Trusting in gold - Austria's Erste Bank
Austria's Erste Bank's latest Special report on Gold still rates the yellow metal positively as an investment. A minimally edited version of the introduction to this report is published below.
Posted: Monday , 06 Jul 2009
Since Erste Bank's first Special report on Gold in 2007 when the gold price was USD 650, gold has outperformed almost every other asset class. The gold bull market has been running with an annual performance of 16% since 2001. Gold closed the year 2008 with the eighth annual increase in a row. And in the year to date, the performance has been outstanding as well: the gold price has recorded an increase of 7% (in USD) and 8% (in EUR), respectively. The average price in 2008 was USD 872/ounce, i.e. 25% higher than in 2007 (USD 695).
But have we missed the gold rush? It is a legitimate question to ask whether we are facing an imminent trend reversal or if the recent correction was nothing but a "little breather" ahead of the next massive upward swing. What could be a potential catalyst to the continuation of the gold rush? What are the risks? I We believe that the gold sector still offers a "shiny outlook" for existing and potential investors.
The strongly expansive policy followed by the Central Banks and the resulting money creation at historic levels as well as the massive expansion of government debt around the globe might make inflation literally the problem of the coming years. In conjunction with the almost worldwide zero interest rate policy and the rising criticism regarding the US dollar as a global reserve currency, in our opinion this situation offers a perfect basis for further increases in the gold price.
Many a market participant expected an exploding gold price due to the panic-stricken and turbulent events of last year, and ended up disappointed by the performance. But even the collapsing oil price or the rallying US dollar failed to put a lid on the gold price. Gold outperformed most other investments both in absolute and in particular in relative terms. On top of that, gold set new all-time-highs in the Euro, the British pound, the Canadian dollar, the South-African rand, the Russian rouble, the Indian rupee, and many other currencies. The comparison with equity indices in local currencies is particularly interesting:
One reason for the devastating impact of the financial crisis is the high positive correlation among many asset classes. Portfolio diversification through alternative investments, equities, and commodities clearly failed in 2008. The S&P 500 index for example lost almost 40% in 2008, as did the GSCI commodity index. Gold on the other hand went against the grain - although numerous leveraged positions had to be liquidated in the third and fourth quarter.
Gold therefore set itself clearly apart from the rest with an annual performance of 6% in USD and almost 10% in EUR.
Gold has long been a way of insuring the portfolio against inflation, but recently investors have started to credit gold also with the monetary role again that it used to play for thousands of years. Gold is a globally accepted means of exchange that locks in the purchase power and thus the value over long periods of time, and due to its natural scarceness, it contains all the essential elements of a currency. As a result of the financial crisis, Central Banks have grown fonder again of the yellow metal. The mere existence of a gold reserve creates trust, and we should have overcome Keynes' notion of gold as "barbaric relic" at this stage.
According to the World Gold Council, gold demand increased by 38% in the first quarter as compared to the referential period of 2008. Total demand was 1,015.5 tonnes. Investment demand exploded by 248% to 595.5 tonnes. The inflows into exchange-traded funds (ETFs) as well as the physical demand for coins (+154%) and bullions were robust. In only the first two months of 2009 more funds were funnelled into ETFs than in the whole of 2008. Jewellery demand on the other hand slumped by 24% to 339.4 tonnes, and the electronics sector required far less gold as well (-36% to 51.3 tonnes). That said, the high gold price also led to an increase in the recycling of gold: the volume of recycled gold increased by 55% to 558 tonnes.
Gold vs. other asset classes since June 2008
Opportunity costs also continue to fall. The yield of the 3M US bills was even negative for a short while in December 2008, which puts an interesting spin on the term "smart money".
2008 was also characterised by an extreme discrepancy between the markets for physical gold and for paper gold. The price of bullion or coins was at times 20% to 30% above its price on the forward markets (mainly COMEX). In the USA, coin sales increased by 123%, in Austria by more than 200%. The US, South African, and Australian mints even had to decline certain new orders and had to work extra shifts in order to be able to satisfy the enormous demand.
Premiums of close to 5% are customary. In the case of silver, some of the premiums on coins amounted to 100% on top of the spot price. At the moment less than 3% of all COMEX positions are covered by real physical gold, and the nominal value of all open derivative positions was a worrying USD 600bn at the end of 2008.
Central Banks around the globe are trying desperately to avoid deflation, although in our opinion inflation is the real danger - as this 2002 quote from Ben Bernanke would confirm:
"The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Ben Bernanke, 21 November 2002, "Deflation: Making Sure "IT" doesn't happen here." http://www.federalreserve.gov/BOARDDOCS/SPEEC
Click here to download the full 53 page Erste Bank report in pdf format.