Good Old Gold
This roundtable discussion was originally published in the 17 December 2005 edition of Business Times Singapore English (c) 2005 Singapore Press Holdings Limited.
THE price of gold soared to a 25-year high of over US$540 an ounce this week and, while it then underwent what was widely seen as a necessary correction after its dizzying ascent, many (although not all) experts believe the upsurge in the price of gold and other precious metals has been based on sound fundamentals. Still, many people are wondering what is behind the current bull market, how much higher the price of gold can go, and how long this spectacular rally can last? Business Times assembled a quartet of investment experts - three bulls and one (increasingly scarce) bear - to answer these questions in this week's Investment Round Table.
PARTICIPANTS in the roundtable
Moderator: Anthony Rowley, Business Times Tokyo correspondent.
Robert Pringle, director of public policy research at the World Gold Council in London
Andy Smith, senior analyst with Ridgefield Capital in London.
Marc Faber, an investment adviser and publisher of the Gloom, Boom and Doom Report.
William Thomson, senior adviser, Franklin Templeton Institutional Asia Ltd and chairman of the Siam Recovery Fund.
Anthony: I want to welcome two new faces (Robert Pringle and Andy Smith) and two old friends to today's Round Table. Robert, as someone who is close to the gold scene on a day-to- day basis, what in your view has been behind the remarkable movement in the gold price, and where do you think it might go from here?
Robert: The erosion of the attractiveness of existing currencies is one of the under-estimated factors behind the jump in the gold price. Existing currencies are being undermined not only by governments' fiscal deficits and unsustainable debt obligations, but also by the erosion of property rights. To fulfil all the functions of money, a currency has to be universally acceptable and useable in transactions, and as a unit of account and store of value. All existing currencies suffer from the fact that governments and their agents now track and monitor all international transactions, access to bank accounts, and what money is used for. Technology allows them to track down individuals' use of currency to purchase individual items - goods or services. Increasingly, people feel they may have to get permission from 'the authorities' to use their own money, or face frightful sanctions for so-called abuse. This is intolerable. So alternatives will flourish. Gold is the prime alternative.
Marc: Over the last few years, all asset classes, including commodities, stocks, bonds, real estate, and art, have appreciated meaningfully as a result of the US Fed's ultra-expansionary monetary policies, which have kept interest rates - despite the recent increases in the US Fed Fund rate from one per cent to 4 per cent - below the rate of inflation. Therefore, it is only natural that the price of gold and other precious metals have also been rising. This particularly in light of the bear market in gold since January 1980, which brought the price of gold down from US$850 to around US$255 in 2001 and down much more in real terms. I expect that in our lifetimes we shall see substantially higher gold prices whereby near term, along with other asset markets, gold is overbought and vulnerable to a bout of profit taking.
William: The last bull market on gold ended in January 1980, when it briefly touched US$870 and, from that point, had a 20-year bear market before it ended a little above US$250, when Gordon Brown, the British chancellor of the exchequer, in a masterstroke of ineptitude and incompetence, sold off most of the Bank of England's gold reserves at the absolute bottom. Since that time, there has been a gradual recovery powered by a series of factors, including a realisation that gold had become far too cheap given what had happened in the global economy in the prior 20 years; the need for a safe haven for Islamic and other investors from the US dollar in the wake of the dotcom bust, 9/11, the Patriot Act, and the complete, wilful loss of discipline over US fiscal and monetary policy. Technical factors have also contributed, including the unwinding of hedges by gold producers.
I believe the recovery in the gold price to date has been measured and rational, and that it could be extended in both time and price. Gold has, in fact, lagged other commodities in the recent boom. The boom has been powered by high global growth led by India and China and fed by the excesses of the US political system. We are likely to see (US) deficits till 2009 at the earliest, to fund wars and finance bailouts of companies and institutions such as GM, Ford, the Pension Benefit Guarantee Corporation, Fannie Mae and Freddie Mac. It is an ugly scenario and no less a figure than Paul Volcker, a former Fed Reserve chairman, is on record as saying there is a 75 per cent of a major financial disaster in the next few years.
