Martin Murenbeeld's "The Bullish Case for Gold (Is There Another Case?)"
The Bullish Case for Gold (Is There Another Case?)
By Martin Murenbeeld Chief Economist of Dundee Group of Companies 08 Jun 2006 at 09:09 AM EDT
VICTORIA, B.C. (Murenbeeld.com) -- It’s a pleasure and honor to be speaking at the New York 2006 Hard Assets Conference. The Resource Investor Conferences, which also includes the San Francisco conference and Mining Indaba in South Africa, are among the most important on the yearly calendar. The Resource Investor website, furthermore, has been one of my most important daily sources of information since its inception
This discussion will outline seven factors that underlie our bullish gold price outlook for 2006 and 2007. There are several bearish factors of a short-term nature that should however also be mentioned. I will conclude with a discussion of our latest (March) forecast for this year and next.
My “bullish” arguments are listed on the slide above. From my perspective the most important factor may yet prove to be “monetary reflation,” but all these factors are very important in our outlook.
Our first factor is the U.S. dollar. The chart below of the U.S. trade balance certainly suggests that the dollar is overvalued. The balance has mushroomed to nearly $800 billion (12-month running total) in February. The implication is that the dollar’s exchange value is uncompetitive at its level of recent years.
The U.S. current account balance (which includes trade in goods and services) also stands at a record deficit. The balance for 2005 was $805 billion, and the 4th quarter deficit was over 7% of GDP. The current account deficit throws off nearly $4 billion a day onto foreign exchange markets. This $4 billion has to be absorbed; if not the dollar falls. Using 1985-87 as a guide, the dollar may well have another 15-25% to fall!
Indeed, there are only three ways to reduce the U.S. current account deficit, and they are listed on the slide below. Stronger foreign growth would help. So would weaker U.S. growth, but no one really wants that. (Who would China sell to?) A lower dollar isn’t a panacea, but it would really help!
Here’s one of the critical problems! The Chinese renminbi was devalued too much in 1993, and is now overdue to give some of that devaluation back! The other Asian currencies can’t rise a lot until the renminbi rises.
I now turn to U.S. dollar reserves, which have risen sharply precisely because central banks have intervened so heavily in foreign exchange markets. Central banks, mostly Asian central banks in fact, buy dollars in the foreign exchange market with their own currency in order to keep their own currencies from rising, and the dollar from falling. These dollars are then reinvested in the U.S. financial market.
This slide below shows that Asian central banks now hold a collective $2400 billion in foreign exchange reserves. This level is “excessive” according to many observers including some central bankers! Asian central banks only hold 1932 tonnes of gold however, meaning only about 1.5% of their total reserves is in gold. Many observers and analysts have suggested that some of these dollar reserves should be diversified into gold.
Indeed, were China and Japan to adopt the ECB’s 15% rule for gold reserves then China would have to buy 6890 tonnes of gold and Japan 6850 tonnes of gold. (These tonnages vary with the precise price of gold and the level of foreign exchange reserves.) I think these Asian central banks should purchase the gold the CBGA signatories want to sell; it would represent no more than a “petty cash” outlay to these banks!
OPEC is another “natural” buyer of gold! OPEC needs to diversify its surplus “Petro-dollars”. OPEC current account balances are in huge surplus again on the back of higher oil prices. The last time OPEC had significant “Petro-Dollar” surpluses, in 1980, gold spiked to an all time high! To be sure there were also significant geopolitical tensions at that time – i.e., the Iran hostage crisis. But geopolitical tensions are rising today as well!
The above slide shows that when OPEC reserves rose sharply in the 1973-81 period OPEC added gold to its reserves - some 270 tonnes in fact. Will it choose to do so again? We think there is a distinct possibility of such. (The “private sector” is undoubtedly buying gold!) To bring its gold reserves up to 15% of total reserves OPEC would need to purchase some 50 million ounces, which is equal to $33bn, or about 480 million barrels of oil. This would not appear to be a terrible hardship now that OPEC’s FX reserves exceed $200 billion again.
In short, I think that some dollar diversification is inevitable. Theory argues it should happen and geopolitical factors suggest it will happen. The main barrier to massive dollar diversification is that other markets are not nearly as “deep” as the U.S. dollar market!
My third bullish factor is that “gold is cheap”. The chart of the gold price shown above is in “constant” dollars. Note that gold has only just risen to its average of the last 25 years! Gold is not necessarily very expensive once INFLATION is factored into the picture.
Gold is also very “cheap” in terms of oil. It takes less than 9 barrels of oil today to buy one ounce of gold, not an “average” 17.5 barrels. (On May 10th it took 10 barrels of oil!) Indeed, if gold was priced at its “average” oil price, the it would be above $1000 currently. Are oil prices too high, or are gold prices too low?? (I quickly admit there is no “natural” oil/gold ratio that should be adhered to, but the ratio currently is a “statistical outlier”.)
This is one of my favorite charts (above)! It shows that gold is “cheap” in terms of the S&P500. It also shows that there were three stock market bubbles during the last 100 years. Economic times were difficult in the wake of the first two bubbles, and shows that something dramatic happened to the gold price about 5 years after each bubble peaked! The year 2005 was five years after the last peak! (It looks that it will be 2006 instead!)
