Is gold still heading for $1,000 an ounce?

The gold price has rocketed this year, and is now already more than halfway to $1,000 an ounce – a level that seemed laughable to most investment commentators even just a year ago. But some experts are now warning that there is no fundamental supply and demand case for investing in gold at these prices. So, asks Martin Spring in the On Target newsletter, can gold’s gains continue – and if so, how much gold should you have in your portfolio?

By MoneyWeek

published 22 June 2006

in Features

Less than four years ago, in one of the first issues of this newsletter, when gold was trading at about $313 an ounce and only favoured as an investment by a few enthusiasts, I explained "why gold is heading for $1,000."

Now we're already halfway to that target, and the yellow metal is starting to attract the attention of the wider investment community.

One example of the new mood is that the independent metals research group GFMS, which only a year ago was cautiously conjecturing that the gold price could hit $500 if global financial markets were destabilized by a major shock, now suggests it could exceed $850 within a couple of years.

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Price of gold: demand uptrend

Unlike other natural resources, gold prices have not been driven up by fastgrowing demand from China. According to GFMS's latest Gold Survey, China accounted for only 8% of world demand for the metal for fabrication last year little more than the 7% of a decade before. Fabrication mainly jewellery manufacture provides fourfifths of annual demand for gold.

Nor has China accounted for much of the growing investment demand for gold. Identified bar hoarding there is tiny compared to Japan, Vietnam, even Thailand.

Although global investment interest in gold is very volatile, there's been a clear uptrend in recent years. Around the turn of the century investment was absorbing an average of about 300 tons a year. That rose to around 420 tons over 2001/2, 650 over 2003/4, and reached 736 tons last year.

A new factor that's a big plus is the emergence of ETFs (Exchange Traded Funds) stock exchange-listed securities giving direct ownership of physical gold.

While much of the increasing investment in "gold" is really in paper, via gold price-indexed derivatives that generate little additional demand for the metal itself, ETFs do boost demand. For every extra certificate sold, issuers provide 100 % backing, buying bars to lock away in bank vaults. According to GFMS, the world's five ETFs accounted for 203 tons of investment demand last year.

Price of gold: biggest risks

As always, the big question for investors is: where is the gold price heading? Will it soar to new peaks above $850 an ounce? Or crash back towards the average cost of producing newlymined gold ($337 an ounce last year)? Or perhaps do both, one following the other?

Because supplies of gold to world markets newly-mined gold, scrap and central bank sales are relatively stable, the big risks to the gold price are on the consumption side. There are two

Investment demand could collapse.

This demand has been unusually strong in recent months, largely because of the new fashion for investing in commodities, but also because profligate credit creation by central banks has lifted values in most asset classes.

The trigger for a big fall in investment demand could be inflation. That's a highly controversial point of view. After all, inflation is seen by almost all as a phenomenon favouring gold. But this time around, it could be a negative for gold.

If inflation in the major economies does look like becoming a problem, that will spur central banks into driving up interest rates more aggressively. That will bring an abrupt end to current massive speculation in gold and other assets based on financing through the "carry trade" money borrowed at little or no interest costs. Rising interest rates already mean that those borrowing in dollars to speculate in gold need a rise of $30 an ounce to break even on their positions.

Another threat to investment demand would be any general collapse in commodity prices because of slowdown in the Chinese and American economies.

Jewellery demand could fall off disastrously.

Consumption of gold for jewellery manufacture has been fairly stable in recent years, but is sensitive to big price rises. When the gold price took off in the final quarter of last year, demand fell sharply in India and Turkey, two major manufacturing nations.

At the launch of GFMS's 2006 Gold Survey in London, chairman Philip Klapwijk warned that, on the basis of current trends, it's "quite possible" that demand for jewellery manufacture will fall by 20% or even 30% this year that would be 500 to 800 tons!

Price of gold: reasons to be bullish

Despite these risks, there are many reasons to remain bullish on gold:

There is growing demand from "strategic" investors who want to hold bullion for the long term, as a permanent or "core" component of their portfolios. GFMS attributes this to the disappearance of anti-gold sentiment after four years of strong price performance, and increasing interest in commodities as an asset class.

