Gold prices and indeed volatility fell for a generation (between 1980 and 2000) and they have subsequently bounced and recovered roughly half that ground over the last five years. It is perhaps tempting, after such a slow and painful decline, for gold analysts and traders now considered mainstream and in the sexier end of the investment world to anxiously call the top of the market too early. A recent poll of leading bullion analysts seems to think so we don't.
Perhaps more disconcertingly the market appears to have migrated from something that one could readily measure and weigh according to a fairly reliable set of fundamentals into one where the tide shifts less to natural market forces and more to what may be described as the "madness of crowds". This brings with it higher degree of forecasting uncertainty and in this article we try to identify some of those features that the new participants to gold may be looking at and its possible impact on the price outlook for the next 12 months.
Broadly one could divide one's thinking into the two distinct areas: those external to the gold market such as geopolitical tension, inflation, US trade deficit, US dollar outlook and the performance of other investments and indeed commodities; and those internal to the gold market that is its supply/demand balances. The former is open to wider conjecture and speculation while the latter is reasonably well-defined and know-able but with some surprises.
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The External Factors
As we near the end of 2005 the US dollar like an aging junkie - seems to have found temporary strength through the repeated injection of interest rate rises. The perception amongst many leading economists is that we may be nearing the top end of the rate cycle and such stimuli to the dollar cannot be guaranteed into 2006. Trade data suggests that the US dollar is considerably overvalued and the burgeoning US trade deficit (currently running at over $700 billion) is likely to further diminish overseas investors appetite to hold US assets in 2006. The world currently absorbs nearly $4 billion of US debt per day through the foreign exchange markets with much of this capital flow taken by (Asian) central banks buying US dollars with their own currencies in order to stop their own currencies from strengthening and the US dollar from weakening and hence maintaining their competitive position for exports. This support cannot continue indefinitely.
It is possible that we shall see further revaluations in the Chinese Yuan (the US has a $180bn trade deficit with China) or worse the US may plunge us into a protectionist trade war. The most likely outcome is a continued weakening in the US dollar and many analysts suggest that this could be a fall of between 15% and 25%. While this is evidently very bullish for gold, it is perhaps even more so than it at first appears - during Q4 2005 the gold price lost patience with the dollar and managed to rally to 18 year highs despite prevailing US dollar strength. Indeed a reversal in the US dollar could prompt a significant spike higher into fresh 24 year highs (above $510) and beyond.
The US has also swung from a budget surplus of $255bn in 2000 to a budget deficit of $430bn in 2004. Corporate and personal debt is also running at levels, savings are at record lows and the US debt is at levels not seen since the Great Depression - when GDP contracted sharply.
Problems are compounded not only by rising interest rates to service the debts, but by higher oil prices which are feeding the potential for rising inflation. The key issues are how the US government is likely to deal with these issues? Renege on promises, cut services, raise taxes or perhaps most likely print more money as it has historically. The latter is certainly the most expedient the lazy man's way out of trouble, with inflation reducing the real value of debt. Almost irrespective of the choices made gold is likely to be one of the beneficiaries. Certainly the correlation between G7 money supply growth and gold prices has remained strong and is likely to hold true.
Looking wider what is your own personal view on the main global political issues? These matter for gold. Are North Korea and Iran going to fall in line? Are fears over avian flu going to evaporate ? Is the Bush government foreign policy going to become dovish? I fear not.
And what of oil and rising Asian demand/stagnating supply - are oil prices going to revert to $35/barrel which, assuming the long term gold/oil ratio holds, would mean that gold is fairly valued at $490 or is a new long term mean oil price closer to $55/$60 per barrel - in which case gold would need to correct itself higher to between $880 and $960 per ounce.
The Internal Factors
If the external factors are supportive, then the internal ones are perhaps more so. Let us look at some of the more pertinent ones.
Global mine supply has peaked and, despite five years of price strength it is showing very little sign of recovering. Many of the leading producing countries are suffering deeper and declining ore grades partially sustained by the higher gold price. Increasing political involvement in the minerals process in South Africa and in South America is making the ability to open new mines in the few cases where they do occur slower and more expensive to bring onstream.
Jewellery has for years provided gold with significant price elasticity not so now ; rising gold prices might formerly have caused lower jewellery sales coupled with more primary and secondary material comes into the market correcting the market lower again. A (hitherto) self-balancing gimballed market now it is different. Record high gold prices in important consuming countries such as India have seen fresh buying on price strength and weaker holders of scrap material will almost certainly now have sold out their long positions.
Equally, producers are less inclined to sell forward into price rallies (because of the small premium that attaches to such a transaction in a low interest rate environment) but perhaps more importantly, because of a gathering consensus that the bull run has legs to run a self-fuelling argument albeit. The result is that the gold market is becoming perfectly inelastic with buying prompting further buying a bubble in the making to you and I. The prospects of currency inflation in non-dollar currencies may also be fuelling ambitions to park saving in a readily available commodity priced in US dollars that will best protect your savings. Couple with this the recent opening of new trading markets in India, China, Dubai, Pakistan and Vietnam plus the widely available raft of bullion ETFs on stock exchanges around the world and you now have the powerfully explosive situation where there is ready access to an attractively performing asset to a wider number of participants.
As if this were not enough, the LBMA Conference in Johannesburg in November 2005 saw a number of Central Bankers - who have been erstwhile sellers of gold looking to possibly increase their holdings. For example, if China and Japan were to adopt the widely held policy of maintaining 15% of the reserve assets in gold then they would still need acquire 17,000 tonnes of gold between them. Currently Asian central banks hold just 1.68% of their assets in gold.
I am running out of space and I have not even had the chance to explore our thinking on the exciting new industrial and chemical applications for gold under development; nor, come to that, the theme that the new breed of investment managers who are buying into gold are so much more "buy and hold" than some of the COMEX floor traders who trade gold like a child high on e-numbers, banging the market this way and that.
Thinking it through it seems there are many reasons to be bullish across the whole front and very few bearish elements. Over the last five years gold has risen 1%, 23%, 22%, 5% and 15% respectively. We see now reason why gold should not repeat the performance of recent years and achieve a rise outlandish though it may sound of 20% in 2006 that would see it between $580 and $600/oz in 12 months time. Time to hang onto your hats because it is going to get bumpy from here on.
By Ross Norman, director at TheBullionDesk.com
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