Where to from here?
Despite the near unanimous negative sentiment towards the gold price and most of the other precious metals, we believe that longer term fundamentals remain price supportive and ultimately will re-assert themselves once cyclical and technical factors move again in their favor.
The weak and fragile nature of the US recovery, continued recession in Europe, and large sovereign debt burdens in the major developed economies are likely to keep central banks firmly in stimulus mode. On the other hand, the growth of precious metals supply, as highlighted above, is being hit by substantially higher costs of production and increasingly scarce new finds. The increase in gold supply has been less than 10% over the past decade compared to a near tripling of US dollar money supply. It should be no surprise that the price of gold has risen so much in US dollar terms!
Emerging market central banks are a new major source of gold demand. Central banks as a group have been large net buyers of gold since 2010. They are now buying the equivalent of over 10% of annual gold supply, reversing years of net selling equivalent to 10-15% of annual supply. Chinese physical demand for gold has exploded, with Chinese imports of gold through Hong Kong now equivalent to just under 20% of total global gold demand, up from levels of under 3% 10 years ago. Increases in China’s gold import quotas this year have led to a renewed surge of China physical gold buying, with accelerated buying since the April price correction. While India has moved to curb gold imports by increasing tariffs on gold imports and forbidding gold import financing, cash purchases and smuggling are likely to at least partially offset the restrictions.
Outlook
Given the technical nature of the recent sell-off, short term moves in the gold price are difficult to predict. Further declines can’t be ruled out. However, at these levels, strategic buyers – central banks, Chinese and Indian consumers, long-term investors – are likely to see value. In addition, with short-term interest rates expected to stay low for the foreseeable future, the opportunity cost of holding store-of-value assets such as gold should remain low. Of course, in the near-term, gold needs a positive impetus – a reduction in US real yields, a weaker US dollar, renewed sovereign crisis in Europe – to sustainably resume its bull market climb. However, with COMEX speculative short positions at an all-time high, physical demand re-emerging, and the gold price now trading well below the average marginal cost of production, we believe gold provides substantial potential upside, as well as continued tail risk insurance, for long-term investors. Silver will likely continue to trade as a higher beta version of gold. Platinum and palladium offer particularly attractive longer-term value at current levels in our view, with prices now substantially below their marginal costs and supply cuts already underway.