My fourth factor is monetary reflation. My argument is that monetary policies around the world will likely be eased within the medium-term future. One reason is the baby-boomer retirement wave; another is the expected consumer slowdown in the U.S.
Remember that the world economy has more capacity to produce than consume at this time; ergo a drop in consumption could go badly for the world economy.
One might argue that the major economies should be running budget surpluses at this time, to prepare for the “costs” of boomer retirements, if not also a potential consumer demand retrenchment.
The chart below shows that the G-6 countries are running significant budget deficits however.
The U.S. budget deficit contributes directly to overall U.S. debt (which is the sum of government, corporate and household debt).
This chart {below} of total U.S. debt shows that it has risen to well over 200% of GDP in recent quarters.
The last time the debt level was this high was during the Great Depression – when GDP contracted sharply.
Not surprisingly, the household debt service burden is at an all-time high – even with these low interest rates! Or governments can “print” more money (MONETARY REFLATION)!
This choice has been taken historically to deal with war debts and such. The resultant inflation reduces the real value of debt.
This is another of my favorite charts:
The OECD estimates that government net liabilities will rise substantially by the year 2030. Take the case of Germany.
The government’s net liabilities in 2002 were about 50% of GDP. These liabilities are expected to rise 4-fold over the next 25 years, to 216% of GDP in the year 2030.
Even U.S. net financial liabilities are set to double over the next 25 years, and it could be worse in the event the U.S. government cannot control its budget deficit in coming years.
What can governments do in the face of these (current and future) debts?
This slide (left) presents some options. The first three put more financial responsibility on the household sector, meaning households are going to have less income for consumption – in turn meaning subpar economic growth.
My fifth bullish factor is supply!
The chart below presents our simple model of Western World mine output based on the real gold price and past mine output. The chart suggests that it takes a long time for output to respond to higher gold prices.
A decline in output appears to have been “baked into the cake” by gold price weakness in recent years. We have however assumed a mildly rising output trend in our forecasts, on the basis that miners are responding faster to the high price then implicitly assumed in the model!
Central banks represent the largest single source of “supply risk”. But the largest gold holders are signatories of the CBGA2.
Indeed, once we subtract from the world total central bank gold reserves that are unlikely to be sold there are only about 4000 tonnes left. Some of that gold has been lent out however, and countries like Argentina have recently shown an interest in acquiring gold again. For the near term, in other words, the risk of more central bank sales is limited.
The sixth factor is demand. Note (below) that the actual dollar expenditures on gold (jewelry and retail investment) by consumers around the world has been rising again .
But now there are also new ETF’s to encourage the fund manager to invest in gold.
Gold held in trust for the various ETF’s has risen sharply in recent years. There are over 470 tonnes of gold held in trust currently – not bad for just over two years! Indeed, gold (and commodities more generally) are becoming an “asset class” for pension fund managers, meaning that very significant monies may be shifted to commodity/ gold-related investments in future years!
Then there is the virtual revolution taking hold of Asian gold markets – deregulation, new futures markets, etc. In short, organizational developments on the “investment-demand” side of the gold market are very, very positive for gold over the medium term.
My seventh factor is geopolitical! What can I say other than that the geopolitical environment is becoming extremely tense again.
Iran was instrumental to the blowup in the gold price in 1979-80, when it hit $850. We think Iran will be at the centre of the next blowup. Indeed, we recommend that some gold be bought for purely geopolitical reasons.
There are some bearish arguments, of course, and the two shown below are important to the near-term outlook.
Gold does not often do well when monetary policies are being tightened. Commodity prices have also risen much more sharply than even the most bullish among us had forecast even a few quarters ago. This sets up the conditions for a significant price “correction.”
Note below how gold and money supply have parted company in recent quarters.
Low money supply growth and a dollar which refused to decline until only very recently again do not support the sharp rise in gold prices this year to date.
And these charts (below) suggest that the uptrend in gold prices against all currencies may have proceeded at too rapid a pace, i.e. the uptrend has turned “parabolic”.
The 200-day moving average price of gold is still below $525!
Let me now sum up. We’ve argued that the dollar has to decline further, but now mostly at the expense of the Asian currencies. U.S. dollar reserves could be diversified, gold is relatively “cheap”, and that high debt levels will pressure monetary policy to remain relaxed well into the medium/long-term. The supply outlook is benign, and demand is expanding rapidly. Last, the geopolitical climate favors gold.
We are concerned that as monetary policies continue to be tightened over the near term that the speculative froth in gold and commodity markets more generally could lead to a significant price correction sometime this year. Of course, it is difficult to forecast a “correction,” which by its nature is unpredictable.
This slide is a condensed version of our quarterly, March-end, gold price forecast. Scenario B projected gold to average $577 in 2006 and $600 in 2007.
It was not our most likely scenario this quarter however. Ergo, we focus more on the probability-weighted outlook this time, and this has gold averaging $603 this year and $658 next year.
Note that we thought there was a 50% probability that gold would break $800 next year –and average $789 in 2007. Back to the drawing board??
Thank you for your kind attention, and enjoy the rest of the Conference!
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