Gold reasserting itself as safe haven – plus $700 price readily sustainable

Investor demand will be the key to gold prices holding over $700, while underlying fundamentals remain robust.

LONDON - 

Independent research house GFMS Ltd has released its first update to the annual Gold Survey, and at the group's annual London seminar on 13^th September and GFMS Chairman Philip Klapwijk noted that gold is reasserting itself as a safe haven. Despite the distinct possibility of an economic slowdown and the associated effect on the commodities complex, Mr. Klapwijk suggested that any negative impact on gold would only be short term.

While the recent push in prices over $700 has been led by investors, the market has remained underpinned by robust fundamentals and the dollar price level at which consumers have been entering the market has been rising. Until recently this was in the region of $650, but Mr. Klapwijk suggested that it now stands closer to $670. Investor activity will remain the key to prices staying over $700. The consultancy is of the view that the credit crisis is likely to get much worse before it gets better and that this implies bouts of significant liquidation across all markets, with potentially short-term negative effects on gold. It is a matter of record that gold was sold in line with other commodities during August, partly as a flight from risk and partly also as a means of raising liquidity. Short term investors, therefore (such as hedge funds) moved swiftly in and out of - and back into - gold during August, but longer term investors remained in the market and did not appear as sellers.

Noting the very high leverage to the domestic housing market among US consumers, with mortgage debt accounting for something like 75% of US household debt, Mr. Klapwijk suggested that the knock-on effect of the state of the US housing market could well lead to an economic slowdown; the associated reduction in demand growth in the commodities markets would be likely to trigger speculative liquidation even if the fundamentals themselves remain relatively strong for the longer term. It is difficult to quantify the extent to which the rate of growth in the emerging economies, notably India and China, would ameliorate a slowdown in the "developed world", especially as a part of their growth is export-driven.

GFMS notes that at the end of June this year the value of the non-commercial and non-reportable net positions in thirteen commodity futures was in the region of $170 billion, up from roughly $140 billion at the end of 2006 and just less than $30 billion in 2001. Within the Survey Update, GFMS comments that institutional investor interest in commodities "seems increasingly not only for enhanced returns but in an effort to maintain a diversified portfolio". Barclays estimated towards the end of last year that $100 billion was invested in passive basket-type commodity vehicles, while in March of this year calPERS, the California pension fund that has $250 billion under management and which is believed to be the largest fund in the US, invested $450 million in the Goldman Sachs Commodity Index. Net speculative gold holdings on COMEX have been on a downward trend over much of this year, although there has been a recent uptick (from 286 tonnes to 387 tonnes) and GFMS expects that there will be an increase over the rest of this year.

In this context it was of interest to study the correlation coefficients that GFMS has constructed with respect to gold and a number of other parameters. Mr. Klapwijk demonstrated that gold's relationships with some other asset classes, often held up to be close, are in fact not that influential at all.

Gold, contrary to some views, is not in lockstep with oil; the correlation coefficient between gold and oil (based on daily log-returns) over the past four quarters, has been 13%, 14%, zero and 7% respectively. Similarly the relationship with the S+P 0500 has been so low as to be non-existent, at -2%, -1%, 18% and 5% respectively. The silver price has the highest correlation with gold, but that is because gold tends to drive silver rather than the other way round. The most significant relationship among those studied remains that between gold and the dollar:euro rate, although even that did not exceed 46% in any of the past four quarters.

Should commodity prices, as an asset class overall, decline, gold prices could remain buoyant amidst an environment of rapid expansion in the global money supply. This, combined with sustained weakness in the dollar and the possibility of inflation driven by high soft commodity prices, and especially if there is a fresh increase in geopolitical tension, would be particularly supportive of gold and gold would thus be likely to de-couple from the rest of the commodities sector.

GFMS comments that gold has perhaps breached $700 a shade earlier than the house had been expecting, in that GFMS has originally been looking for $700 to give way in the fourth quarter of the year. Mr. Klapwijk commented, however, that there should be little problem in sustaining prices above this level. The dollar is expected to be forced to new lows and this should generate an increase in investor demand. Investment inflows are expected to intensify in market crises and that the norm of safe haven buying should henceforth dominate investor activity as gold reasserts its role as a form of money.

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