By Michael Jansen, JPMorgan
Although gold has been a store of value and a medium of exchange for thousands of years, in the modern era it has suffered an identity crisis, reflecting the rise of the U.S. dollar (USD) as the global reserve currency. Accordingly, global central bank gold reserves peaked in the mid-1960s and have trended lower ever since. International Monetary Fund (IMF) data shows that official sector reserves peaked in 1965 at 1.2 billion ounces, and now stand at 847 million ounces. However, this statistic will be revised upward very soon on the back of confirmation that China has, without declaring such activities to the IMF, quietly accumulated a further 454 metric tons of gold (14.6 million ounces) to its stated reserve base of 600 metric tons, largely through purchases of gold in its own domestic market.
Nonetheless, the shedding of official sector gold reserves in the mid-1990s was seen as so destabilizing for the gold price that producers and hard asset evangelists were able to persuade central banks - those in Europe, in particular - to put a cap on their open market sales of gold bullion. The original cap was 400 metric tons per year, for the five years through to 2004, and is now 500 metric tons per year. The second iteration of this Central Bank Gold Agreement (CBGA) is due to expire in September 2009 and is expected to be rolled over for a second time, especially as the IMF is seeking to sell approximately 400 metric tons of gold in the next few years to finance its third-world aid operations.
Gold became a fully floating asset in the early 1970s, when U.S. President Richard Nixon closed the window that allowed the conversion of USDs into gold at a fixed rate. Since then the price has been driven by the whims of supply and demand. This has meant that the price of gold has largely reflected a few major drivers. First, there is the level of production at gold mines, now falling at 1 to 2 percent per annum. Next is the demand for gold by traditional buyers, the jewellery and non-jewellery fabrication sectors. Sales of old gold by private sector holders, the so-called scrap sector, play a role. Finally, there is the impact of central bank gold flows, both in and outside of the CBGA and private sector demand for gold. The latter is historically in retail form - small bars and coins - and now more recently in gold-backed paper form as exchange traded funds (ETFs).
Another factor that was especially dominant from the mid-1990s through to the early 2000s was the hedging of future production by gold producers. Such hedges were carried out by selling future production in the spot market, and then subsequently adjusting the delivery profile to match the producer's production plan. This front-loading of future production was especially destabilizing to the gold price in the mid to late 1990s and was another reason that central banks agreed to conduct their gold sales through the CBGA. That said, gold hedging is now out of vogue for most producers and the size of the hedge book has collapsed to a point that such activities are barely noticeable in the spot bullion market today.
Financial demand sharply higher
While gold's "commodity fundamentals" are arguably bullish in their own right, the most interesting facet of the demand side of the global gold balance sheet is a clear pick-up in demand by private sector investors for gold. This demand shows up both in traditional products - deliverable bullion in both London Bullion Marketing Association (LBMA) and COMEX forms - as well as allocations to ETFs.
At the public-sector level there has not yet been any clear evidence of an ideological shift in policy in favor of gold, but the sense of unease of central banks and sovereign wealth funds over the value of their USD holdings is clearly palpable. That the People's Bank of China has quietly increased its own gold reserve holdings, albeit from domestic supply, has potentially larger ramifications. It could signal a move in policy from other large holders of USDs in the region to accumulate bullion. If acquired from domestic production, it is not necessarily destabilizing for the USD but is positive for the gold price in terms of directing gold production away from the cash market and into a vault instead.
The rise of exchange traded funds
One of the most important innovations in gold investment options in recent years has been the rise of ETFs. Of the various ETFs that have been launched in the past five years, the common theme is that the ETFs, like COMEX futures, are backed by physical gold, silver or platinum group metals held in allocated form in commercial vaults. There are many ETFs in existence, but Figure 2 shows the growth in ounces under management of the main funds.
Currently there are around 50 million ounces under management in ETFs, approximately 1,650 metric tons, still a fraction of the above-ground gold stock, an estimated 145,000-155,000 metric tons. But the influence of the ETFs on the gold market is considerable given that the ounces under management are "sticky," in that they represent to a large extent portfolio-driven appetite for gold, and as such are proving quite unresponsive to the short-term swings in the gold price. Putting this in perspective, the level of gold in the ETF has barely budged this calendar year in spite of the gold price trading more than a $100 range.
Another market trend is the relatively flat gold curve, which means that for the first time in living memory, investors and speculators can buy deferred call options at strikes at only a modest premium to spot gold. This, in turn, is encouraging investors towards structures in the over-the-counter (OTC) market, either cash or physically delivered, which allow investors to take advantage of the flat curve, attractive implied volatility levels at an arguably attractive spot gold price. Such structures are encouraging significant volume of activity in the OTC market. This helps to explain why the level of market turnover in the OTC market, as measured by the LBMA monthly clearing statistics, is holding up quite well (see Figure 3).
