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A Strong Base for Gold - Outside View

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A Strong Base for Gold
Jun 10, 2010

With gold prices ruling near record highs, many are questioning the sustainability of these price levels . Let us try to figure out whether the price increases have been fundamental in nature or otherwise. If you carefully analyse the current Bull Run in gold that started in 2001; there has been a peculiar pattern that it has followed. The pattern has been:

  • An increase in prices from current levels
  • Followed by a standard correction and
  • Then a phase of consolidation.

After prices consolidate at a particular level, then a fresh upward move takes place.

Chart: Bull Run in Gold ($ per ounce)
Bull Run in Gold ($ per ounce)
Source: Bloomberg

Such pattern is nothing but an outcome of two divergent sets of buyers operating at different times. We identify this behavior as a "Two Hand Approach" leading to a steady and gradual price increases over the years. When prices rise higher, we have seen it accompanied by a lot of investors chasing gold as a safe haven on account of fears / uncertainties surrounding the global economy. When the prices correct and consolidate at lower levels, we have seen the traditional physical buying come in strongly and support prices. So, one hand i.e. traditional buyers supports prices at lower levels serving as a floor and the other hand investors take gold to another level higher as a reaction to changes in global economic conditions. (So on one hand you have traditional buyers of gold who will not allow it to fall below a certain level due to their purchases and on the other hand you have the investors taking the price even higher from that base level)Factors like rising deficits/ debts, currency debasement, inflationary prospects, etc act as catalysts for the investment demand leading to price increases.

Chart: Two Hand Approach (Demand in Tonnes)
Two Hand Approach (Demand in Tonnes)
Source: World Gold Council

This 'two hand approach' is even now ensuring that the prices of gold move to higher levels. If you analyze demand patterns in 2010, the year saw good demand from physical consumption side in the first quarter following a correction. India and China saw stronger purchases as compared to the same period last year, despite prices being a lot higher. Post the first quarter, sovereign debt fears forced investors to safer assets like gold, thus increasing the demand and taking gold to another record high.

We believe this "two hand approach" would continue to take gold higher. Traditional buyers would continue to adjust to higher prices; thereby elevating the floor price of gold. Also, gold is clearly an under owned asset and as investors and central banks continue their shift to gold, this investment demand would help gold prices move even higher.

The Golden Myth
There is a myth that challenges the fundamental reasoning for rising gold prices. There is a belief that 150,000 tonnes of this precious metal is being hoarded and is capable of preventing gold prices from rising.

Such supplies have been in existence for a long time but still we have seen a fivefold increase in prices. If you carefully analyse the supply side situation, scarp supplies have significantly dried up compared to what we saw in the first quarter last year. Physical holders have burnt their fingers last year when they tried a trade off by selling their gold, assuming prices were at its peak, to buy back the new set of jewelry when prices fall. But the anticipated fall never came and they either lost what they held or had to buy back at higher prices. We have seen this happening in the first quarter last year, there was a queue of sellers in zaveri bazaar even ready to sell at steep discounts. This time around it's not prevalent. Much higher prices will be now required to induce sellers to part away with their gold.

Also, central banks have been reluctant sellers. Central bank selling is almost nonexistent. Rather, on a net basis, central banks are showing signs of being net buyers.

Chart: Central bank and scrap sales drying up (in Tonnes)
Central bank and scrap sales drying up
Source: World Gold Council

So, the holders of gold aren't ready to part away with their gold and on a net basis purchasing more of the existing production, how then would the hoard of gold affect or restrict gold's prices from rising?

What makes gold prices really move?
The demand - supply scenario at best is able to shape prices in the short term and does not affect prices in the long term. However, it may induce actions from the stakeholders that may impact prices over the long term. For e.g.: continuous increase gold in prices may induce miners to invest more in exploration projects or induce buyers to consume less.

Widely viewed factors like exchange rates, interest rates, inflation etc also stimulate prices over the short to medium term but cannot explain their behaviour long term.

We believe that the long-term trends in the gold prices are driven by changes in the overall level of confidence in the monetary system and the economy. Therefore, gold needs to be seen as a monetary asset rather than a commodity. Given the current economic backdrop, where governments are laden with problems like rising deficits and unsustainable debts, it is indeed logical for gold prices to increase in value. Currencies are being continuously debased by policy makers. Gold is the only true monetary asset which cannot be printed by policy makers at will. Thus gold seems to be becoming some sort of a 'replacement' for fiat (paper) currencies across the globe.

This clearly explains why gold is rising in value and this upward trend will continue unless there is some rational decision making at the center of the global economy, which will again put some faith back into paper currencies.

The Golden Truth is authored by Chirag Mehta. Chirag is Fund Manager - Commodities at Quantum Mutual Fund. Views expressed in this article are entirely those of the author and should not be regarded as views of Quantum Mutual Fund, Quantum Asset Management Company Private Limited and Equitymaster. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Equitymaster has not verified the facts contained in this column and it does not accept any responsibility for the same. Please read the detailed Terms of Use of the web site.

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