Gold in meltdown?
Vanessa Drucker looks at the events behind gold’s violent price plunge in April and the rationales for investment demand to continue to thrive
Gold was heavily in the news last week after its price dropped to its lowest level since August 2010 as it looks set to post its worst quarter since 1968.
However, despite dropping below the $1,200 mark, April proved to be the cruellest month this year for the yellow metal.
A violent plunge took the gold price down $240 in two perilous days, from Friday 12 April through Monday 15 April, leaving even seasoned traders rattled. Over that weekend, more bullion was sold than is produced by the entire mining industry in one year. So what constituted the cocktail of ingredients that precipitated the chute and how far back can we trace it?
The technical charts had already begun to look weak by early April, prompting speculation that a large player or two had decided to hit the market hard. On 11 April, it transpired that the European Troika had asked Cyprus to sell about 10 tons of its total gold stock of 13.8 tons to support that nation’s demands for financial help.
“Cyprus itself was not the issue,” says Martin Murenbeeld, chief economist at Dundee Wealth Economics, “but rather the fear that the Troika’s request to Cyprus would become a template for other hard-pressed countries.”
The thinking ran that Spain, with its 282 tons, and Portugal, with 382 tons of its own, might well be next in line, with the biggest threat looming from Italy, which holds a whopping 2,452 tons. Those jitters provoked an orgy of selling as the price cascaded through a series of stop loss levels.
Now travel back another couple of days of that week to recall what had already happened. By midweek, it was leaked to the media that Ben Bernanke was on the verge of an important announcement. At the same time, on Thursday 11 April, the senior analyst at Goldman Sachs came out with a short recommendation on the gold price.
T Doug Dale, cofounder of Consilium Capital Advisors, notes that Goldman, with 4.78 per cent of the GLD, is now second behind Paulson & Co.’s 6.51 per cent as the largest holder of the gold exchange traded fund. (The other leading GLD owners, in order, include JP Morgan at 3.32 per cent, UBS at 3.19 per cent and Bank of America at 2.99 per cent). Dale cannot help musing: “Was this collapse orchestrated to some degree and, if so, why?”
It is significant that the final bloodbath represented the extension of a “steady exodus of portfolio and asset managers,” says George Gero, senior vice-president at RBC Wealth Management.
That pattern began back in November 2012. More specifically, in hindsight, a major shift in investors’ attitudes toward commodities in general had gained traction since January of this year; the price of gold had fallen $100 from $1,680 from January until mid-February, and then proceeded to flatline until April Gold coin sales in the US had also been declining, from 222,000 ounces in January, to 92,000 ounces in February, to 73,000 ounces in March, along with coin premia over gold around the world.
Short levels on the Comex commodity exchange increased enormously, says Jeff Christian, managing director at CPM Group, “with a larger short position at the end of March than at any point since 1999.”
Since November, major US funds had been rotating out of commodities altogether, most notably the macro hedge funds of George Soros and Louis Bacon. The outflow of money accelerated along with chatter that the Federal Reserve might begin to taper off its bond buying program ahead of schedule, a move destined to dampen liquidity. Money was pouring into equities and other risk assets although nothing had really altered on a fundamental basis. After all, the background environment had not changed radically. Central banks were continuing to accommodate, the risk of currency depreciation remained at large and central banks were consistently adding to their gold reserves.
William O’ Neill, founding partner at LOGIC Advisors, describes the current paradigm for commodities markets: “Traditional supply and demand are not working any more as they used to. Money flows have become so gigantic that they determine the market.”
While one can make the case that fundamentals still operate over, say, a six-to-12 month period, it is the money flows that influence shorter cycles. As a nail in the coffin for the gold bull, the GLD has seen a 25 per cent bite taken out of its holdings year-to-date. The other ETFs have witnessed similar withdrawals, to such an extent that the ETF impact is virtually equivalent in scale to what O’Neill calls “another country” for gold holdings. He adds that “the market is dependent on the speculative player, at least at high levels. When that player went away, it also caused other markets, like copper, aluminum, silver and platinum, all to fall out of bed.”
Supply and demand
Of course, supply and demand still matter, at least in the longer term, and the same perennial components apply. On the demand side, the gold price is mainly driven by three elements – central bank purchases, investment and jewellery.
Recently, about 50 per cent of gold demand has derived from jewellery while central banks comprise 18 per cent and investment 16 per cent. On the supply front, mine output accounts for a modest portion, as well as scrap sales. Supply tends to be stable, since almost all the gold ever been mined is still available, amounting to approximately 170,000 tons, and valued at about $8tn.
‘Was this collapse orchestrated to some degree and, if so, why?’
New mine output merely contributes 1.4 per cent to the entire above-ground stock, according to J Michael Martin, president and chief investment officer of Financial Advantage. He summarises: “Change is all about demand change.”
James Steel, chief commodities analyst at HSBC, agrees. He notes that “gold will grind higher, predicated on tight mine supply. Right now supply appears to be relatively static or possibly falling, with reduction in scrap, and limited possibilities for mine expansion.”
