Are Gold bears too bullish about the US?

Gold has been making headlines. In January, the price of the precious metal climbed to a 2013 high of almost $1,700 an ounce. That month, Germany asked for the repatriation of gold stored in France and the US. In February, gold dropped for the first time in six months after the Federal Reserve’s minutes suggested that some members want to vary the pace of asset purchases. In April, gold tumbled, entering a bear market, reportedly triggered by two huge sell orders from a US investment bank.

 Further falls are expected as the commodity’s relevance in portfolios diminishes amid views that the American economy is on the mend. While most central banks bought gold in the fourth quarter of last year, gold reserves held by China, the biggest foreign lender to the US, is at a minuscule 2% of its foreign reserves. China’s undeclared gold reserves remain an uncertainty in the gold market.

‘Game changer’

Societe Generale says growth in the US economy until summer will be a “game changer” because it will tempt the Fed to consider withdrawing its lax monetary policy strategy. “When you have in place the prospect that the Fed is looking to exit its strategy that means that the bond market in the U.S. or the treasury market are going to normalise,” says Head of Global Asset Management Alain Bokobza, adding that the 10-year yield on US treasuries may reach 3% by next year.

SocGen adds: “The VIX volatility index should rise from the summer from a very low regime; as the USD turns stronger, EM assets (equities but also some bonds and currencies) as well as commodity markets (gold especially) should suffer most.”

SocGen had been negative about gold and silver since February, slashing its fourth-quarter price target for gold to around $1,375 a tonne before the metal’s mid-April plunge. Goldman Sachs followed suit, however, it exited its bearish stance following gold’s April plunge. Goldman says on April 23 that gold may trade at $1,530 in three months, $1,490 in six months and $1,390 in 12 months. Gold reached a record close of $1,900.23 in September 2011.

Their report, “The end of the gold era”, sparked a strong retort from Sprott Group, an investment manager whose funds include Sprout Physical Bullion Trust. Sprott compared central banks’ assets with the price of gold and concluded the association shows that for every $1trn increase in the collective central banks’ balance sheets, the price of gold has generally appreciated by an average of $210/oz.

Sprott explains the collective central bank balance sheets shrunk in the first three months of this year by approximately $415bn with the biggest decline coming from the ECB (European Central Bank). The $415bn decline should equate to a gold price drop of roughly $87/oz and “as it turns out, gold fell by $76/oz over the first quarter of 2013,” says Sprott.

The investment manager says Japan’s quantitative easing programme would add to the global banks’ balance sheet. “Given Japan’s considerable contribution, we seriously question how SocGen believes gold can drop to $1,375/oz by the end of the year?” asks Sprott. The collective balance sheet would need to fall 15% for gold to drop to $1,375/oz, it says. “Does SocGen seriously believe the US Fed (or any other central bank for that matter) is going to reverse its QE accumulation and then start aggressively selling balance sheet assets over the next year?”

Central bank buying

As late as the fourth quarter of last year, gold was still seen as a safe haven asset. Central bank gold buying rose in that quarter, marking the eighth consecutive quarter of net purchases and the highest level since 1964, according to World Gold Council’s report, “Central Bank diversification strategies – rebalancing from the dollar and the euro.” Based on the council’s portfolio optimisation analysis, which took into account market size and access constraints, gold received a prominent 8% allocation, surpassing the 4% to renminbi and 3% to Australian assets.

The bullish trend behind gold since 2008 was in part caused by inflation fears as the US government’s balance sheet ballooned and its deficit rose following its QE programmes. However, the US Consumer Price Index has been relatively benign, increasing at an average annual rate of 1.87% since 2008. Meanwhile the US budget deficit has been falling despite the country’s rising debt levels, a result of the US Federal Open Market Committee’s pledge to buy $85bn in bonds every month until the labour market outlook improves “substantially.”  In March, the deficit totalled $106.5bn, a drop from $198.2bn a year ago. The US’s overall fiscal gap will narrow to 6.5% of GDP this year from 8.5% 2012, according to the International Monetary Fund.

Bolstered by benign inflation numbers, a falling deficit and a pickup in economic activity, investor confidence started to return as US jobless rate held at four-year lows. As the US equity markets rose to record highs, the gold price began to fall. “The downward trend has been confirmed since the start of the year, when charting signals hinted first at a more uncertain, and then a bearish, scenario,” says Günter Tschiderer, director of THEAM, Asia Pacific, a unit of BNP Paribas Investment. Tshiderer has a “moderately bearish” outlook for gold and expect the possibility of rising interest rates and a strengthening U.S. dollar to give rise to “significant headwinds.” Priced against oil or copper, gold’s fair value would be between $1,100 and $1,400 per ounce, he says.

Blackrock, however, is taking a more bullish stand. “We do not see this sell-off as the beginning of a bear market for the metal,” the investment manager said in its April 29 Weekly Gold report. “Longer term, the factors that have driven the bull market in gold have not gone away. Importantly, we are yet to see the full ramifications of quantitative easing, in terms of inflation.”

