Friday, June 8, 2012

Gold and Emerging Markets

A friend of mine asked me for some views on gold the other day and I had to confess that it’s not something I have a definitive trading view on. In summary, I think it is an investment bubble, predicated on prices rising higher so that it can be sold onto the next man.

However, calling a bubble too early has been the ruin of many investors and risk averse investors should, in my humble opinion, shy away from taking a substantial position either way. Yes, I think it's a bubble, but I also think it is underpinned by some very powerful structural drivers from the Emerging Markets.

Obviously the key stocks affected would be the largest gold ETF, namely the SPDR Gold ETF $GLD or even an ETF of gold miners such as the Market Vectors Gold Miners Trust $GDX. Alternatively, investors can get gold price exposure by buying gold miners like Goldcorp $GG, Kinross Gold Corp $KGC, or Barrick Gold Corp $ABX. Ultimately, the underlying driver for all of these stocks’ price movements will be the price of gold, even if the miners have been underperforming gold prices of late.


What’s Driving Gold Demand, Speculators?

It’s usually a good idea to start with the hard facts, so here they are.  All figures are from the World Gold Council (WGC).


The interesting thing is that the demand for bar & coin really picks up after 2008, and I suspect this is largely a consequence of its relative attraction as an asset class. I think that asset classes tend to move in cycles of popularity. So for example, at the end of the '90s equities were the "must-have" asset class and prices reached extremely high historical multiples.

Then the 2000 crash came along, interest rates were lowered, nobody wanted equities anymore, so housing (particularly in countries like the US, Ireland and Spain, where housing gets built) became the new investment vehicle of choice. Despite good performance from equities from 2003-2007, they never reached the kind of multiples that the market had been on previously, when interest rates were so low. Everybody wanted housing and everybody wanted housing derivatives.

They also wanted gold.

Gold prices doubled to $600 from 2000-2006. Then when the US housing bubble started bursting in 2006, people wanted more gold. Prices then tripled to $1,800 in 2011.  ETF issuers weren’t slow to get in on the act and suddenly a plethora of ETFs were created, which helped prices go even higher. Fortunately, the largest gold ETF of them all, GLD, has a policy of actually buying the underlying gold, so we were somewhat spared from the exposure to the usual inadequacies of the financial services industry and their structured derivative products.

I have initially focused on bar & coin, because this is where the big increase in market demand has come from. This is illustrated here.



But that is only part of the story.


What is Driving Demand, Emerging Markets?

Obviously, emerging market demand is going to make up a fair portion of the total and with the strong growth rates in China and India over the past few years, their contribution to global demand has been on the increase. Aside from the cultural predilection for gold that the Indians and Chinese undoubtedly possess, there is also the issue of the availability of domestic asset classes for them to invest in.

Whilst the Indian wedding season remains the biggest single driver of jewelery demand, investors should not forget that China’s demand for gold jewelery is now almost equivalent. In addition, as long as China keeps buying US Dollars and selling RMB – in order to keep its currency weak -- it will carry on flooding its markets with capital. China doesn’t have significantly developed equity markets, so we have seen domestic RMB flowing into the China housing market and to alternative assets like gold.
I want to demonstrate this by showing a remarkable chart.

 

The rise since 2008 has been startling and contributed much to the rise in gold prices. However, there is a key point here. Aside from the Total figure, every one of these percentages fell in 2011. Granted, this does not mean they fell in demand terms, but rather they didn’t grow as much as in other markets. Consequently, as gold prices started falling from mid-2011, China and India’s growth started to slow and GDP forecasts in both countries have been lowered this year.  I do not think this is a coincidence.


So What Next for Gold?

In my view, the risk is on the downside for both China and India growth this year. China’s property bubble has burst and history tells us that it takes a while for property-related bubbles to correct themselves. In fact, the US property bubble burst in 2006!  So, I would expect demand growth from China and India for a discretionary element like jewelery to slow.

That said, if China’s property markets do continue to trend downwards, will this create a second wind for gold as their investors start piling into gold as a safe haven asset class?

I don’t have a strong view on this yet and I think that it is difficult for anyone to know confidently. This is why gold is such a tricky asset class to play with. Following the US property bubble, US investors have been favoring bonds, but I’m not sure if Chinese investors will react in the same way.
As for the global ETF demand, I think that this will be price dependent. In classic bubble fashion, investors tend to pile into the asset class as it is going up, but once a period of underperformance comes, the speculative money will file out.  We can see this in the reduction in ETF demand. Similarly, if prices keep falling then investors (wherever they are) will be induced to sell out of their positions.

Perhaps the safest conclusion to draw from this analysis would be that the key to future gold price movements is likely to be China and India demand. The latest WGC figures to Q1 show India jewelery, bar & coin demand down 13% year on year in dollar terms, but China demand up 33%. So, there is no sign of Chinese demand slowing yet and it may prove a safe haven from falling property and equity markets for them. However, let’s recall that this appeal tends to last as long as gold prices are rising. The longer gold stays in this trading range, the shorter will be the patience of speculators and with Indian demand falling, the downward pressure is building up.