o Reports that Cyprus was readying the sale of its excess gold reserves to help fund its government’s debt payments led to fears that the gold supply will increase. While Cyprus’ gold stock remains too small to have a material impact on gold prices, investors fear that other troubled European states could follow suit.
o Arguably the most important catalyst was that a number of gold price technical support levels were breached (with some saying they were strategically pushed through by well-timed large hedge fund selling), triggering margin calls, momentum and model-based investor selling. This then created a cascading and self-fulfilling downward spiral in the gold price.
• Is gold in a bubble?
Looking at the past 10 year performance of gold to known historic bubbles in other assets, we can see that price gains in gold have been modest. For example looking at the 10 years running up to the peak of the NASDAQ bubble of 2000 and the gold bubble of 1980, the rise of the gold price seems far from excessive. With gold price at a 2-year low, this could be perceived as a potential buying opportunity. The governments backing the world’s major reserve currencies are faced with extremely large and growing debt burdens. Aging populations and insufficient working population to support current levels of benefits means that debt levels will swell significantly further without very substantial and politically painful cuts or tax raises. These can also be counter-productive to the extent they reduce economic growth and therefore government revenues. This puts government in a particularly tight bind. Europe faces the added problem of backing a single currency for countries with substantially different economic and social fundamentals. Until these issues are resolved there will be a natural demand from the public for alternatives to these fiat currencies. Gold historically has been the first stop of the public when it loses faith that governments will be able to pay back their debts without resorting to inflation/currency debasement. This time is unlikely to be any different.
• What is the outlook for the gold price?
The longer term fundamentals for gold remain strong and ultimately should re-assert themselves once cyclical and technical factors move again in gold’s favor. The fragility of the US recovery, on-going Eurozone weakness and continued high sovereign debt risks are likely to keep central banks firmly in aggressive stimulus mode. The growth of gold supply remains limited with production growing by just over 9% over the past decade and recent disruptions in South Africa threatening miners’ productivity. Emerging market central banks have become large net buyers of gold since 2010, equivalent to around 12% of total supply. Chinese physical demand is the second largest in the world, after India, with Chinese imports of gold now accounting for nearly 20% of total annual demand, from levels of under 3% 10 years ago. China’s demand for gold has been accelerating in recent months.
Given the technical nature of the recent sell-off, short term moves in gold are especially difficult to predict (both up and down). However, at these levels physical buyers – central banks, India and China jewelry demand, long-term strategic investors in gold – will likely start to emerge once the market calms down. Gold needs a positive impetus – a reduction in US interest rate increase expectations, signs of deteriorating European sovereign debt fundamentals, a weaker US dollar – to resume its bull market climb. However, with COMEX speculative short positions at all-time highs, in our view the likelihood of a short-covering rally are now higher than another large downward leg of the price correction.
ETFS Physical Swiss Gold Shares (NYSEArca: SGOL)
