Ancient Egyptians considered gold to be divine and indestructible. Emanating from the sun it was the flesh of the gods, and the store of wealth on which the Pharaohs built their kingdoms. Three thousand years later demand for gold has reached fever pitch, but as prices soar some investors are beginning to have second thoughts finds David Wigan.
Amid the gloom following the 2008 financial crisis the fast-growing Asian economies have provided a rare source of light, as globalisation and industrialisation lift hundreds of millions into the consuming middle classes.
Fuelling that growth, commodity demand has boomed, with investment through tracking indexes such as Standard & Poor’s Goldman Sachs Commodity Index (GSCI) and Dow-Jones UBS Commodity Index (DJ-UBS) hitting $376bn by the end of 2010, according to Barclays Capital, triple the amount of 2005.
Although comprising only 3.2% of the GSCI index, precious metals have benefitted not only from rising demand for commodities, but also from their reputation as a safe haven from the slings and arrows of economic misfortune. The price of gold has risen 50% this year.
Growth drivers
The multiple drivers of demand for precious metals include Standard & Poor’s downgrade of the US credit rating in August, historically low interest rates in the US and Europe, a weak US dollar, the view that central bank holdings in the American currency remain excessive, the European sovereign debt crisis and ongoing concerns over the stability of the financial system.
On the economic front there is little sign of imminent recovery. While Europe is mired in financial crisis, US reports suggest the manufacturing industry may be tipping into contraction, the housing sector remains in the doldrums and consumer confidence has plunged.
The primary beneficiary of the economic downturn is gold, the price of which hit a record $1,921.15 an ounce on the London Bullion Market in mid-September, and is now on a par with the much rarer (and more useful) platinum.
“Demand is exceptionally high, in particular from Asia, where there is less trust in stocks, bonds and even printed money,” says Gavin Lavelle, CEO of commodity risk manager Brady. “The amount of gold produced each year would only fill a small swimming pool, so there are a lot of people going after a relatively tiny amount.” Global gold production is around 10 tonnes per working day.
The highest levels of demand have come from China and India, which accounted for 52% of global bar and coin investment and 55% of jewellery purchases in the second quarter, according to the World Gold Council.
Year-on-year growth in consumer demand was 38% in India, driven by reported frenzied buying around the Hindu festival of Akshaya Tritiya in May, and 25% in China, compared with a global growth rate of 7%.
Demand for gold bars, coins and other pure investments in India soared 83% in 2010 from the year earlier, according to precious metals consultancy GFMS, while the amount of gold used in making jewellery rose 36% in 2010.
“The demand for gold has traditionally been driven by seasonal factors, including the Indian Wedding season, however this year there are many more market factors at play,” says Pat Hendry, an options trader with broker GFI.
Safe haven
Global demand for gold in the second quarter was 919 tonnes and was worth some $44.5bn, the second highest quarterly value on record, according to the World Gold Council.
Among the most active buyers were central banks, which purchased four times as much in the second quarter as in the same period in 2010. Emerging countries were at the fore, with Mexico, Korea, Thailand and Russia leading the charge. The later now holds 8% of its reserve assets in gold.
Money managers have also piled in: the Commodity Futures Trading Commission said there were 228,800 net long positions in its disaggregated commitments of traders report in early August, the highest level ever recorded. SPDR Gold Shares ETF in September saw its assets rise to $73.9 billion, making it the second biggest exchange traded fund in the world.
Historically, gold has performed best in periods of weak economic growth and low interest rates, because of the lower opportunity cost of holding a non-yielding investment.
The decline in the S&P500 since in April 2011 peak is, according to some analysts, an indication that the world’s largest economy may regress into recession before the end of the year. If that is the case the current period of expansion will have lasted just 26 months, the shortest period of business growth in the post war period.
On that basis the bull market in gold may have further to run -- while the price has already out-performed the 1930s recessionary period, it would need to rise to over $2,100 to match the rally seen in the 1970s, according to analysts at Deutsche Bank.
Moreover, against stock valuations gold is still cheap. Assuming the S&P500 remains close to current levels, gold would need to rise to around $2,960 an ounce to match the levels it reached in the 1930s and to $6,400 an ounce to hit the peak at the beginning of the 1980s.
“In our view, recent events have raised the probability of a price spike in gold,” says Deutsche Bank analyst Michael Lewis. “Indeed we believe financial markets will be vulnerable to recurring bouts of risk aversion for the next few years as governments in the US and Europe struggle to bring down debt levels to more sustainable levels.”
Global trade
The centre of the world gold trade is London, which trades an estimated $240bn a day over-the-counter, according to the London Bullion Market Association, with spot transactions accounting for 90% of the total.
While London is dominated by the OTC market, the US has a bigger focus on exchange trading, led by the CME, which bought the New York Mercantile Exchange (NYMEX) in 2008 in deal worth £9.5bn.
The Comex division of NYMEX in August set a daily open interest record for options on gold futures of 1.26m contracts. CME meanwhile has been aggressively marketing new short-term and micro-gold futures, alongside its OTC clearing platform Clearport.
“We have seen a 142% increase across clearing of all metals in the past 12 months,” says Harriet Hunnable, managing director of metals products at the CME. “The feedback we have had from the London OTC market is that there is increased understanding of how central clearing increases capital efficiencies through margin offsets.”
Sterling progress
As activity in the gold markets accelerates, other precious metals are riding the crest of the wave. Silver is seen as a geared proxy for gold prices, appreciating faster when gold rises and falling more quickly when its more illustrious cousin declines.
