Is Gold Due for a Pause?

Precious metals consultancy GFMS are bullish about gold prices. Executive Chairman Philip Klapwijk explains why.

Strong demand for gold from jewellery manufacturers is providing underpinning for the market, so when stronger investment demand comes through it should lift prices from current levels of around $472 to above $500 in the first half of next year.

That's the bullish forecast from GFMS, the precious metals consultancy. At a presentation in London last month, GFMS executive chairman Philip Klapwijk spelled out these reasons for optimism:

  • The dollar will come under renewed pressure because the US foreign trade deficit will get even worse due to the higher cost of oil imports, and the fiscal deficit will also deteriorate given post-Katrina reconstruction costs and a slowing economy.

The greenback's rally this year has been driven "mainly by interest-rate differentials which may not increase much further."The threat of inflation has grown, mainly because of higher energy prices. This "boosts the appeal of gold as an inflation hedge and it's not going to do a lot for consumer sentiment, either."

  • Costlier energy is likely to put a brake on the world economy and perhaps even tip some economies into recession. Poorer economic growth will undermine the attractions of other investment alternatives.
  • Demand for jewellery fabrication is buoyant up 200 tons, or 16%, in the first half of this year as consumers have grown comfortable with gold prices above $420.
  • Dehedging continues to provide important support adding 102 tons to demand in the first half. With prices in a rising trend, there is no sign of enthusiasm among producers for any new hedging.
  • Investment demand is likely to add about 164 tons to demand in the current half-year, GFMS predicts.
  • The recent rise in the gold price in euro terms at a time when the dollar has been rallying suggests that gold has at last "decoupled" from the dollar.
  • The geo-political environment is "supportive," given situations in Iraq and Iran that seem "set to become more serious."

How about a strong dollar?

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These seem to be convincing arguments, yet I am uneasy.

Even if the gold price is no longer inversely coupled to the dollar, strength in the US currency would provide a headwind for gold. The greenback has been in a rising trend all this year, and I believe is set to continue for some time yet.

Although almost everyone seems to believe that this is only a strong rally in a bear market, it may not be. It could be that the dollar's bear market is over.

If it becomes clear that their economy faces a politically and financially dangerous slowdown next year or (more likely) in 2007, American policymakers will act aggressively to stimulate. All thoughts of rising interest rates and restoration of fiscal prudence will be forgotten.

So long as Americans continue running a huge trade deficit with the rest of the world, other countries will continue to recycle their trade surpluses back into the US, underpinning the dollar.

And while the US maintains economic growth much higher than in other major nations, private investors will continue to be attracted to American assets. All this suggests that betting against the dollar is becoming increasingly risky.

Some major uncertainties

I am also worried that the fundamentals for gold aren't as strong as I would like them to be.

There is reasonable certainty that the major negative factors impacting on gold big sales by central banks, forecast to reach about 672 tons this year; and fading demand from dehedgers will persist.

But there is considerable uncertainty about the major positive factors needed to support gold and keep prices rising.

  • Will the strong jewellery demand recently experienced, and arguably largely due to special circumstances in India and Turkey, persist? Even on GFMS's forecasts, total jewellery demand this year will be some 200 tons below the levels of 2001.
  • Will supplies of old gold "scrap" (largely from cashing-in of relatively crude "high-carat" jewellery in Asia) continue to decline?
  • Will the strong investment demand that bulls such as myself have been expecting and hoping for for a long time, ever arrive at the party? No convincing evidence of that yet.

The bull market in gold that started in 2002 has been losing some of its momentum. Average gold prices in dollar terms rose 17% in 2003, 13% last year, and are forecast by GFMS to rise only 6% this year.

What's more, gold has been a disappointing investment compared to other commodities, equities and even bonds. Over the past 12 months German government ten-year bonds, for example, have delivered a total return of nearly 28% in dollar terms, compared to gold's 15%.

I don't think there is a convincing case for buying any more gold now though of course you should always keep a core holding of the most "defensive" (safe but unexciting) investment of all.

At current levels above $470 there is a stronger case for taking some profits than for buying more. Better to do that after the coming correction.

By Martin Spring in On Target, a private newsletter on global strategy.