How long could this bull last? After a 20-year bear market, 10 years plus or minus is not unreasonable. The public and most institutions have barely noticed the move to date. How far could it go? The price reached an absurd level of US$870 in a mania. Since that time the US money supply (M3) has grown 5.6 times, while the above ground supply of gold expanded perhaps 1.64 times and global wealth well over 10 times in nominal dollar terms. In a mania, you never know how far things can go, but taking those factors into account, we can say US$870 in 1980 terms translates into a least US$3,000 today.
What might a 'reasonable' level be? We can come to a figure of at least US$1,000 plus in a number of ways. First, if you said that a reasonable level for gold was US$350 in 1980 - a figure that reflected changes in the US economy since it was fixed at US$35 in 1933 - then that translates to about US$1,200 today.
Secondly, let us look at the gold-oil ratio that has ranged from a low of six to a high of about 25 and has averaged 14.5 over the past 20 years. Today, it is 8.3, very much on the low side historically. Gold today is priced on average for US$35 oil. If oil stays at US$60 and gold gets its historical average ratio, then it goes to US$870, its historic high to date. If oil were to reach US$100 a barrel, as the Institute for International Economics believes possible, then the price for gold based on the average ratio would be US$1,450 and the 'high' value US$2,500. The day Alan Greenspan took office, gold was priced at US$480 and M3 has expanded 2.72 times since then, while the gold supply is perhaps 1.42 times its 1987 level. Again, that equates to US$1,000 as a reasonable target, without any premium for a mania or a panic that could take it considerably higher.
Andy: It's a tribute to gold's 5000-year-old brand that many still regard its recent rise as 'remarkable' or even with a pseudo-religious awe that gold is uniquely farsighted about the panoply of future macro-economic horrors that ostensibly await us. It isn't. To believe so is touching, but not perhaps ultimately profitable. Copper, zinc, lead, nickel, oil, platinum, silver - the whole kitchen sink of commodities - have risen more remarkably than gold since 9/11. All have risen especially rapidly since Q4 2003. Was China discovered then? Did the Indian middle class emerge then? Was faith suddenly lost in paper money then? Well, no this was just when 'passive' money began moving in its billions into commodity indices as investments. Gold will likely cool when the momentum of this inflow into commodity space slows. This might not even need a cure for the twin US deficits, international terrorism, bird flu, or global warming.
Anthony: What forms of investment in gold do you gentlemen recommend - physical, gold shares, gold funds, exchange-traded funds (ETFs), futures, etc, and how accessible is each of these approaches to individual investors?
Marc: I recommend investors hold physical gold stored in a safe deposit box of a bank in a 'gold friendly' country, such as the United Arab Emirates, Singapore, Hong Kong, India, France and Switzerland. The last place you may wish to hold your gold is in the US, where gold holding was already declared illegal once before, in 1934.
William: All these forms have their merits and demerits and it is very much up to the individual which he chooses. Physical gold brings problems of storage but coins have the advantage of portability and numismatic coins the pleasure of being a part of history. Shares bring the advantages of leverage to the gold price but one is subject to political risk, mining risk as well as the liquidity risk of the individual securities. In a crunch, shares can move adversely to the gold price and are, therefore, not a perfect hedge. Funds provide professional management that may or may not be worth the extra cost, but there are a few good ones around. Futures are for speculators, but in the right hands can be efficient. Exchange-traded funds are the 'new thing' and offer the small investor the opportunity of a pure play in gold, with liquidity and low charges. They trade in New York, London (Gold Bullion Securities), Australia and shortly in Paris. They may be the wave of the future for the smaller investor as well as pension funds that may be prohibited from owning commodities directly.
Anthony: Do you think that gold is being re-integrated into the international monetary system now after being relegated to the ranks of a 'commodity' only?
