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In order to look ahead to 2009, it is important to understand the environment that has shaped the gold market in 2008. As of this writing, the gold market looks to end 2008 in the same mid $800 price range in which it entered the year. Reading that statement one might surmise that 2008 was a calm uneventful trading period, however those that were involved in the 2008 gold market know that the yellow metal was anything but uneventful. After making its yearly high in March near $1,030/oz., the gold market trended lower the last nine months of the year making a low near $680 in mid-November, before bouncing off that low into 2008 year end.
In the first half of 2008 the commodity boom was in full force. The US dollar was under pressure and every commodity from metals and energies to grains and meats was rising. Commodity price inflation was the talk on Wall Street. The Federal Reserve seemed to have nestled itself between the proverbial rock and a hard place. Both producer and consumer prices were rising in the midst of what seemed to be a rapidly deteriorating economy led by the housing downturn and sub-prime woes. To the Fed's credit, the US central bank took a defiant stance, implying by their continued Fed Funds rate easing, that they did not find inflation to be a growing problem. Remember, this Fed rate easing was being done in the midst of dramatic increases in commodity prices, which in most instances would be viewed as fueling the commodity price fire. Obviously the Fed saw something out the front window that they could not ignore – a potential deepening of the economic downturn.
The Fed was right - by three quarters through the year there was a new word being thrown around the commodity pits – that was economic led 'deflation”. By Q3 commodity prices had fallen precipitously off their earlier highs, and somewhat in line, gold was 25% lower. The combination of a rising US dollar, steep economic downturn, concerns about demand destruction, and falling commodity prices led to lower gold prices the last half of 2008. I will now consider those factors and others to determine gold's outlook for 2009.
Safe Haven Asset?
I will start first by offering an answer to a question that I have been asked many times over the last several months, and I expect to answer many times over the next year – 'is gold still viewed as a safe haven asset, and why hasn't it performed better during this economic turmoil.” To answer, one must understand all the factors that influence gold, and one must understand that gold truly is a doubled faceted asset. Gold remains a store of wealth, a safe haven asset, a portfolio diversifier, and an inflation and US dollar hedge. Gold also remains a commodity that reacts to its own supply and demand fundamentals. Gold is both a monetary asset and a physical commodity.
Gold certainly remains a safe haven asset. The fact is that in relative terms gold has not nearly experienced the same percentage decreases as other commodities nor has gold experienced the extreme volatility that has been seen in other financial instruments. Gold continues to outperform most other commodities or asset classes in relative terms. Gold also remains the perfect hedge against US dollar woes. The near perfect negative correlation between the US dollar and gold (chart 3) solidifies gold's use as a hedge against inflation and US dollar devaluation. In addition, keep in mind that gold (as I will discuss later in this report) was subject to a significant amount of selling specifically due to its characteristic store of wealth, and ease of liquidity. In addition, one only need to look at the large increase in physical investment demand to realize that gold will remain the preeminent choice for safe haven buyers, and inflation hedgers.
Influence of the Economy & the US Dollar
My expectation is that the economic turmoil that we are currently experiencing will continue to worsen throughout most of 2009. During the coming year there will certainly be periods of euphoria as some begin to believe the worst has been seen, but unfortunately economic hardships, job losses, slack consumer spending, wealth destruction, and consumer credit issues are all but certain to get worse before an end to the recession is seen. Bankruptcies, lower real estate prices, and sharp equity market declines are likely on tap for 2009. The bigger question may just be timing such events.
Given the already large percentage declines for most asset classes, and the negative consumer sentiment that is priced into the market, it would be plausible and even likely that a near term rebound could be seen in commodities in early 2009. More notable this near term recovery should be led by the less industrial commodities such as gold. Gold's oversold condition due to the unwarranted liquidation of strong assets along with other more toxic investments has led to a near term bottom. Based on this premise I expect gold will initially recover in late 2008 and Q1 2009. This recovery, however expansive it may be, will be short-lived. The trend of the commodity market is what will take center stage in 2009, and it will likely remain lower. The main driving force behind commodity prices in 2009 will continue to be the deflationary environment created by slackening consumer demand. This being said, gold will continue to perform exponentially better than most industrial based commodities that do not have the safe haven, portfolio diversification, and hedge for all occasions, status that the yellow metal boasts.