He does, however, point out that the scrap market has gained importance over the past decade, rising from 15 per cent of mine supply to a current 60 per cent. The drop
in the gold price has meanwhile prompted some merchants to withhold their scrap off the market.
Let us next examine the demand factors, where the change occurs at the margin. Central banks, which are no longer obliged to back their paper currencies with gold, had become net sellers of bullion over the past 20 years. Martin describes how they were so inclined to sell off their gold reserves that they had to make three formal agreements among themselves, to restrict annual sales, “lest they depress the value of their major asset”.
But that trend reversed from 2010 to 2011, when central banks as a whole reversed position to become net buyers. Among keen purchasers, Korea, China, Vietnam, Russia, Mexico and Kazakstan have all been eager to the party. In general, those institutions have seeked to reduce the amount of currency in their asset portfolio mix and diversify away from the dollar, euro and yen.
Gero, reflecting on how many of those nations are already net mining producers, explains that“they do not really need gold since they own it already. But the purchases are a good way to get rid of excess dollars.”
Investment is the second pillar of demand. The ETFs have been phenomenally successful, absorbing the equivalent of almost a full year of mine production from their inception in 2004 until the end of last year. The tide, however, is turning. The ETF holdings have shrunk by 15 million ounces from the end of last year to the present time, contracting from a peak of 85 million ounces to 70 million.
Steel is not surprised to see some outflows taking place. He notes those funds were originally holding 52 million to 55 million ounces during the period leading into the global financial crisis. He says: “They could still lose another 15 million ounces just to get back to those levels.” But that loss scenario is in fact unlikely, since all the buying over the past five years has not been predicated merely on the crisis.
“The hedge funds have really put the juice into the market over the last few years,” says Steel. Since the end of 2007, gold embarked on a high octane ride, as faith in the global financial system teetered. It was not long before the credit crisis morphed into the sovereign debt crisis and unhinged the eurozone. “With quantitative easing programs and the return of some stability – not normalcy but stability - gold has corrected, being deprived of its high oxygen diet,” he adds.
All that glisters
Notwithstanding, there are still rationales for investment demand to continue to thrive. “The private sector is discovering that gold has attractive portfolio characteristics and improves the efficient frontier,” says Murenbeeld. He adds that the coming deregulation of the Asian gold markets should spur more local demand there.
With about half of all gold demand arising from jewellery, marginal changes in that function are critical. Martin quips: “Any husband from any era in history could tell you that jewellery is a demand you can count on.”
Steel also likes to compare jewellery demand to how the ocean subcurrents help propel a vessel. The top level current, which extends about 30 meters down from the surface, directly determines navigation. Meanwhile, the subcurrents, which reach as deep as the ocean floor, “are more decisive in pushing the ship long term by affecting weather,” he describes.
Thus, the locus of the market is already shifting from the institutions that have sold gold in recent months to the millions of consumers, mainly in emerging markets, who have bought the metal and helped stabilise the price.
Taking the multiple drivers into account, analysts largely concur that prices are likely to move sideways in a fairly volatile range over the next year or so. The price collapse in April severely damaged market psychology, which will need some time to repair. O’Neill, who is not yet convinced the worst is over, expects it to “chop around” between $1,350 and $1,450, with a longer term goal of $1,535. A breach of that ceiling might signal a higher breakout.
Gero, who is a bit more optimistic, predicts a “slow and steady climb back to $1,500 and even $1,600. But I do not foresee a resumption of new highs, or the 1900 area, barring some unexpected occurrence.”
Christian, however, is wary of another leg down arriving any time soon. He points to the vulnerability of the short position on the Comex, which is now even larger than it was in April. “That tells you a lot of people think the price could spike lower again in the next two or three months,” he warns. A year from now, he sees the price around $1,450 while moving between $1,350 and $1,550 over a two-year period.
The economic backdrop, coupled with the level of interest rates, will provide a key driver for the medium term price. Gold, like other asset classes, languishes in times of economic distress. Murenbeeld reminds that, away from the US, much of the world is still struggling, with parts of Europe even mired in depression. If China, one of the major gold buyers, hits the wall, further recessions may develop. When economies struggle, it is not long before inflation declines followed by disinflation and, even in extreme situations like peripheral Europe, deflation.
“Those conditions take away the investment incentive,” Murenbeeld says. In general, gold tends to flourish under two disparate scenarios, either rising inflation expectations or systemically driven deflation. Where gold underperforms is in a climate of modest economic growth. “In other words, it does not work to own gold in a moderately improving economy, like that of the past 18 months,” says Dale.
Whether for sustainable reasons or not, global equity markets have been rebounding since 2010. The result is that equities have offered more tempting competition to commodities, along with better yields, creating a perception of better uses for funds. In the aftermath of the 2008 crisis, investors turned to gold as protection, fearing the whole global financial system might implode or the euro might blow up or hyperinflation might take hold. Yet Armageddon did not arrive.
