Metals Resurface

Commodities had a strong run in 2008, and the metals market is no exception. Emerging markets growth fueled a bull market in certain metals, such as copper, and gold has been a traditional safe haven during troubled economic times. Current demand also benefits from new products and clearing solutions that provide credit efficiencies in a tight credit market.

Metals prices cooled off in the last half of 2008 along with global economies, but activity in metals futures on the Comex subsidiary of the New York Mercantile Exchange, both now part of CME Group, continues to heat up along with the volatility of the marketplace.

Unprecedented price action in many commodity markets – from crude oil to grains to a number of others, including gold, silver and copper – accompanied the historic global financial crisis that unfolded in 2008. As a result, investors began looking for safe havens not only from price fluctuations, but also from the threat of counterparty risk. The impact of that concern is reflected in that metals volume on the CME ClearPort platform, a clearing facility for over-the-counter transactions, has more than doubled over the past two years.

“We expect turbulent financial markets to persist in 2009 and for the legacy of the credit crisis to remain with us for some time,” says Barry Wainstein, vice chairman and deputy head, global capital markets and global head of foreign exchange and precious metals at Scotia Capital, Scotiabank Group’s capital markets division. “This argues in favor of a more prominent role for exchange-traded products with centralized clearing processes. These offer a relatively straightforward way to express a view on the precious metals market, while limiting the various ancillary risks that come with purchasing equities.”

With futures it is as easy to go short as long, which is not the case in equities or physical markets, and the clearing organization is on the other side of every trade so there is no need to assess whether the counterparty will be around to fulfill the terms of the transaction.

 

INFLATION AHEAD?

With governments and central banks around the world pumping billions – and probably trillions – of dollars into their financial systems to alleviate the credit crisis, preserve their financial structures and stimulate their economies, many analysts believe that a weaker U.S. dollar and higher inflation rates are inevitable once the U.S. economy works its way through the worst recession period since the Great Depression and the reflationary efforts take hold.

With that scenario, many investors are anxious to get out of cash and into gold, a store of value throughout history and around the world. And it is not just the diehard goldbugs who have always been long gold in one form or another through all kinds of conditions.

When President Nixon closed the gold window in 1971, holders of U.S. dollars could no longer convert their dollars into gold. Today, both big and small investors who are worried about the economic outlook and potentially rising inflation rates are finding ways to get their dollars into gold again – creating a tight supply situation for gold coins and helping to build up exchange-traded funds (ETFs), based on precious metals, a segment of the investment world that did not exist in the 1980s, when the last bout of rampant inflation occurred.

For a number of years, analysts looked at gold as a “dead investment,” since it paid no interest nor produced any kind of return. In fact, owning gold involved a cost for storage fees and handling. Other than the comfort of possessing gold as a safe haven and the hope of price appreciation some day, there was not a lot of reason to hold gold when investments in equities or real estate or interest rate instruments were producing big returns. That attitude has changed.

 

THE "ULTIMATE CURRENCY"

“Gold is the ultimate currency,” says Robert Gottlieb, managing director at JPMorgan. “It doehttp://online.wsj.com/article/SB123836246095967147.html#mod=todays_us_the_journal_reportsn’t require the backing of any country. It truly is an international currency.”

“Including precious metals in an investment portfolio makes a lot of sense from a diversification standpoint, particularly in today’s turbulent market,” adds Wainstein. “The multi-year commodity (including gold) bull market saw capital flow into commodity and hedge funds. Many of these investors then exited the market in the last quarter of 2008 due to the rise in volatility and the need to raise cash.”

The urgency of this deleveraging process and the need to get into cash at almost any cost contributed to a 70 percent fall in crude oil prices, a collapse in the value of stocks, and the lowering of short-term U.S. interest rates to near zero percent. On a relative basis, gold has been a major out-performer compared to many other commodities. Prices for copper, for example, and silver to a lesser extent, continue to be especially sensitive to weak industrial demand and soft economic conditions.

Interest in gold runs the gamut of investors – major macros, wealthy individuals, funds – according to Gottlieb. He notes the gold coin business has really taken off, to the point that a number of gold coins are out of stock or are on back order, even though refineries are running at full capacity.

“Despite the recent volatility, investment funds remain active with our London and New York trading centers, where we have also seen unprecedented demand for coins and bars,” Wainstein adds. “Demand for physical material – both for jewelry and investment purposes – also has been strong in India and the Middle East, where investors have the added advantage of being able to trade gold in their local currencies.”

 

ETFS' BIG ROLE

Gold ETFs have claimed a big stake in this interest in gold. That is easy to explain, says Gottlieb, who helped develop the SPDR Gold Shares (GLD) contract and whose firm is by far the biggest participant in GLD trading.

“If gold prices go down $100.00 an ounce – say, from $850.00 to $750.00 – all the funds would be selling. In the same situation, the GLD price is only down $10.00,” Gottlieb observes. (GLD prices are based on 1/10 of an ounce of gold, so GLD would drop from $85.00 to $75.00). “In today’s stock market, a $10.00 drop in a stock is not that big a shock any more.”

Typically, gold ETF traders tend to be buy-and-hold investors who are not as sensitive to price changes and hang on to their positions longer than futures traders do. Therefore, the amount of gold in the hands of long ETF traders has risen significantly in recent years to record levels (see graph), potentially affecting the dynamics of the gold market. However, if stability replaces volatility in the financial system and everything returns to “normal” ETF investors might decide to get out of their positions and gold would flow back into the market.

Stability, of course, is a big if.

The effect of other overhangs on the gold market in the past are pretty much diminished. Mining companies, stung by criticism from shareholders for hedging their production when prices were lower, have generally stopped hedging, reducing selling pressure from that source. Central banks, which at one time were always a threat to dump substantial amounts of gold onto the market to raise funds for one reason or another, have an agreement through 2009 to limit gold sales to no more than 500 tons a year.

Together with larger stocks locked up in bank vaults because of ETF demand, mining production continuing to decline, and jewelry demand remaining rather strong – notably in Asia – the longer-term fundamentals for gold all seem to be on the bullish side. The impact on gold futures also looks bullish.

“Dealers need to hedge, and futures provide the most liquid hedge for dealers,” Gottlieb points out.

The global economic outlook remains the key issue for gold prices. For many looking at the investment landscape today, gold is one market that glitters.

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