To look further into the relationship between the economy and gold it is important to understand the interest rate environment affecting the economy in 2009, and maybe to a larger extent to understand the driving forces behind the US dollar in the coming months.
One will notice that over time there is a strong positive relationship between falling interest rates and a weakening USD (chart 2). This relationship in its simplest form can be drawn from the assumption that as US interest rates fall, foreign investment finds US dollars a less attractive asset. In turn, as US interest rates rise, foreign investment will act positively towards the US dollar. Keep in mind this exercise assumes that US interest rates are falling/rising relative to the rates of other major countries. As the Fed seems poised to lower US interest rates even further in the face of other major countries touting that they will not ease further, it seems most likely that the US dollar will be undermined in the first part of 2009 supporting my theory for a near term recovery in gold prices.
The answer to the often asked question would now seem a bit more logical, 'why hasn't the recent string of Fed rate cuts had a negative affect on the US dollar and in turn a positive affect on gold.” First the Fed cuts have been done in line with relatively similar cuts by other major countries, leaving the net relative interest rate change close to nil. Second, and most important, as the world economy struggles it is the world's stance that the US dollar remains, for the moment, the preeminent world currency. This is not to say that the US and her currency do not have deep rooted problems; however it is only to say that those problems relative to the concerns found in other major countries and their currencies may look relatively not quite as bad. This currency reserve status during tumultuous periods will likely underpin the US dollar, and will add pressure to gold during those periods.
Investment and Physical Demand
On the investment side gold remains well bid. As the global economy suffers gold has retained its safe haven status as a viable currency and store of wealth. ETF holdings made new records in Q3 2008, and unprecedented sales in retail gold coins and bars shows investment demand remains a strong positive factor for gold. I believe that given my outlook for a further weakening economy in 2009 that gold's investment demand will only increase. The worse the economy gets, the greater the desire there will be for gold as an investment asset. This investment component though now only a smaller 20% of overall demand has the most opportunity for increases. There are already notable shortages of retail forms of gold signifying the desire for gold holdings by the general public. This demand will only see increases in 2009. Gold viewed as an investment asset and a store of wealth will also help increase the longing for gold jewelry in many countries.
Jewelry demand, which normally accounts for as much as 70% of overall gold demand, has always been a staple buy-side element. In 2009 however; given the dramatic downturn in the world economy it is not hard to understand our forecast for slackening jewelry demand in the US and Europe. India, however, the world's largest consumer of gold jewelry is less likely to be as affected as gold buying there remains a cultural activity. The demand destruction created by the economic slowdown is likely one of the main negative factors for gold in the supply/demand equation in 2009. Even with the expected increase for gold as a safe haven asset, and the relatively stable demand expected from India and Asia it is likely that this large percentage demand component will suffer. Gold jewelry demand is very seasonal. Fourth quarter demand due to Diwali and Christmas is a key component. The demand season then continues with the Chinese New Year in Q1. Data for Q4 2008 and Q1 2009 has not yet been seen and will likely give a clear view of exactly how much demand will be lost due to economic strife.
Lastly, gold as an industrial component mainly in the electronic sector will most certainly see decreases in demand. This relatively small 10% portion of gold demand will likely remain pressured and dampen the affect investment demand increases have on the market.
Supply Side
One component that has affected the market so dramatically over the last several months is worth noting. Market deleveraging has become a significant negative component of gold's supply side equation. One of gold's prominent investment appeals actually worked against the yellow metal in the second half of 2008; however I expect it to be much less of a factor in 2009. With the credit crisis worsening hedge funds, banks, and large institutions found themselves searching for cash. Gold, often viewed positively for its natural liquidity became an easy solution. Entities started dumping gold for cash to meet margin calls and calls for redemptions. In addition to liquidity problems, there was also a large amount of speculative leveraged positions being unwound. This negative factor in mid to late 2008 can not be discounted as a prominent factor in the market's decline. In addition to the widely quoted deflationary environment, this market deleveraging was responsible for some large gold market sales. More importantly it is likely at this point that the bulk of this market deleveraging has run its course. It is more likely that any abrupt downturn once again on the economic front in 2009 will more likely bring about another round of gold liquidation as holdings are once again used for cash.