Pension funds are starting to invest in commodities, which have the potential to simultaneously raise portfolio returns while reducing risk. Such investment is usually done through index-linked "basket" products that have a gold content, where institutional investment is forecast to nearly double by the end of next year, to $150 billion.

Future potential is great. The combined assets of pension funds in the 11 major markets has been estimated at more than $16 trillion, yet the proportion invested directly or indirectly in gold is miniscule.

Then there are the wealthy private investors millions of millionaires and hundreds of billionaires who "have already had a considerable impact on the gold market," GFMS says.

Smaller private investors, who are still largely absent from the market, could easily be lured into it by the explosion of headlines as prices head towards $1,000, especially if mainstream investments such as equities, bonds and real estate disappoint. A trigger for a revival in mass-market interest could be something like the launch this summer of the new official US gold coin, the Buffalo, with an accompanying marketing blitz. That "could take quite a lot of gold off the market," says Klapwijk.

Any significant shift of capital by global investors into the metal would produce a price explosion because the market's capacity to absorb money is so small.

GFMS says it believes investors put less than $11 billion into gold last year a tiny amount compared to their annual purchases of and holdings in mainstream assets.

Over the past year gold prices have strengthened in all currencies, without getting any lift from a weakening dollar. When the greenback resumes its slide, that could give new impetus to gold. The fundamental imbalances in America's foreign trade remain, and indeed grow worse. For the moment, private investors and foreign central banks remain willing to continue financing the deficit by pouring money into the US, but for how much longer?

Any weakening in the greenback would be good for gold. But if a gentle slide picked up momentum on the downside, that would trigger a fireworks display in the gold market.

Increasing international political uncertainties terrorism, Iran, Iraq, tensions in East Asia provide a favourable environment for gold.

There are other accidents waiting to happen. Consumer debt is at extreme levels in America and Britain. Low yields on the bonds of emerging market securities suggest that financial risk isn't adequately priced. Real estate is a dangerous bubble in many places.

Inflation and interest-rate risks are probably exaggerated. Inflation remains very subdued. And central banks are under increasing political pressure not to be aggressive in tightening up on credit creation. I agree with Marc Faber's prediction that if the US stock market or house prices were to fall by, say, 10%, the Fed would quickly slash interest rates.

Although high prices initially damage demand for gold in jewellery, historical experience suggests this is a short-term phenomenon. Consumers adjust to the higher prices after a year or two.

Downside risk in gold is quite limited because there seems to be a substantial amount of demand from long-term investors waiting to buy in at lower prices. Citibank says in a new Industry Note that gold "will prove resistant to any catastrophic sell-off, due to pent-up physical demand in price-sensitive Asian markets."

Klapwijk did warn at the launch of Gold Survey 2006: "There is no fundamental supply/demand case for supporting gold at current levels. Investment is really doing all the lifting. There is a danger that we're in a bubble market investment is driving up the price, sucking in more investors, which drives up the price further, and so on.

"In the long run, it's not sustainable. But bubbles can inflate very much more than one expects, and stay larger for longer." Downside risk is currently "quite limited.

"Our conclusion is that the rally should continue for this year and through into 2007. New money from investors coming into the market should be sufficient to overcome the headwinds from deteriorating fundamentals." Any shock such as a sharp fall in the dollar, or US military action against Iran, would give a kick of a hundred dollars or so to the gold price.

So: "Further hefty gains over the next year or two are quite possible in the right circumstances, the 1980 high of $850 could even be taken out. In real terms, that peak would be $1,450 an ounce."

Price of gold: investment conclusions

What investment conclusions should we draw from this scenario?

Gold should be a core holding in everyone's portfolio. 10% would be a good figure, with a spread across physical metal (bullion coins or bars), ETF certificates, and units in broadbased gold mining funds.

If you're only moderately overweight in the yellow metal, this probably isn't a good time to take profits. For the moment it looks reasonably safe to stay invested as gold prices head north, and to ride out corrections as they come.