Gold and Precious Metals

Why gold will keep on climbing…eventually

Gold is up over 20% from its December price lows, measured in US dollars. Most people would call that a bull market, at least for now. OfWealth has long argued that everyone should own some gold, our favourite “lustrous lump”. Today we’ll look at what could be driving it in the short term, and add more evidence for why it should keep climbing in the future.

First  let’s examine what’s driving the gold price in the short term, and what’s likely to keep driving it higher in the longer term. It doesn’t always make sense to have a big allocation to gold, although you should always have some as insurance. But are we entering a golden era for gold? Is this something that you can expect to make big profits from?

First some figures. Gold reached an all time peak price of US$1,896.50 per troy ounce on 5th September 2011. It then went into a bear market that lasted over four years, until it bottomed out at US$1,054.68 on 3rd December 2015.

Gold price in US$, last five years

Gold-price-in-US$,-last-five-years

The gold price is now $1,273.70 per ounce, which is up 20.8% from the December lows. Historically, when gold has rallied more than 20% over a few months, it has usually signalled a new bull market.

Here’s a number to fix in your mind. At exactly 20% above the lows the price would be US$1,265.62. So if gold stays above US1,266 per ounce then there’s a good case for saying it remains in a bull market.

Gold price in US$ since December 2015 low

GoldPrice-since-2015-low

This performance makes gold one of the best performing investments in recent months. Stocks, including expensive US stocks, have mostly moved sideways. Long dated government bonds have held up, as yields have fallen to even lower levels (as yields fall, prices rise). But gold has outshone them all. At last.

We can’t know for sure why this is. There’s evidence that investors have suddenly turned bullish on gold, as witnessed by record inflows to gold ETFs in February. There was even more buying last month than during the height of the “flight to safety” panic set off by the global financial crisis of 2008 and 2009 (see chart).

A big spike in gold ETF demand in February

GOLD-ETF

If there are big inflows into gold ETFs, then has there also been big buying of gold coins and bullion by investors?

Probably, but the authoritative source on this, the World Gold Council, won’t produce its quarterly report until late April or early May, so we can only guess.

The question is why ETF investors have started accumulating gold again. There are many short term possibilities.

Perhaps people are increasingly fed up with the near zero yields on cash? Or the actually negative yields on trillions of dollars worth of government bonds trading in Europe and Japan?

Or could it be fear of another banking crisis? Back in late January and early February rumours were swirling around of imminent problems at Deutsche Bank (company motto: “A passion to perform”). And that’s not just any old bank.

It’s Germany’s biggest, and also one of the world’s largest investment banks. If Deutsche Bank went down it would mean all sorts of problems for both the German government and its trading counterparties (and their governments), not to mention the European and world economies.

Italian banks have also been in trouble, and Italian stocks are down 14% this year, in US dollar terms, largely because of it. It’s estimated that around 20% of loans made by Italian banks are “non-performing”, which means a large part of them won’t get paid back.

Despite lower leverage than before the global financial crisis, big banks today typically still have assets that are 15 to 25 times as big as net assets. Net assets are assets less liabilities – also called book value or shareholders’ equity. At 20 times leverage you only need to write down 5% of your assets to be bankrupt, as in having negative net assets.

If Italian bank loans are 50% of the total bank assets (actually it’s probably more), and 20% of them are non-performing, and they expect to write off half of those loan values (about typical), then the result would be a write down of 5% of total assets.

At that point you could say ciao to the Italian banking system, barring another massive government bailout. This would be a huge deal – much bigger than the problems in Greece. Italy is still the world’s 8th largest economy, which is to say it’s nine times larger than 44th ranked Greece. It’s not even clear if the Italian government could bail out its banks. Government debt is already 132% of GDP.

Then there are the perennial fears about China. The exact pre-occupations vary from year to year. But I can’t remember a single time since I started studying the place – over 15 years ago – when a large number of people haven’t been predicting its imminent meltdown and demise.

Could they be right this time? Perhaps. There has certainly been a massive expansion of corporate debt in recent years, although it appears to be concentrated in state-owned enterprises. And recent figures for exports have been weak.

Yet China most likely has the firepower to contain any crisis – such as cutting interest rates (they still have that luxury), or using part of its trillions of foreign exchange reserves to recapitalise the banks, or increasing government spending. It will most likely keep the economy chugging along with positive growth.

But maybe Chinese investors have been drawn to gold in recent months. The local currency, the renminbi yuan, weakened a few percent against the US dollar between November and January. And there was a huge bubble and bust in the local Chinese stock market last year. Perhaps many Chinese are looking to gold as a safe haven.

For now we can only speculate as to why interest in gold suddenly got a kick start. But as the price rises strongly, and as so many other major asset classes offer poor future prospects, we could find more and more investors jumping on to the band wagon.

Or not. Perhaps this is a false dawn, and a sharp downwards price correction is imminent.

Whatever happens, the long term for gold looks bright. There’s only so much of it around and it’s hard to produce, meaning supply is constrained.

Consider this. While I was researching the upcoming report on ways to buy gold I found some work I’d done back in 2012 for a group of very wealthy families in the US and Europe.

One important insight was that Taiwanese GDP per capita was over three times as high as mainland Chinese GDP per capita. Taiwanese gold consumption per capita was over five times as high as on the mainland.

Those are two countries populated by Chinese people, with shared cultural values once you dig below the politics. The only thing separating them, apart from the Taiwan strait, is 20 to 30 years of economic development. That’s how big Taiwan’s head start has been.

If the mainland Chinese eventually tried to buy as much gold per person as the Taiwanese there simply wouldn’t be enough gold in the world to go around.

And this is before we’ve even taken India into account, already the world’s second largest gold buyer after China and also on a wealth growth trajectory. To maintain the balance with supply the gold price will have to rocket over the coming decade or two.

The gold price has beaten US dollar based inflation by 2% a year over the past 40 years, on average. There are good reasons to think that it will do better in future. Perhaps much, much better.

Gold may not have outperformed US stocks in the past (see here and here). But there are good reasons to think it could beat them over the next decade or two.

What’s your view?

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.