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Steve Platt Stephen.Platt@Archerfinancials.com
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Focus: Gold’s new found luster
The record high reached recently in gold raises many questions for the precious metals trader. Can existing fundamentals continue to support the elevated price in the current economic environment, and if so for how long and to what levels? In addition, given the volatility of these markets a trader needs to develop the tools upon which to assess the relevant fundamental influences to know if a break in values is merely a correction or a change in trend. Given the turmoil in financial markets and the dollar, the gold market has shown a resiliency that is indicative of a market that does not yet appear to have reached its zenith.
Although never perfect, history does tend to repeat itself. Many of the same factors that propelled the gold price to record highs throughout the 1970’s and to a top of $850 in 1981 are similar to the factors that are now influencing the sharp run up in prices. These common factors include the following:
- Sharp increases in energy values.
- Devaluation of the dollar.
- Growing current account deficit.
- General commodity inflation.
Although their relative impact on macro economic relationships has changed their order of importance, they remain in the background as integral forces encouraging strong growth in investment demand. It is this demand that on the margin has the largest impact on price movement and associated volatility.
Key Variable: Investment demand
The changes in investment demand have been pronounced. No longer confined to merely high priced physical purchases such as coins or bullion that need to be stored and insured, the typical stock investor can avail themselves to a number of investment vehicles that are securitized gold derivatives, such as Exchange Traded Funds (ETF’s) and Structured Gold Notes, whose valuations and yield are tied to the price of gold. The sale of these instruments is offset or hedged by a corresponding transaction in the gold futures market or as unallocated and allocated metal by the LBMA (London Bullion Market Association). These funds reportedly had inflows of as much as 8 million ounces in 2007, or just over 10 percent of world mine production. Quarterly inflows ranged from a net outflow of 100,000 ounces in the 2nd quarter of 2007 to a quarterly net inflow of 4.5 million ounces in the 3rd quarter. With gold ETF’s holding as much as 29.3 million ounces, a substantial net increase or decrease in their holdings has the potential to overwhelm the market relative to other factors, such as changes in scrap, fabrication or mine production. Other commodity index funds that have gold as a component merely exacerbate the ultimate impact.
The growth of investment in these types of instruments is likely to persist, providing strong support to gold. The diversification from strictly dollar denominated financial assets into hard assets such as gold and commodities will likely continue until a more stable financial environment presents itself. So far the factors which have encouraged this asset transfer appear to be intensifying:
- Energy values have yet to show any meaningful declines. The growth in emerging market economies continues to underpin demand, with forecasts suggesting that supplies will remain tight. With recessionary fears building in the background, forecasts still suggest that for the most part the high energy prices are her to stay for the foreseeable future. The inflow of petrodollars into the economies of oil exporters will continue to foster the diversification into other assets including gold.
- The weak dollar has attracted demand for gold. Although much of the focus has typically been on key currencies such as the euro and yen, they will likely become secondary for price direction. Instead the valuation of the BRIC currencies (Brazil, Russia, India and China) will become a key force given the potential for reinvestment of excess dollars and for further large scale revaluation of these currencies against the dollar.
- The growing current account deficit is a reflection of the U.S. economy living beyond its means. Currently the deficit has reached above 7 percent of GDP and has been steadily expanding. These dollar denominated assets overseas pose substantial risk, and only with a contraction in our consumption, and likewise an increase in exports, might we see stabilization and potential improvement. Whether the adjustment is gradual through continued devaluation in the dollar, particularly against the Chinese Yuan, or through a sharper economic contraction in the U.S. will be a key determinant for the durability of the rally in gold. A recession would likely lead to a quicker adjustment, while a soft landing, which the Fed is attempting to engineer given the recent movement down in rates, will tend to maintain the upside movement in gold prices.
- Another factor critical to the continuation of the rally in gold prices is general commodity inflation. The battle for acres has been intense for key commodities such as corn, wheat and soybeans and also appears to be bleeding into other food crops. Although the CPI has been slow to react to the increase in commodity prices, the factors that have limited its reaction, such as productivity increases and imports, may be losing sway over prices.
Price Outlook- How high can it go?
Given the record high price levels, it is difficult to say definitively how much upside potential prices might have. The strong fundamental influences surrounding the increase, along with the momentum of the market following its move through all-time highs, suggests that further upside exists. If values were to advance on the same order of magnitude that they did from 1976 to 1981, when they moved from near $100 to $875, or approximately 875 percent, prices could conceivably advance to the $2230 level given the low of $255. On a more conservative basis, if values advance on an absolute basis of $775 per ounce, that would put the potential level at $1030. Needless to say when the market does top, its reversal will likely be fast and furious. After reaching the high of $875 in January 1980 values sold off to a low of $462 by March.
In conclusion, it appears the attitude toward ownership of gold by the general public has changed over the past few years. Once seen as a wasting asset strictly geared to the needs of fabricators and the fringe investor, it has attained a role in investment portfolios as a form of diversification, a holding that is seen as non-correlated with other financial assets. The ease of ownership through securitization, and the resulting positions that are offset in the physical market, have provided an impressive adjunct to what had been rather unimpressive demand, particularly from U.S. investors. The new found attraction continues unabated despite the move to historically high levels, leaving room for further upside potential as steady global investment demand absorbs limited supplies.
Feel free to contact me at (877) 377-7931 or at Stephen.Platt@archerfinancials.com with any questions regarding this story, for a market update, or for any other issues you may have in relation to the commodity markets.
The information and comments contained herein are provided as general commentary of market conditions and are not and should not be interpreted as trading advice or recommendation. The information and comments contained herein are not and should not be interpreted to be predictive of any future market event or condition. The information and comments contained herein is provided by ADM Investor Services, Inc. and not Archer Daniels Midland Company. Copyright © ADM Investor Services, Inc.
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