impressive surge in buying. Only time will tell.
A key support for this rally in gold prices has been the move by major gold producers to reduce their forward sales book in response to shareholder reactions, rising prices and low interest rates. Further, the acquisition of “hedgers” by “non-hedgers” provided fuel for significant reductions in hedge books.
However, several of the major gold producers, such as
We had been expecting a major slowdown in de-hedging for these reasons. However, the decision by the world’s largest hedger,
September 2004 marks the end of the European central bank Gold Agreement (EcbGA), and the renewal occurred in early March, at a “modest” increase to 2,500 from 2,000 tonnes over five years. The announcement was as expected, and thus was market-neutral.
Outside EcbGA countries, sales have increased, encouraged by higher prices, while buying is rare, even from local production. Disappointing the hopes of bulls, the People’s Bank of China is estimated by Gold Fields Mineral Services to have been the largest seller (albeit into the local market) among non-EcbGA countries in 2004.
Fabrication demand for gold has been in trend decline since peaking in 1997, and in 2003 it recorded its fourth successive fall. Demand is suffering on two main fronts.
The first is the most obvious — price. Rising and volatile prices dampen demand. India is the most obviously price-sensitive market, with import demand rising and falling on an assessment of “value.” Notably, 2003 imports were inflated by growth of letter-of-credit imports and involved a round trip to the United Arab Emirates in order to obtain a tax advantage, but this may not last. However, price sensitivity has also been evident in the U.S., with rising prices meaning key retail price points cannot be met.
Second — the continuing trend away from plain gold jewelry in the West, particularly Europe. The only bright spot is some growth in white gold demand as a substitute for platinum, particularly in Japan and China.
Not only has the rise in prices dampened fresh demand for gold jewelry; it has also caused a further increase in scrap sales. This increase has been dominated by East Asia (+35%, to 177 tonnes) and India (+26%, to 182 tonnes). There is a rising trend of scrap supplies in contrast to gold demand, and this contrast is no mere coincidence. The rise in local gold prices clearly also encouraged higher sales of scrap into the market, and we would expect that pattern to continue in 2004.
Mined gold production has largely stagnated in recent years at around 2,600 tonnes. There have been many predictions that global gold output will decline markedly in a delayed reaction to the fall in prices in the 1990s. Certainly, growth in the traditional producing countries of South Africa, the U.S. and Canada is in decline. However, offsetting these gains have been increases in Australia, China, the former Commonwealth of Independent States, and South America.
It is true that rising local mine costs are placing some gold producers under increasing pressure, and the strength of the rand, in particular, is likely to lead to further losses. However, at best, the outlook for global gold output is neutral, with the major change over the next decade likely to be in the sources of mine output rather than any market significant decline.
The sizable decline in equity markets from early 2000 until mid-2003 created a supportive environment for gold. The fact that this coincided with a volatile and uncertain performance across the major financial markets, bonds and currencies, encouraged investors to consider all alternative assets, with property and commodities, including gold, benefiting.
However, the recovery seen across most equity markets last year, combined with the prospects for further gains on the back of stronger economic growth and high corporate profits, is a threat to gold.
Overall market and, particularly, public confidence is cautious, and gold should hold support. However, we see broader financial market performance as being an increasingly negative influence on gold prices as the year continues.
The relationship between inflation and gold is an enduring one. Intuitively, it appeals to investors because gold is a genuinely tradable hard asset and hence “should” hold its value against paper assets as inflation rises. Inflation is becoming an increasingly common topic, with loose monetary policy and rising commodity prices raising the spectre of rising inflation in the future. However, first, underlying rates of inflation are low.
Also, gold has arguably already factored-in more expectations and fear of inflation than bond markets.
Finally, there is now a wide range of inflation-protected paper assets on offer to the potential consumer that offers greater liquidity and lower risks than gold. The products are specifically designed for this purpose. As a result, we believe inflation is a supportive theme for gold but one that will take considerable time before it is market-significant, if ever.