“Stock prices began rising and maybe for bad reasons,” says Christian. “But those reasons did not matter to investors who poured in.” That influx has gradually drawn away investment from more defensive assets.
Liquidity is another traditional friend to gold. The yellow metal is sensitive to the money supply and tends to rise when M1 or M2 measures are growing rapidly.
“That measure includes the US monetary base, plus the foreign exchange holdings of every country except the US,” Murenbeeld explains. Since last year, however, the ECB’s balance sheet has contracted as banks have been repaying LTRO borrowed money while over most of the past year, the Fed’s balance sheet has not expanded either.
“Basically, we would need global liquidity to pick up to help gold,” says Murenbeeld.
Among the usual suspects, the dollar remains a key driver and acts as a measuring stick against the gold price. As the greenback rises, gold declines, in a negative correlation that has been -.81 since 2006. Most countries prefer to keep their currencies muted against the dollar in order to gain foreign exchange trading advantages. The US though has little control over any such manipulations beyond imposing tariffs. Over the past two years, “the dollar has been on a tear, acting as a major headwind against gold. But it is fundamentally become too high, as reflected in all the American trade balances,” Murenbeeld concludes.
Last but not least among the usual list of drivers comes geopolitical risk. Especially since 2008, one can augment that factor with the fear of a global financial meltdown, since the fragile underpinnings of the banking interconnections have become more exposed. (Yet we seem to have weathered the most alarming chapters of the crisis and some arguments of the doomsayers have lost steam. While it is still fretted that quantitative easing will lead to inflation, that condition has been a long time coming and there is still not enough of a whiff to embolden the gold market. “If anything, the opposite,” Steel comments.)
The danger of political flashpoints is always present – from the Middle East to the South China Sea – but confrontations appear to carry differing effects on gold. The classic example is the Russian invasion of Afghanistan in December 1979, which caused the price to rocket from a pre-Christmas $1,473 level to $1,850 by 21 January 1980.
That case, though, was singular, in that it looked to an anxious world like a superpower face-off. Many subsequent crises have come and gone, creating less dramatic price movements. Moreover, all emergencies do not equally affect the ultra wealthy, particularly those in the Middle East with their large gold troves.
Gold’s unique role
Gold is a hybrid beast, part-commodity, part-currency, part-asset class in its own right. As such, it commands a unique role in an investor’s overall portfolio. Pension funds and asset managers may retain some allocation to it “just in case,” says Steel, and that portion is generally under 5 per cent. Ownership is quite skewed, with some managers who adamantly refuse to buy and others who hold a sizeable amount. Unlike, say, treasuries, there is no perceived obligation to some allotment.
Gold is a hybrid beast, part-commodity, part-currency, part-asset class in its own right
The main rationale for owning the yellow metal is diversification and to serve as a hedge to defray risk in the rest of the portfolio. Outside the trading community, most do not buy it simply because they believe the price is going higher.
A well structured portfolio should ideally include some non-correlated assets. If, for instance, the S&P 500 is booming, it makes sense to keep some other holding that is underperforming; if the S&P tumbles suddenly, the ugly duckling might shine. That said, many managers resist that strategy, knowing their clients want everything to be ascending at once. In any case, the alternatives are not compelling.
Cash earns nothing while treasuries have little headroom left and could be decimated should interest rates move. Equities, kept afloat on an ocean of liquidity, look vulnerable to any reversal in central bank policies.
Given the inherent risks in the other asset classes, and considering that gold has already taken such a bath since its peak value in 2011, Christian advocates some move into gold “now rather than later” for increased portfolio diversification and protection against losses in stocks and bonds.
Murenbeeld is even more bullish. He says gold has years further to run, possibly another two decades, in its cycle. “We are just at the beginning of the global debt crisis, which will go on for years,” he predicts. With 60 per cent of the US budget now spent on entitlements, the government has become increasingly indebted and beholden to entrenched interests.
Yet others are attracted to what they perceive as better investments, notably equities. If we are indeed embarking on a major asset class rotation, we can expect the move to take time. Gold goes through significant corrections, in both up and down markets, such as the 50 per cent pullback from 1974-1976, a whopping 30 per cent downdraft in 2008 and a lurch of 23 per cent in 2007.
O’Neill warns: “As long as global equities do not totally collapse, we will continue to see reluctance to get back into commodities in general and gold in particular.”
It is enough to strain even a longer-term investor’s patience. Yet as we close a door, we could also be opening a window. Technician Louise Yamada of LY Advisors points out that the Dow/Gold ratio has now “definitely and rather impressively” reversed upward on the charts in favor of equities versus gold.
Taking history as a guide, Yamada notes that each time that ratio has reversed upward after a consolidation period, as in 1942 and 1982, it has heralded a new equity structural bull market. Conversely, when the ratio headed south in 1930, 1966 and 2002, the good news for gold shadowed a new equity bear.
If Yamada’s observations bear fruit, gold could be enacting its age-old function of the canary in the coal mine. When the metal picks up pace, stockmarket investors know to tread warily. From the opposite side, when gold loses its luster equities may be poised for a new secular spring.