Robert: Governments will fight this to the death, so the existing system will have to be seen to collapse first. That will take 20 years or so.
Marc: There are five major currencies in the world: the US dollar, yuan, yen, euro, and gold. The supply of paper money can be increased ad infinitum by central bankers, which means that over time all paper money has lost purchasing power. The supply of gold is, however, limited by the annual mining output of around 2,500 tonnes. If there is more and more paper money per unit of gold, it is logical that over time paper money depreciates against gold, or in other words, that gold appreciates in paper money terms.
William: Gold's role in the international monetary system is marginal at best, a trend that will continue so long as the United States is able to exert its hegemony over the system. The IMF charter prevents members denominating their currencies in gold. Ironically, while sparing no effort to denigrate the metal, the US exhibits exquisite hypocrisy in clinging limpidly to its hoards and supplying its aircrew in the Middle East wars with gold coins to use if shot down.
Gold will never be just a commodity. Ask the boat people from Vietnam. Ask the Korean government after the Asian crisis in 1997 or the Indian government in 1991. As the only asset that is not someone else's liability, gold will retain a position as the asset of last resort. Despite their public protestations, central banks are unhappy with their forced acquisition of excessive dollars and the lack of viable alternative opportunities, but they do not want to lose their competitive currencies. The euro has a place, but it is also flawed. Some banks are flirting with equities and even hedge funds to obtain a real return. Now a few (Russia, Argentina, Taiwan) are quietly buying gold. China is making it easy for its citizens to buy the metal. This nascent trend of central bank buying is likely to increase in Asia and the Middle East, where some Islamic countries have flirted with settling their trade differences in gold dinars.
Andy: Gold has always been money to half the world outside 'The West', whose financial choices are constrained, and whose lives are more 'nasty, brutal and short', as Hobbes once put it. Are we in 'The West' frightened or financially straitjacketed enough, even after 9/11, to think this 'Eastern' about gold? I don't think so. In fact, the chances are that as choices in 'The East' progress from 'life or death' to 'which plastic card is best', gold's monetary heartland will be hollowed out. China, for example, consumes less gold now than a decade or two ago, even as living standards have tripled. 'Blame' the progress serum of banks, equity markets, life insurance and low inflation. In 'The West' champions of gold born again as money are either buyers late in the rally (needing a profound reason for their tardy participation), visceral opponents of the 'American Way' (investing with their anti-Bush/dollar biases, not their heads), or believers in the original sin of paper money (nostalgic for a flatter earth).
The topical twist to this 're-monetisation' persuasion is the idea that 'Eastern' central banks are buying or will buy gold. At 25-year highs? When 'Western' central banks evidently cannot exit a small portion of their long position without queueing for years and years? If financial regress of this kind is being advocated for 'Eastern' central banks, perhaps someone will urge them back into the metal that was money way before gold and whose performance has recently eclipsed it copper?
Anthony: Have silver and platinum enjoyed similar rallies to that experienced by gold, and should they have a place in an investment portfolio alongside gold?
Marc: I only hold gold and silver, but platinum and palladium have similar upside potential. For 2006, I like silver and palladium the best in the precious metals sector.
William: Percentage-wise, silver and platinum have done much better than gold. They have not been as subject to the same central bank selling and bullion bank manipulation as gold. They also have greater use as industrial metals although less attraction than gold for jewellery. In a larger portfolio, they have a place. Silver is still very attractive here, but its problem is that there are few pure silver plays and there is no ETF for silver yet, although Barclays has an application for one with the SEC. Platinum is not cheap at US$1,000 an ounce, but there are some good companies mining the metal.
