The Yellow Fever Isn't Abating

Evy Hambro, Managing Director and Portfolio Manager with the Natural Resources Team, Blackrock Mutual Fund.
His call: There will be no net increase in gold mine supply over the next five years.
His investment idea: Choose gold for medium-term returns.

Gold has been in a bull market since 2001. However, having made a new life-time high in recent weeks, where do gold prices go from here? Market fundamentals suggest that gold prices could continue to trend higher from here. The financial crisis has accelerated an already existing upward trend which is supported by favourable supply-demand fundamentals.

First, the gold mining industry is struggling with production — annual production has fallen by 8.7 percent since its peak in 2001. Despite a historically high gold price and a sharp rise in exploration expenditure, I can see no net increase in gold mine supply over the next five years and expect the declining trend in production to continue.

This is likely to prove supportive for gold prices; as is the strategic shift in the attitude of the world’s central banks towards gold. Bullion sales by European central banks have slowed significantly after 20 years of large disposals and we are seeing developing countries (most notably China, India and Russia) significantly increasing their gold reserves as they seek to diversify away from US assets amid concerns over the weakness of the US dollar.

China has almost doubled its gold reserves over the last six years and had been expected to prove to be the chief buyer when the International Monetary Fund (IMF) put more than 400 tonnes of its stockpile up for sale in September. However, India took markets by surprise when it announced in early November that the Reserve Bank of India was buying 200 tonnes of the IMF gold, marking the biggest single central bank purchase of bullion for around 30 years.

 

Illustration: Abhijeet Kini

Even with this purchase, India’s gold represents less than 10 percent of its total reserves. This move fuelled speculation that other central banks with large US dollar exposure might also diversify into hard assets such as gold. Indeed, Sri Lanka also subsequently admitted to making gold purchases in the past six months. Although the immediate impact on the gold price of this shift in central bank sentiment may be limited, I believe that its longer-term implications are likely to prove extremely supportive for the gold price.

I continue to see a strong investment demand for gold, as witnessed by record levels of purchases through Exchange Traded Funds (ETF). ETF holdings, as a whole, have now reached the very high level of more than 50 million ounces of gold. Investor demand for ETFs seems to be driven by a variety of factors, with investors viewing gold as a hedge against US dollar weakness and against medium-term inflationary pressures, while also providing important diversification benefits.

With regard to gold equities (mining companies), they now appear to be generating leverage to movements in the bullion price, a characteristic that had been conspicuously absent in recent years. We believe that earnings will expand as gold prices rise and investors will be attracted back into the sector.

So overall, the positive fundamentals for gold have not gone away; the dollar remains weak, uncertainty remains in financial markets and most importantly mine production is still falling.
Barrick, the world’s largest pure gold mining company, predicts that mine supply could fall by 10-15 percent over the next five years and despite a significant increase in exploration spending, the gold industry has not found more than it has mined since 1995. All the easy gold has been found, which means the industry needs a higher gold price for longer before they have enough of an incentive to begin to significantly invest in bringing on new supply. With gold hitting new highs, a concern for some investors, it is worth pointing out that in real terms, gold is some way below its previous high. The 1980 peak of US$850 per ounce, when adjusted for inflation, is over US$2,000 per ounce.

 

Indians form the largest market for gold jewelry in the world. If you believe — as we do at DSP Blackrock Natural Resources team — that gold price is trending upwards and that it will offer positive returns over the medium term, there are ways you can derive the maximum benefit from this. But first, consider the amount of exposure you have to gold as a proportion of your whole investment portfolio. Include your gold jewelry as well as other assets such as property.

Then, you also need to consider what your appetite for risk is - are you looking to diversify away from financial markets, are you looking for protection from inflation or the value of the US dollar etc; you can then ascertain whether further investment into gold is required.

 

 

Owning physical gold has its advantages: It is exchangeable anywhere, it is easily transportable and there is no counter-party risk. But ETFs are more easily tradeable. However, remember that you pay a management fee on an ETF. So if the gold price were to stay flat for example, your ETF would actually decrease in value over time.

Questions are asked in India about why gold and equities are moving up together. Given the different drivers for the gold price, namely fear, currencies, inflation etc, gold can and does move in line with equities in the shorter term. In other words, the direction of the gold price does not depend on movements in equity markets.