Silver
Silver made an early claim to be the star of 2004, with prices bursting to 6-year highs. The move in silver is difficult to attribute directly to its commodity fundamentals, though it is true that silver is increasingly being traded as an industrial commodity and often followed the base metals trend last year.
Furthermore, the commodity fundamentals of silver are improving from poor levels, with demand from jewelry and electronics showing signs of growth, while there is hope that growing photographic demand from emerging markets will offset losses due to the fast growth in digital photography. However, in truth, the recent surge has been based more on silver’s traditional role as an investment alternative to gold, with investors seeing silver as better relative value.
The speculative appetite for silver is ravenous, with long positions on Comex surging to record levels equivalent to half of annual mine supply. Current price levels are unsustainable over the medium term; we can expect a significant reaction from Indian demand (less), scrap supplies (more), Chinese exports (more), and producer selling (more). However, all these market-balancing factors need time to take effect. Hence, aside from the occasional correction, we expect prices to test higher in the first few months of the year before correcting back below US$6 per oz.
Jewelry and silverware, outside India, remain dependent on fashion trends and the economic outlook. Jewelry appears to be resilient, but silverware is suffering.
In India, there has been a recovery in demand boosted by both strong growth in agricultural incomes, following the strongest monsoon in a decade, and the relatively high price of gold. Industrial demand (largely electronics) has been weak, though demand is showing some signs of recovery. The end of de-stocking is a major element of improved demand, with stronger growth expected in 2004.
Demand from photography has been affected structurally by the rapid emergence of digital photography in the major Western economies. Last year, sales of film globally fell by 8%, with little recovery expected in 2004. Kodak announced in January that it will stop selling traditional cameras in the U.S., Canada and Western Europe, though it will continue distributing one-time use cameras globally and traditional cameras in emerging markets like China, where demand is still growing.
However, it should also be noted, firstly, that reduced silver use in photography will eventually lead to less scrap recovery from this source. But more importantly, prints from digital still cameras are growing strongly, and a growing proportion is being printed in a larger size on silver halide paper by retailers.
Silver prices have leapt higher since November 2003, hitting 5-year highs above US$6.70 per oz. in the second week of 2004. The driver of this move was not any huge change in fundamentals, though it is true that industrial demand should improve as economic growth strengthens. Rather, it was a case of relative value, with silver having underperformed gold (let alone platinum) and the base metals. Investors looking for attractive risk-reward propositions found silver.
Similarly, investors are looking for industrial commodities as a proxy for economic growth, and hence we have seen silver being traded increasingly in line with the base metals, particularly copper. On top of this was a steady uptrend in prices since late 2001, and the importance of CTAs means there is, therefore, more than sufficient fuel for prices to surge higher.
Silver supply has become dominated by byproduct mine output of lead-zinc, copper and gold. Fortunately, for silver, mine supply for these metals is under pressure and resulted in a modest fall in silver mine output in 2002 and 2003, with another similarly small fall expected in 2004.
Scrap supply is a growing threat, given improved industrial scrap recycling regimes and the price sensitivity of jewelry and silverware scrap. Last year saw only a modest increase in scrap supply, but higher prices in 2004 are likely to encourage higher volumes, particularly in Asia and the Middle East.
The largest change in physical supply has been lower official-sector sales from China. We had felt that the Chinese stockpile had been significantly drawn down in recent years. However, recent evidence from China suggests that significant stockpiles remain.
On an annual basis, China produces around 40 million oz. from mine output and another 6 million oz. from scrap. However, in addition, the People’s Bank of China has been selling around 50-60 million oz. from its stockpile. We believe this stockpile still stands at considerable levels, given the consistency of its sales policy since 1998. China consumes around 42 million oz. per year, and this is rising. Hence, the Chinese surplus for export stands at between 50 million and 70 million oz. This has been the range over the past four years.
— The opinions presented are the authors’ and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the authors at kevin.norrish@barcap.com and ingrid.sternby@barcap.com
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