Andy: Silver and platinum have out-rallied gold. Since monetary advice is the most serious inflation we have these days, it probably won't be long before someone suggests central banks re-institute Bi-metallism, with a gold-silver price ratio fixed nearer the 15 that obtained in the 19th century. With gold at US$530/oz, this would mean silver officially supported at US$35/oz. If, one day, cooler heads prevail, someone may point out that silver and platinum price volatility is two and three times that of gold. In other words, that someone might say, they're a 'buy and hold' only if you're wearing industrial-strength gloves. In one technical but important sense, silver and especially platinum rallies have been similar to gold's. Futures buying by banks offering structured platinum notes to speculators has removed platinum's natural backwardation - the premium of current over future prices. The forward price curve of platinum (and oil, and many other commodities swept up on the tide of new money) now resembles that of gold contango, futures at a premium to current prices. This means that even at US$1000, platinum costs almost nothing to borrow - the antithesis of the physical shortage many expected would be required to get the platinum price to four digits. So there's been a Midas touch in commodities. This has wiped out their own 'rate of interest', traditionally a significant part of their total return. Touch, or curse?
Anthony: Let's talk a bit more about the factors driving the gold price higher.
Marc: What is driving gold and other assets higher is excessive liquidity, which brings about rapid debt growth and, with it, high asset inflation. There is also momentum buying, that is speculation, in all other asset markets. Finally, it would seem to me that some central bankers and investors are becoming nervous about their large dollar and other paper money assets. So, given that Asian central banks have only about 2 per cent of their assets in gold, some buying is taking place. Moreover, you can be sure that the 'wise' central bankers, who sold their gold positions below US$300, will buy back gold once it reaches several thousand dollars.
William: The price was suppressed in the bear years by central banks both selling some of their bullion directly and lending some to bullion banks, who then sold it in the markets and invested the difference - the so-called carry trade. As a result, a huge short position was built up in the market and some of that (possibly a lot) remains. By suppressing the price with their financial engineering, there was little incentive to look for and mine new discoveries. As a result, production declined, especially in South Africa, which was the number one miner back in 1980. Miners are now looking at other parts of Africa, including Tanzania; Russia; China; and Latin America. But significantly increased supply is not yet on the cards. It takes years to discover and open a new mine. It is harder today with all the environmental restrictions. Globalisation helped suppress inflation in the OECD countries and inflation expectations declined until the new millennium when oil and other commodities started their price recoveries. But with deregulation and the decline of worker power, there is still only minor feedback from increased energy prices this round. However, US workers' real after-tax take-home pay is now lower than it was in 1973. They have kept their living standards up by increasing the percentage of women in the work force and going deeper into debt, effectively turning their homes into ATM machines. But the piper will have to be paid sometime. I am concerned that the result, in the US, will be a turning away from globalisation in a crisis and a return to protectionism.
Andy: When gold's above US$500, supply/demand is as useful as trying to measure hurricane speed with a wet finger. Faith in gold's supernatural properties tends to rise with price as it blips onto the radars of those usually too distant from the market to know or care about fundamentals.
So, the memory that last time gold broke up through US$500, in late 1979, it stayed above there for almost 14 months, matters a lot more now than the facts that central banks are selling more gold than ever, and Indian and Middle East markets are re-selling gold, pushing local prices to big discounts to the world price. In the late 1990s, gold miners were adding around 400 tonnes a year in supply through hedging - selling forward to lock in a price for part of their output. In the last four years, as gold's forward premium fell with market interest rates and as shareholders demanded 'full exposure' in a rising market, they have removed a similar amount of supply every year by de-hedging - closing those 'price insurance' programmes. This means there's been a swing from over 20 per cent to gold's good from 'add' to 'subtract'. No other commodity has enjoyed such a turnaround.
The recovery in the gold price could be extended in both time and price.
It's ideal to hold physical gold stored in a bank safe deposit box in a gold-friendly country.
As the only asset that is not someone else's liability, gold will retain a position as the asset of last resort.
Some central bankers and investors may be nervous about their large dollar and other paper money assets. Given that Asian central banks have only about 2 per cent of their assets in gold, some buying may be taking place, pushing up prices.