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ETF Securities head of Research and Investment strategy says the key risk to the gold flows this year would be a substantial and sustained rise in global interest rates but this, he says is unlikely
GEOFF CANDY: Welcome to this week's edition of Mineweb.com's Gold Weekly podcast. Joining me on the line is Nicholas Brooks, he's the head of Research and Investment Strategy at ETF Securities. There has been a lot of talk recently about whether or not gold is heading towards a cyclical high or if perhaps it is entering bubble territory and then on the other side there is no such thing as a bubble in the gold market or at least in the near term and there's still a lot of room to run. How do you see the gold market currently?
NICHOLAS BROOKS: The gold market is in a very interesting position now. There are a number of key factors driving the gold price at all times and some of those currents are shifting how - on a medium to long term basis one of the key factors underlying the demand for gold is gold as an alternative currency. That is a new demand driver that has built up since the financial crisis in the second half of 2008 and many investors, conservative long term investors as well as the man on the street is looking at gold as an alternative to holding paper currencies. It doesn't mean that they are selling all their paper currencies or assets but that they are putting a larger proportion of their assets in gold. Again the key reason for that of course is that if governments are now post the financial crisis running extremely large debt burdens and not just in peripheral Europe which is where the attention has been but also in the United States, Japan and the United Kingdom and also some of the core European countries and the concern always is that governments made have some temptation to inflate their way out of these problems or debase their currencies and gold is looked at as an alternative. Again going back to the euro crisis, the first euro crisis in early 2010 there were very substantial inflows into gold of all kinds with gold ETP (Exchange Traded Products) seeing very substantial in flows during that period again - investors starting to wonder about the structural outlook for the euro as a currency, again conservative long term investors putting a larger proportion of their portfolios into gold. So that's a long term structural factor that supports gold. You are also seeing central banks moving from net sellers to net buyers of gold, particularly the larger emerging market. Central banks like the Reserve Bank of India, the People's Bank of China, etcetera. So these structural factors will support gold prices for some time to come and then on top of that just the natural rise in per capita income in China, India, etcetera will likely also increase that demand. On the other hand you have shorter term factors or more tactical factors that affect the gold price and the key one of course is real interest rates or nominal interest rates and generally when interest rates are rising - certainly if they are rising at a rapid pace - gold underperforms and now with inflation rising in many economies across the world there is a rising belief that the ECB, possibly eventually the Federal Reserve, Bank of England may start to raise rates and that may take some of the steam out of the gold market rally and that's certainly a possibility. The tricky bit about calling the market right now is that all things equal, if rates were to rise you would think that it would possibly have a negative impact on the gold price. The problem is that at the same time we are having these peripheral European sovereign issues taking place where it looks increasingly likely that Portugal is going to need a bail out, markets are in fact starting to price in the faults or restructuring of some kind in a number of the peripheral European economies. If these types of factors start taking place gold is going to be in strong demand so I think there are these kinds of competing forces driving the gold market right now which make it somewhat difficult to call. My own view would be though that interest rates, even if they were to be increased by the ECB or maybe eventually the Federal Reserve are going to have limited upside and the reason for that I think is because of these very large debt burdens, and the need to run primary surpluses eventually, there's going to be a fiscal drag on growth for some time and on top of that you have the banking sector and real estate issues in many of the key markets and that will limit central banks' ability to raise interest rates. So the interest rate headwind to the gold price is likely to be somewhat temporary and also ultimately not prove to be all that strong.
GEOFF CANDY: I spoke to Eric Sprott who says investment demand for silver is going to take off over the next few years partly as a result of those factors you were alluding to, that view that gold and now silver as well is being viewed as a currency. Would you agree with that, and if so, would that investment be coming in lieu of gold or as well as gold?