Financial demand for gold: Can it be sustained?
The main reasons investors appear to increasingly be allocating funds to bullion are:
- The current monetary and fiscal policy settings are consistent with an eventual recovery in economic conditions, complete with a potentially significant inflation problem as excess capital "spills over" into the broader economy. Key to this view is a deep concern that the monetary authorities will not remove the punchbowl before the party gets started, waiting instead for clear confirmation that the global economy has sustainably turned higher before removing the excess liquidity. Under such a scenario, commodity prices could benefit from the late removal of monetary excess, which would be of particular benefit to gold.
- Concerns hover around the underlying robustness of fiat, or paper, money-based monetary regimes. As highlighted above, gold has a long-term history of being a robust store of value in the longer-term context, and thus has been an integral part of the monetary and reserve base of most developed economies. The practice of the past 40 to 50 years - jettisoning gold in favor of holding paper assets from monetary issuers - means that the net value of the global financial architecture hinges upon the creditworthiness of individual issuers. Investors are clearly becoming somewhat concerned about the creditworthiness of issuers such as the U.S. Department of the Treasury, holding the view that the massive deterioration in fiscal balances globally and the rise of twin deficits in specific countries undermines their creditworthiness. Monetary authorities in key creditor nations, in turn, may reduce their exposure to paper assets in favor of hard assets. Gold is clearly the best placed to benefit from this, as the minute storage cost of gold relative to its value makes it an efficient store of value. However, if the "Bancor" system, in which there is universal reserve currency whose value is tied to a basket of commodities, being suggested by some creditor nations gets further airtime, then other commodities could also benefit.
- Concerns have mounted over the value of the USD in the long term. The relative health of the U.S. economy following the conclusion of World War II meant that the United States was able to formulate a post-war financial system that encouraged international counterparts to hold USDs in favor of any other currency. In turn, the United States would, to satiate concerns of USD holders, make its currency convertible into gold. So for many monetary authorities, this was a "win-win" as the USD was as "good as gold" but even better because it carried an interest rate. The USD/gold peg eventually broke down in the early 1970s when the spread between the London a.m. gold fix and the USD-gold exchange rate became too wide for the United States and its allies to continue to fund. This reflected, in part, the relative cheapness of gold and the fact that the economic pendulum, and financial flows, had swung in favor of countries such as Japan and Germany. Hence, the USD's role as the sole reserve currency has in effect been waning since the early 1970s, but the outlook for the USD has darkened even more materially of late, given that its fiscal balances have deteriorated so sharply. While the ending of the USD's reign as the singular reserve currency is not necessarily the prelude towards a new gold standard, gold has become in recent months the "anti-currency" especially at a time when governments across the world have adopted extremely lax fiscal and monetary settings. Put another way, when almost all countries in the OECD have adopted economic settings consistent with weaker currencies, the resulting currency-détente is likely bullish for gold, being the only currency in which the supply is fixed.
The outlook for precious metals
The key underlying premise in much of the gold investment that has taken place is a deep unease over the long-term health of the current financial architecture. Thus, the current increase in risk appetite that is being reflected in robust equity markets and in other risk assets is not necessarily bearish for gold, especially if these rallies are consistent with heightened concerns over the level of inflation going forward.
Figure 4 shows that the most dominant driver of gold in the months ahead is inflation expectations. It maps the market's anticipated inflation outcome in the period from five years out of today, for the following five years. This part of the curve is extremely sensitive to changing inflation expectations. As such, it is notable that the market is concerned that inflation may measure 2.2-2.5 percent per annum for the five years commencing five years from now, an extremely elevated inflation environment given that the starting point - inflation today - is marked by deflation, U.S. inflation being -2.1 percent in the year to August.
We are bullish on gold in the next 12 to 18 months, seeing that the risks around the financial system, inflation and the USD are so asymmetrically biased in favor of gold that more investors are likely to allocate capital to the space. Whether such risks materialize is difficult to forecast, but the prospect alone and the hedging of such outcomes is strongly bullish towards gold.
We strongly favor gold over silver and platinum group metals. Indicators of industrial activity are improving at the moment, which is bullish to silver and platinum group metals relative to gold as more of the demand base in both platinum and silver is industrially driven relative to gold. However, the thematic appeal for precious metals is consistent with gold clearly outperforming. As such, our year-end forecast for gold of $1,000 an ounce has gold markedly outperforming both platinum and silver.
Michael Jansen is an executive director, commodities, at JPMorgan in London.
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