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Why Gold Is Looking Lustrous Once Again

20
Feb, 2015

 Since peaking above $1,900 an ounce in September 2011, gold prices have declined by nearly 40%, settling at around $1,200 an ounce on Friday. I  became bearish on gold in January 2013 and discussed why this January 25, 2013 global macroeconomic commentary, citing: 1) the passing dangers of a euro zone breakup (after Spain, Portugal and Greece were bailed out by their richer peers), 2) the recovering U.S. economy, and 3) that gold was highly vulnerable to a major decline after a 12-year bull market. I slapped a 12- to 18-month price target of $1,100-$1,300 an ounce—when gold traded at $1,660 an ounce.

It now appears that the decline in gold prices is nearly over, and that there will be a great long-term buying opportunity in gold this year. Here are three reasons why gold is looking good for the long run.

1. Gold mining production growth to be tepid over the next several years

Since gold prices began declining two years ago, the gold mining industry has shifted its focus away from developing new mines to consolidating and reducing costs of existing mines. A recent PricewaterhouseCoopers survey of global gold mining executives shows that 73% of them rank cost cutting, productivity enhancements and consolidation as their top business imperatives in 2015; while only 13% have capital expenditures (i.e. mine expansion) as their top business priority.

This shift away from developing new mines is already impacting production growth. According to the World Gold Council, mine production increased by 4.7% a year from 2008 to 2013. Last year, mine production grew by only 2%.

Our studies also show that the average gold mine has an all-in sustaining cost of around $1,000 an ounce. That is, half of the world’s gold mines would incur losses if gold declines to $1,000 an ounce. For example, Newmont Mining NEM +4.58%, the world’s second largest gold miner (responsible for nearly 5% of the world’s annual gold production), will be forced to cut expenditures or reduce production if gold hits that price level.

Finally, the vast majority of gold production is not hedged. Gold miners are therefore subject to the full force of declining gold prices; should prices decline below $1,200 an ounce, we believe gold mining production growth will stop altogether—thus putting a floor on gold prices.

2. The outlook for global monetary policy is highly uncertain and incoherent

After President Nixon severed the U.S. dollar link with gold in mid-1971, the global economy entered an environment where the world’s major currencies were no longer tied to the price of gold. Gold prices subsequently entered a nine-year bull market—rising from $35 an ounce to $850 an ounce at the peak in January 1980—as inflation ravaged most of the world’s currencies. The structural rise in inflation in the 1970s was fueled by spending on the Vietnam War, the rise in social welfare, and the fact that the Federal Reserve did not recognize the dangers of inflation until much later.

While there are still no signs of rising inflation (as measured by the U.S. Consumer Price Index), it is sensible to be wary of the global, fiat “monetary experiment” that has been in place since the 1971 “Nixon Shock.” With the European Central Bank about to embark on a 1 trillion euro quantitative easing policy, most of the world’s central banks remain highly dovish, including the Bank of Japan, the Swiss National Bank, the People’sBank of China , the Reserve Bank of India , the Bank of Canada, and the Reserve Bank of Australia. Most recently, the Bank of England signaled that it stands ready to expand its asset purchase program or cut its policy rate further from the current level of 0.5%.

The Federal Reserve may find it difficult to begin a new rate hike cycle in such an environment, especially since the Fed has always leaned towards an easing bias over the last several years. We also do not believe that the Fed’s balance sheet, at $4.5 trillion today, will ever been unwound. The size of the Fed’s balance sheet could easily hit $7-$8 trillion when the next financial crisis hits.

3. Indian and Chinese demand for gold will continue to rise

By far the most important drivers in gold demand in India and China are income levels and urbanization. According to the World Gold Council, gold demand from India and China have risen 71% over the last decade; collectively, the two countries now account for 54% of consumer gold demand, up from just 33% a decade ago.

While both Indian and Chinese demand for gold were down (-14% and -38%, respectively) last year, we believe this drop is temporary. For example, much of the decline in Indian gold demand was due to a rise in the gold import duty from 2% to 10% in August 2013. Recently, India’s Trade Ministry has proposed to cut the import duty back to 2%.

Meanwhile, the recent decline in Chinese demand was due to last year’s anti-graft crackdown as well as a rising domestic stock market (which encouraged investors to shift away from buying gold to stocks). From a structural standpoint, both Indian and Chinese gold demand should rise over the next several years as income levels and urbanization continue to rise.

 

We thus believe gold remains a solid, long-term investment and that we should see a long-term buying opportunity in gold sometime this year. Such a purchase could be made either through an ETF, e.g. SPDR Gold Trust (GLD) or physical gold.

 

http://www.forbes.com/sites/greatspeculations/2015/02/20/why-gold-is-looking-lustrous-once-again/

 


 

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