China et al: Puts Floor in Gold Market

By Dian L. Chu, Economic Forecasts & Opinions

Gold finally made its run above the magical $1,000 mark on Tuesday, September 8th, 2009 breaking free from a two-month trading range between $930 and $970 an ounce. For the third time, gold soared past the $1,000 level, causing the market to eye the precious metal's record of $1,033.90 reached in March 2008. While Citigroup is predicting a $2,000 scenario by next year due to continuing dollar weakness, a number of bullish factors, both near and long term, have converged to boost gold.

Technical Rally

Gold rallied to $997.20 an ounce last week after an earlier slide in stock markets pushed it through key technical resistance levels of $962 - $976 triggering buy orders (Fig. 1). Currently, the $1000 - $1035 is a technical pivot point for gold. In dollar terms, gold broke the 1,000 resistance, with the next hurdle of February’s peak of $1,005 followed by the March 2008 record of $1,035. In euro and sterling terms, spot bullion broke above its 100 and 200-day moving averages, both considered as buying signals.


China Effect

China has been increasingly vocal about their concern for the U.S. dollar and the U.S. bailout policies as of late, and has explicitly called for replacing the U.S. dollar as the world's reserve currency in favor of Special Drawing Rights (SDRs) from the International Monetary Fund (IMF). Beijing followed up that rhetoric by announcing their intention to purchase up to $50 billion in SDRs from the IMF. Russia and India have likewise indicated an interest in purchasing SDR-denominated IMF bonds, putting more pressure on the dollar.

Beijing also has been actively seeking to diversify its $2 trillion stockpile of foreign-exchange reserves into other assets, especially commodities. According to an April 2009 report, China has boosted its gold reserves to 1,054 metric tons, up about 76% since 2003. The increase makes China the world's fifth-largest holder of gold. Last year China ranked as the world's largest gold producer with 12.2% of world output, equivalent to 288 metric tons. Another news report suggests that the Chinese government is pushing the general public into buying gold and silver bullion, which could have a dramatic effect on the markets

From all indications, China has emerged as the driving force in the global gold market and will likely buy whenever there is a price dip, putting a floor under any correction. However, don’t expect China to bid the prices too high, as Beijing is also cautious not to “over-stimulate” markets.


Inflation/Dollar Hedge

Gold has attracted many investors since the collapse of Lehman Brothers last year. Growing investor concerns that the sharp rise in major country debt levels and aggressive quantitative easing will impact sovereign ratings, currency values and potentially cause inflation to rise sharply appears to be causing investors to raise their holdings of hard assets.

The agreement last week by the G20 to keep the economic stimulus flowing until the global recovery was well entrenched led to rising speculation across markets regarding central banks’ exit strategies, as well as dollar weakness. Hedge funds have bought heavily into gold as a bet against the ability of central banks to stimulate economic growth without triggering inflation.


Risk Aversion

Asset-diversification demand for gold and other precious metals by nervous investors amid unstable equities markets has contributed to gold's latest rally. Historically, gold has an inherent inverse relationship with the U.S dollar as well as equity markets (Fig. 3). Gold has tripled in value over the last seven years, vastly outperforming equities, and is now benefiting from uncertainty over the strength of the economic recovery. Investors are buying gold as a diversification from risk, while those who believe it is sustainable choose the metal as an inflation hedge.

Global monetary authorities have long held gold in their reserves for economic security in addition to asset diversification. Emerging sovereign-wealth funds are buying gold as well due to volatility in their economic and/or political environment. When these sovereign-wealth funds are not actively purchasing gold they are at least reconsidering the level of gold in their reserves.

Supply & Demand

Distrust of any paper investment due to the global economic crisis has pushed up gold demand when global gold production is falling (Fig. 2). According to the World Gold Council's Gold Demand Trends report for the second quarter of 2009, investment demand for gold rose 46% from earlier in the year but was down by 9% year-over-year. Demand for gold exchange-traded products also rose with a total net inflow of 1.9 metric tons for June 2009, compared with net outflows of 38.1 metric tons a month prior.

Fundamentally, lack of exploration expenditure in the 1990s, coupled with the inherent delays between discovery and production mean that the gold supply will remain inelastic and is likely to reduce slowly over the coming few years.


To Hong Kong, with Gold

Hong Kong is repatriating its physical gold reserves from London to high-security vaults at home, and it is inviting the region's central banks to store their bullion there. The move raises a potential price-settlement hub in Asia to rival the New York and London daily spot-price fixes. The Hong Kong Monetary Authority is also targeting a new gold bullion ETF using the new vault as a repository, which would remove yet more physical supply from the market.

De-hedging by Barrick Gold

Citing a bullish outlook for gold, Barrick Gold (ABX) indicated that it will eliminate all of its gold hedges and raise about $3.5 billion in a share offering to help pay for the move, giving the company full exposure to changes in the precious metal's market price.   Barrick's dehedging & buying since the end of the second quarter reportedly had been a major contributor to the nearly $100 rise in the price of gold over that period.  To investors, this move spells a very bullish golden outlook from the world’s largest gold producer.

According to an August 2009 analysis by Société Générale, the majority of the global hedge book is still under the control of two main players, Barrick Gold (ABX) and AngloGold Ashanti (AU). Thus, there remains significant scope for the two companies to act as a swing factor in the world’s gold market.

Seasonal & Regional Effects

September is historically a strong month for gold, partly because it precedes the wedding season in India, when jewelry demand typically picks up. Although jewelry demand for gold sank to a five- and-a-half-year low in the second quarter of 2009, gold is still considered the best possible protection against upheaval, both political and economic in much of Asia, the Middle East, and the Indian subcontinent.

Gold Rush to Continue?

Even with resurging investment demand, gold's recent rally has been largely technical, amid weakening physical demand. Nevertheless, China, inflation/dollar hedge, risk aversion and supply/demand are the main longer term bullish factors underpinning gold prices. Dollar movements and external economic factors will continue to greatly influence precious metals' prices. While a resurgence of inflation fears would ultimately skyrocket gold prices, it is not a likely scenario in the near-term, as we are still pretty much in the deflationary cycle.

Technically, if gold breaks the $1,035 point, expect to see a lot of new funds inflow and short covering bidding prices even higher. However, if the yellow metal fails to break higher, there could be a sell-off from profit taking and/or panic.  Fundamentally, a sustained rally in the gold price beyond $1,000 remains doubtful, as commodity prices in general are overbought, and there could be room for a correction.

Therefore, from all the factors examined so far, gold is likely to remain range-bound around $900’s to $1,000’s in the near-term, while markets and the global economy stabilize.

Sector Strategy

As discussed, since gold prices have a virtual floor built in, buying on the dip at around $940 price range should be a good strategy for the physical futures market. 

To get the upside on gold with less risk and volatility, equity investors could focus on gold mining companies such as Freeport-McMoRan Copper & Gold (FCX) and NovaGold Resources (NG) with a favorable gold production cost structure. Jaguar Mining Inc. (JAG), one of the very few unhedged miners, could be worthy of a look as well.

For new gold ETF investors, ETFs like the SPDR Gold Trust (GLD) and Market Vectors Gold Miners (GDX) offer good inflation protection. Investors already own gold related holdings could consider diversifying to precious metals ETFs such as PowerShares DB Precious Metals Fund (DBP) or broad commodity ETFs like DB Commodity Index (DBC).

By Dian L. Chu, Economic Forecasts & Opinions