Mining, Hedging, and Scrap
One might quickly surmise that the significant rise in price over the last several years would have undoubtedly brought about an increase in supply, and it has, but not significantly. Those making such a statement; however, would likely have a muted understanding of the supply side condition in gold. Gold supply is traditionally viewed as inelastic. A new gold mine does not sprout up overnight attempting to take advantage of the relatively high price. Nor do current mines have the ability to quickly and conveniently increase production by any significant amount. The addition to supply has most notably come from other sources such as producer hedging, an increase in scrap, and only to a lesser extent increases in mine supply. It has been a widely known fact that producer hedging for years became a large supply side factor. However, this practice has and seemingly will continue to be a much less relied upon strategy for producers. In 2009 I do expect there to be a small increase in mine production and a small net decrease in producer de-hedging (increase in supply). With the credit issues in the market there will be more pressure on producers to conduct forward sales; however, this will in turn be offset by a decrease in new mine projects due to lack of capitalization.
Scrap or recycled gold typically increases in times of economic strife or during price spikes. With this understanding it is all too obvious that gold scrap supply has and will continue to increase in the subsequent year due to economic factors; however, as prices declined late in 2008 scrap sales declined significantly. This purports that significant scrap sales truly take place only during tumultuous economic periods coupled with relatively high prices. I do expect the scrap supply to moderately increase in 2009.
Central Bank Activity
Another very significant component of gold's supply/demand equation is official sector purchases or sales. Central banks hold about one fifth of the world's non-mined gold supply as reserve assets. Because this is such a large relative amount, keeping an eye on central bank activity is extremely important to understanding the supply / demand balance in 2009. Central banks outside of the Central Bank Gold Agreement are generally net purchasers of the yellow metal; however those countries that are part of the CBGA are the most notable sellers. The current Sept. 2004 to Sept. 2009 CBGA allows for 500 tonnes of gold to be sold per year by the participating countries. This net central bank selling has been taking place since the first CBGA was put in place back in 1999 and has been adequately absorbed by the market keeping the supply / demand equation mostly in balance. This is why recent declines in central bank selling has been so significant. With current sales under 400 tonnes going into year end this lack of expected supply is a bit of a surprise to the market. The current CBGA expires in September 2009, and at this point it would be expected that a new similar sales program be put in place. Lastly, there has been no new news in relation to talks about the IMF selling off a portion of their gold holdings to raise cash. Any move by the IMF would need congressional approval so this is not potential supply that I would expect anytime within 2009.
Conclusion
Gold is unique in that it reacts to fundamentals of both a commodity and a monetary asset. With this understanding I have researched each facet of gold's commodity and monetary asset fundamentals, and have concluded the following outlook for 2009. Given all of the above data it is likely to see gold recover late in 2008 into Q1 2009. Then encounter a period of negative activity through the middle months. Finally reacting to expected positive fundamentals to end 2009. The yellow metal will be supported early in the year by a combination of associated factors. An easing Fed policy creating near term pressure on the US dollar will drive prices off recent lows. Strong investment demand will continue to support the yellow metal throughout all of 2009. Gold will be aided by a rebound from an oversold condition created by indiscriminate selling of both stable and toxic assets alike. Lastly, market deleveraging, which added to the extreme nature of the sell off in gold has mostly run its course, and should no longer be a negative force.
At some point in late Q1 our expectation is for the main market moving factor of 2009 to take hold. The overwhelming deflationary environment for all products will weigh on gold. The term 'demand destruction” will once again be in vogue. Gold during this period will be hampered by the deflationary environment, and potential additions to the supply side most notably the use of gold as liquidity and the need for cash. As the global financial turmoil reemerges, gold will be dampened by the firm US dollar, but supported by safe-haven buying. The net effect as it was in mid to late 2008 will be negative.
As the financial crisis runs its course gold will inevitably bottom by late Q3 and seasonal factors will begin to support once again. The combination of investment and seasonal jewelry demand along with support from a negative USD, stemming from a very low interest rate environment will again underpin gold prices.
Lastly, we live in uncertain times in an uncertain world, and gold is traditionally and correctly viewed as the quintessential hedge for all occasions. Whether it is currency devaluation, asset diversification, economic or geo-political concerns, gold remains the number one investor choice for a safe-haven asset. Though gold will not always produce positive returns during every market mishap, its relative performance is what bears notation. Particular price targets and trading strategies are available to Alaron clients. |