Billionaire Sam Zell, founder of Equity Residential, the largest publicly traded US apartment landlord, is also cautious. “We are in the middle of a currency war,” he told participants at a real estate conference in Singapore in April. “Everybody is depreciating and everybody is printing. I don’t have a time of reference of anytime in history when printing was followed by real economic growth.”

“The stock market is at all-time high, but the operating companies that we run are not at all-time high in terms of their performance,” Zell adds. “It would seem to me that a correction is only a question of time and I think the longer it goes the higher the risk and the degree of correction.”

Despite a falling US deficit, the IMF has warned about the impact of high debt. “High debt - even if stable - retards potential growth, constrains the scope for future discretionary policy, and leaves economies exposed to further market shocks,” the global lender said. The absence of a ‘‘clear and credible plan to bring debt ratios down over the medium term” in the US and Japan is a “significant concern,” it says.

Gold as a hedge

Holding gold is a hedge against risks and no other country is more exposed to the US dollar and uncertainties of its economy than China. China’s central bank is a major purchaser of US financial assets, largely because of its exchange rate policy. In order to limit the appreciation of RMB against the dollar, China must purchase US dollars.

Chinese officials have criticised US fiscal monetary policies, such as its QE programmes, arguing they could lead to higher US inflation and a significant weakening of the dollar, which could reduce the value of China’s US debt holdings in the future.

Despite China’s exposure to the US and its large foreign exchange reserves, its gold holdings remain at less than 2% of its reserves, or the equivalent of 1,054 metric tons. In marked contrast to the US, Germany and even France and Italy when gold’s share of national foreign exchange reserves is over 70%. According to the World Gold Council, gold constituted an average 13% of total central bank reserve holdings between 2000 and 2012.

Some commentators have questioned China’s official gold reserves. The People’s Bank of China last made known changes to its gold reserves in 2009, raising it from 454 tons in 2003. The bank hasn’t made any revisions since then. China does not publish gold data. The Chinese central bank will not telegraph its purchases to the market as doing so would lead to a surging gold price and to a further devaluation of its foreign exchange reserves.

Other data seems to suggest that China’s gold reserves have risen. According to figures released in April from the Hong Kong government, gold imports by China from Hong Kong jumped 89% in February to 51,303 kilogrammes, rebounding from a decline the month before. According to media reports last year, a black market exists in Mongolia for gold that is mined and smuggled into China. As Mongolia’s overall trading volume with China soared primarily in bulk shipments like coal and copper, mining company officials said it would be easy - and virtually untraceable - to smuggle a few ounces of gold in one of the thousands of coal trucks heading south.

In the Philippines, up to 90% of small-scale gold production is being smuggled out of the Southeast Asian country, according to estimates from officials and traders, much of it to China and Hong Kong.

While questions abound on China’s official gold reserves, there are also issues about the reserves of the developed world, notably the US, following Germany’s Bundesbank’s January request to repatriate 674 tons of gold from vaults in Paris and New York by 2020. The phased relocation, aimed at restoring public confidence in the safety of Germany’s reserves, will begin this year and result in half of German government gold being stored in Frankfurt by the end of the decade. The phased seven-year move led some to query the reasons and the time taken for the repatriation.

Sprott Group’s February report “Do Western Central Banks Have Any Gold Left?” says there has been inconsistency on the data available for demand and supply of gold. It concludes that “central banks have most likely been a massive unreported supplier of physical gold.”

The European Central Bank’s publication: “Statistical treatment of the Eurosystem’s international reserves” (October 2000), says its current reporting guidelines do not require central banks to differentiate between gold owned outright versus gold lent out or swapped with another party. “In spite of the fact that gold loans/deposits may involve opposing economic considerations as compared with gold swaps/repos (as revealed by the direction of the income payments), the statistical treatment of the gold is similar.”

The fact that gold reserves data may include swaps and loans, coupled with an inconsistency in the data available, central banks’ stated gold reserves may be “a paper entry on their balance sheets – completely un-backed by anything tangible other than an IOU from whatever counterparty leased it from them in the past years,” says Sprott.

Price rebound

Gold prices have since rebounded from their April lows as retail outlets across Asia were sold out with some traders reporting levels of demand not seen since the late 1980s. As buyers in Asia, notably from India, form queues outside jewellery shops – a move that will be seen as value investing in financial markets, gold prices have risen to above $1,400/oz, possibly indicating the precious metal’s floor price.

As advanced economies continue their loose monetary policies, billionaire Zell says he is “cautious and disciplined.” “There is a tonne of headwinds out there and headwinds are defined as uncertainty,” says Zell, referring to the American economy. CEOs are confronted with a dilemma of adding investments to expand production or taking risks by increasing their commitments. “The US economy will not grow without an appetite for risks.”

While SocGen recommends switching out of safe havens in the second-quarter of this year, Bokobza adds that from an asset allocation stand point, gold is different from any other assets. “Gold has a non-typical fundamental which has nothing to do with bonds, equities or other commodities. I have gold in my asset allocation permanently.”