NICHOLAS BROOKS: It's a difficult call as well - to answer that question one has to understand what's been driving silver more recently and as you highlighted earlier, the silver price has been performing extremely strongly, one of the best performing commodities and in fact assets globally over the past 12 months. Certainly substantially outperforming the rise in the gold price and then pushing that gold/silver ratio down to multi-year lows - one of the key factors that have been driving silver has been the strong pickup in global economic growth. The sharp rise in the silver price has corresponded with the higher than expected rise in global lead indicators like the US ISAM, European PMIs and other indicators of growth such as employment data etcetera. So because silver is heavily used in industry, around 50% silver input goes into industry as opposed to 10% to 12% for gold, silver does tend to be much more geared into the industrial cycle, so the environment we have seen over the past 12 months has in some ways been almost perfect for silver. Investors have been looking for alternative currencies and safe havens and silver does play that role. Secondary to gold but it does play that role and they've also been looking at ways to play this rise in the industrial cycle and silver has benefited from that. So when we look out over the next year or so, whether silver outperforms gold will really depend on your assumptions of the global macro environment. If we stay in this kind of environment, high sovereign risk, a lot of political risk but yet continued strong growth in the industrial sectors, silver will likely outperform gold. On the other hand if growth were to turn down later this year, if growth indicators started to disappoint, then I suspect that silver would underperform gold - it really depends very much on one's macro view over the next six to 18 months.
GEOFF CANDY: I suppose if the macro economic sphere were to turn down you'd also be unlikely to see an increase in interest rates which would lessen those headwinds that you spoke about earlier as well.
NICHOLAS BROOKS: It's interesting because we saw some of that in the second half of 2008 where when asset markets around the world collapsed and growth slowed very sharply, initially the gold price came off together with the silver price, but gold came back and actually ended the year up. Positive in dollar terms and very significantly positive in euro or sterling or a lot of other currency terms, where silver under performed gold in that period - but at the same time silver did outperform some of the more highly industrially geared industrial metals, so the safe haven properties were the quasi alternative currency characteristics of silver did help it outperform a lot of the other highly cyclical assets. So it may under perform gold but it would probably outperform some of the more cyclically geared commodities in that type of situation.
GEOFF CANDY: Looking at the ETF space in particular and in the European geographical region as well, in the height of the financial crisis, when sovereign debt worries originally emerged around the likes of Greece and Ireland, there was a strong leaning towards gold and particularly small denominations which you alluded to earlier. Is a similar sort of thing happening now that we are seeing a return to those concerns or are those concerns re-emerging?
NICHOLAS BROOKS: Yes absolutely. We put out a report, a global commodity ETP quarterly and our new one will be coming out very soon and I've gone through all the data already and have the numbers through to the first quarter to the end of March and what is interesting to note, is that while there are very large outflows from global ETPs in January 2011 we saw those flows flatten out in February and by March they were starting to come in at a pretty strong pace. So clearly in my view what happened was asset allocators came back from their Christmas holidays in January, looked at the pick up in global growth indicators and decided it was time to go into risky assets, time to take some profits in gold and they sold gold ETPs. However, in mid January we started to see the problems in the Middle East come through and then later in January the European peripheral economy sovereign risk started to come back again and investors remembered that there were still some pretty big risks out there. The world wasn't completely safe and they started to put positions back on in the gold ETPs and that's what has been continuing on into the early part of April.
GEOFF CANDY: To close off with, how do you expect those trends to continue within the ETF space?
NICHOLAS BROOKS: Again I think it is going to turn very much on the macro environment - as long as the environment remains risky, as long as the peripheral European sovereign risk remains an issue, as long as the Middle East remains in turmoil, there is always going to be a demand for an asset like gold. The key risk to the gold flows this year would be a substantial and sustained rise in global interest rates but again my own view is based on the need for fiscal tightening that is unlikely - ultimately if they look out through the year investors will probably continue to take a bar-bell approach to investing hedging out sovereign risk through gold and other instruments, hedging out Middle East risks through oil and other instruments like that and remain long risky assets until there are signs that global is slowing. So ultimately the trends that we have seen in the first quarter of this year are likely to continue through 2011.
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