Unlike gold, the price of silver is also driven by industrial considerations, reflecting its use in electronic and photovoltaic industries, such as the manufacture of solar panels. Silver was one of last year’s best-performing commodities and surged to a record $49.51 an ounce in April, fuelled by demand from China. Silver daily trading volumes on the Shanghai Gold Exchange hit a record 2.18m kilograms in April.
Such was demand for silver at the beginning of the year that it outperformed all other commodities, rising as much as 60% by the end of April. Still, alongside the rise in prices came a jump in volatility, and in the first four months average 30-day volatility was 2.3 times as high as for gold, compared to 1.5 times across 2010. The result was a sharp selloff and 28% drop in the silver price over a week at the beginning of May.
A key metric for silver is its price ratio against gold. That stood at around 1:41 in recent weeks, compared to an average of 1:47 over the course of the twentieth century.
Despite silvers volatility, analysts are largely positive on the metal going forward. “We are bullish on silver because of gold related momentum,” said David Wilson, a director in metals research at Societe Generale, in a note.
While silver has risen on the coat tails of gold, platinum has fared relative badly of late. Demand for platinum and palladium is predicated largely on the fortunes of the car industry, with autocatalysts accounting for over 50% of demand.
While recent global auto sales data was not as weak as expected, in China rising 7% in July after the introduction of a rural scrappage scheme, there are medium term concerns over demand that may restrict the potential for platinum and palladium gains.
“We have seen a huge expansion of auto production in the developing world but, with interest rates in many countries heading higher, credit is going to be harder to secure,” says Nic Brown, head of commodity research at Natixis.
“There may be a period where demand and production may be scaled back in developing countries, which could mean a lull before we see a better environment for platinum and palladium.”
A golden bubble?
Given the macroeconomic issues surrounding precious metals with connections to industrial demand, investors may feel they are best advised to focus their resources on gold and silver. However, there are signs that the recent rally, particularly in gold, may be overdone.
One illustration of the strain on prices is realised volatility in the spot market, which rose in recent weeks to 31% on a 30-day basis, the highest level of the year and far above the long term average of around 15%. Following its rise to a record price in late August, gold fell by $130 an ounce the following week.
The signs of rising investor nervousness were “not surprising” given how far and how quickly the gold price has moved, says Anne-Laure Tremblay, a precious metals analyst at BNP Paribas.
The rise in volatility could also be a precursor to margin increases on Comex, which could catalyse a wider sell off. The sharp falls in silver in early May followed a margin increase on the US exchange.
“We have definitely seen some profit taking since gold reached its highs,” says GFI’s Hendry. “The moves have been dramatic as confidence has been questioned; investors follow suit and turn bearish following the trend.”
A touchstone for hot money is the ETF market, where funds can be added or taken off the table easily. Perhaps surprisingly, demand for gold ETFs fell sharply in the first quarter, and dropped 82% year-on-year in the second quarter after a strong performance in early 2010. ETF demand has reportedly risen again in recent weeks, but the mass exit seen earlier in the year is perhaps an indicator of the gold market’s soft underbelly.
“We saw a large ETF pullback in the first part of the year from hedge fund investors,” says David Nadig, director of research at IndexUniverse.com . “As problems have mounted in the recent period demand has picked up again but we have also see days of huge outflows, which is pure profit taking.”
Another sign that gold’s meteoric rise may not be invincible is the hedging activities of gold producers, which are on the rise according to a report from Societe Generale.
SocGen says options rather than futures were the hedging tool of preference, with producers willing to pay a small premium to buy the right to sell. Just one producer, Canada’s Kinross Gold Corp, engaged in de-hedging in first quarter.
Amid rising nervousness amount producers, some analysts are concerned over the future path for prices.
“We think gold is in a bubble, boosted by high powered money and with interest rates at record lows and central banks injecting liquidity into the financial system,” says Natixis’ Brown.
“These are helping boost gold but the difficulty is judging how much further the rally will go. I think we are closer to the end than to the beginning.”
Given the uncertain future for the global economy, many analysts see prices rising slowly from here – BNP Paribas predicts the metal at $2,200 an ounce by 2013, while Societe Generale describes itself as “bullish”.
Still, forward curves suggest there is little confidence that prices will gain much more, with the June 2014 contract trading around flat to the current spot price.
According to the gold options market, the probability of the gold price trading at around $1,800 an ounce for the foreseeable future is high, but a move lower to $1,600 an ounce is seen as more likely than a rise to $2,000. The skin of the gods may be experiencing its first intimation of mortality.
Highlights from the October issue of FOW:
News
News analysis: Data gap remains in commodity speculation row
News analysis: rogue trades at UBS
News analysis: LSE's bid for LCH.Clearnet
News analysis: EU set to take tough stance on derivatives
Regulars
Market focus: EU carbon market set for growth
Technology report: Low latency systems aim to meet HFT demand
Buyside: Asset managers ready their systems for OTC clearing
Comment
Maciel: Preparing to become a SEF aggregator
Hegarty: Getting Frank about Derivatives
Casey: Dividend futures - Nokia single-stock dividends, hedged
Features
From upstart to industry star: the rise and rise of ICE
Risk management: the long search for real time
Nationalism fights pragmatism in Canada's growing market
Precious metals: The flesh of the gods may be stretched to the limit
Roundtable: International access to Brazil