While lately not much, if anything, has changed in our and the broader secular outlook on gold, which has been and continues to remain the only currency equivalent that isolates devaluation risk, and excludes counterparty risk while being an implicit bet on the stupidity of those in charge (the fact that various tenured "Ph.D. economists" hate what it represents for their tenure prospects of course only makes the bullish case far stronger). True, in the past month it has surged from $1520 to $1660 but only Ph.D. economists (indeed, that 200 DMA proved to be a complete non-event) could not have foreseen that year end liquidations in a desperate drive to shore up liquidity (as explained here) by institutions, always end, and the reversion to the above thesis sooner or later reappears. So while it won't say much new, below we present Nomura's just released Gold Sector Initiation, which is a must read for new entrants to the field of physical and paper representations of gold, as well as a timely reminder for everyone else that in the past 3 years nothing has changed with the fundamental thesis, and in fact recent actions have merely reinforced it (and if we indeed have a €1 or €10 trillion LTRO, then watch all resistance levels in the metal get blown off).
A longer-term perspective on gold
Ineffective global governmental and central bank responses to the financial crisis of 2008 and the related sovereign debt crisis are causing investors to rethink some of the fundamental tenets of fiat currency systems. Associated with this, gold’s historical position of importance has the potential to re-emerge, with many important consequences for gold demand.
Gold has occupied a significant, yet constantly evolving place in the history of financial markets. Gold coins were first minted in ancient times, beginning gold’s tradition as the ultimate store of value. The use of gold coins as a mainstream currency persisted until the 16th century when significant discoveries of silver in Latin America saw a dual system develop; with gold and silver competing for use in international and domestic trade. By the early 18th century gold had re-emerged as the de facto monetary standard when Britain set a gold/silver ratio that eventually relegated silver from significant use. By the end of the 19th century most industrial countries adhered to a gold standard.
World War I and its associated pressures on government expenditures saw the gold standard end when major European countries halted the convertibility of their currencies into gold. The gold standard was generally restored in the post-war years; however, this return was short-lived, as leading economies once again suspended convertibility in order to devalue their currencies in response to the Great Depression. The US remained on a gold standard, although the 1934 Gold Reserve Act nationalised private gold holdings and devalued the gold dollar.
The end of World War II saw the implementation of what came to be known as the Bretton Woods system, a two-tiered gold-exchange system where the US dollar was backed by gold and all other currencies were pegged to the dollar. This lasted until 1971 when a combination of short-term pressures alongside the rise of German and Japanese economic power caused US president Richard Nixon to end the gold standard.
It has only been since 1971 that the world has shifted to a sustained, full-faith, fiat currency system. Between 1980 and 2000 the gold price fell as economic prosperity and contained inflation expectations led private investors, institutional investors and central banks away from gold. The 2000s saw gold demand rebound as lower interest rates and strong growth from Asian economies started a bull market that is ongoing today.
Nomura’s Quantitative Research report, Why gold is cheap in Asia, dated 16 August 2011, on why Asian nominal income growth and not US CPI has been the driver of the gold bull market. It provides a crucial perspective shift in understanding that gold has become a global commodity with global demand drivers and has been heavily influenced by Asian economic growth.
Gold has moved in and out of vogue many times over the past 100 years. Figure 6 provides perspective to the drop in gold prices that occurred at the end of 2011. A price correction was arguably overdue, especially in the context of the cyclicality of certain demand segments and the above-trend price increases in mid-2011. That said, our analysis suggests that the forces that have pushed gold up by 480% in the past 10 years are still in force and could well be exacerbated over the medium term.
Gold price appreciation has increased exponentially since the market stabilisation following the initial impact of the 2008 financial crisis. Concerns around the stability of fiat monetary systems in conjunction with exceedingly high sovereign debt levels are leading investors to review alternative stores of value, increasing gold investment demand.
Gold certainly has a long and well-established pedigree when placed in the context of its historical role in financial markets. We expect this re-emergence of gold as an asset class to persist over the medium term even as the world emerges from the sovereign debt crisis and continued shifts in the global economic landscape will see further shifts in reserve currency systems.
This is likely to have important implications for the gold producers. Figure 8 shows global P/E multiples for gold equities remain remarkably constrained despite the shift in gold prices seen over the past 10 years.
The practical constraints of re-implementing a gold standard system after the financial innovations of the past 40 years make a return to a Bretton Woods type system unrealistic, especially when we consider the gold standard’s lack of flexibility in implementing Keynesian or monetarist economic policies. However, it is important in the light of the current fragility of the world’s financial system and the ongoing paradigm shift with regard to the value of fiat currencies, to analyse gold from a broader historical perspective. This time might not be different.
In addition to the paradigm shift questioning faith in fiat currencies and longer-term shifts in world reserve currency systems; from a fundamental perspective, various longer-term trends are supportive of the gold price including:
- secular demand growth from Asia,
- a lack of flexibility in medium-term mine supply growth potential; and
- a shift in emerging market central bank attitudes toward gold as part of reserves
Short-term volatility drivers
The exogenous risks are likely to favour gold prices, as well, in the context of a limited response from near-term new mine supply. There are a number of factors that could cause gold to trade above our estimates in the short term. These include:
- the perceived threat from elevated inflation expectations from potential further quantitative easing,
- the potential for a lack of alternatives to the eurozone crisis, other than monetisation of debt and
- an increase in investor activity in an era with expected near-zero real interest rates.
The speed of the changing fundamentals within various sub-segment demand categories will no doubt add volatility to the gold price. Current weakness in the Indian rupee has seen Indian gold imports fall sharply. Financial system deleveraging can place pressure on investment demand for gold, which tends to be a larger proportion of demand than for other commodities.
Overall, our analysis suggests that the gold price remains well supported over the medium term, albeit with potentially high volatility from the demand perspective causing wide potential swings.
For Nomura's forecasts on future gold prices, supply and demand trends, and what this means for gold equities, read the full 105 page report below.