In the Bullring With Gold

 

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

After prices fell 10 percent in December, many investors wondered if the bull market in gold was running out of steam. That was before Federal Reserve Chairman Ben Bernanke swooped in with a “red cape” and fired the bulls back up. Since the Fed reassured the world that interest rates will remain at “exceptionally low levels” for another two years, gold has jumped more than three percent.

UBS described the situation simply, “if investors needed a (further) reason why they should be long gold now, they got it yesterday … a more accommodative policy is a very good foundation for gold to build on the next move higher.”

To gold bugs, two more years of near-zero, short-term interest rates means negative real interest rates are here to stay, and this has historically been a strong driver for higher gold prices.

Bernanke and the Fed aren’t the only central bankers in the fiscal and monetary bullring. Brazil has cut its benchmark interest rate a few times and China lowered its reserve rate for banks in December. According to ISI Group, 78 “easing moves” have been announced around the world in just the past five months as countries look to stimulate economic activity.

One of the main weapons central bankers have employed is money supply, which has created a ton of liquidity in the global system. Global money supply rose 8 percent year-over-year in December, or about $4 trillion, according to ISI. I mentioned a few weeks ago how China experienced a record increase in the three-month change in M-2 money supply following China’s reserve rate cut.

Together, negative real interest rates and growing global money supply power the Fear Trade for gold. The pressure these two factors put on paper currencies motivates investors from Baby Boomers to central bankers to hold gold as an alternate currency.

Adrian Ash from Bullionvault says global central banks are on a buying spree and they have been since the Fed cut interest rates by 25 basis points in 2007. Central bankers’ shift to buying gold was a significant sea change for the yellow metal.

You can see from the chart below that official gold reserves have historically been much higher, averaging around 35,000 tons. In the 1990s, central banks began selling, with reserves hitting a 30-year low right around the time the Fed began cutting rates. Adrian says that gold holdings are now at a six-year high with the current amount of gold reserves just less than 31,000 tons.

These are countries large and small. In December, Russia, which has been routinely adding to the country’s gold reserves since 2005, purchased nearly 10 tons; Kazakhstan purchased 3.1 tons and Mongolia bought 1.2 tons. UBS says “although reported volumes are not very large, it is still an extension of the official sector accumulation trend.”

Not all central banks are recent buyers, though. The “debt-heavy West” has sold its gold holdings, while emerging markets increased their gold reserves 25 percent by weight since 2008, says Adrian.

Reserves as a percent of all the gold mined has also declined, with “a far greater tonnage of gold ... finding its way into private ownership,” says Adrian. Since 1979, you can see the percentage of reserves to total gold has declined at a much faster pace as individuals increasingly perceived gold as a financial asset.

Adrian points to China’s Gold Accumulation Plan as a recent example of this trend. A joint effort between the Industrial & Commercial Bank of China (ICBC) and the World Gold Council (WGC), the program allows Chinese citizens to buy gold in small increments as a way to build up their gold holdings over time. The WGC reported in September that the program had established 2 million accounts during its first few months in operation and the amount is growing by the day.

These programs open the door for gold as an investment to a whole new class of people in China but that’s only a fraction of the tremendous demand for gold that we are seeing from China. In addition to the Fear Trade, gold is driven by the Love Trade, which is the strong cultural affinity the East, namely China and India, has to the precious metal.

In 2010, the Indian Sub Continent and East Asia made up nearly 60 percent of the world’s gold demand and 66 percent of the world’s gold jewelry demand, according to the WGC.

Indian jewelry demand has historically increased during the Shradh period of the Hindu calendar, but last year, high prices and a volatile rupee kept many Indian buyers on the sideline.

If you thought $1,900 was too much to pay for an ounce of gold, imagine how Indians felt when the rupee fell against the U.S. dollar, causing a gold price spike in rupees. Gold in Indian rupee terms rose more than 35 percent from July to November, roughly three times the magnitude of gold priced in U.S. dollars, yuan or yen. This currency swing significantly impacted Indian gold imports, which dropped 56 percent in the fourth quarter, according to data from the Bombay Bullion Association.

“Indian buyers will be back” after they adjust to the higher prices, says Fred Hickey. In one of his latest editions of “The High-Tech Strategist,” he cites late 2007 as a recent example when the Indian gold market experienced a similar rough patch. That year, gold demand in India fell off a cliff after prices spiked more than $1,000 an ounce in one quarter, tarnishing the country’s love affair with gold for a “brief period.” Fred says their cultural affinity for gold as an important store of wealth and protection against inflation will drive Indian buyers back into the market.

The trend was already changing in 2012, as UBS reported that the first day of trading saw physical sales to India were twice what they usually are, according to Fred. Although this is a very short time frame, I believe the buying trend will continue in this gold-loving country.

In China, “just as in India, gold is seen as a store of wealth and a hedge against inflation,” says Fred. Demand has been growing, especially in the third quarter, when China’s gold purchases outpaced India. “Physical demand for gold from the Chinese has been voracious all year,” says Fred. As of the third quarter, China had already obtained 612 tons, eclipsing its total 2010 demand, according to the WGC.

Across the Chinese retail sector, gold, silver and jewelry demand was the strongest performing segment in 2011, says J.P.Morgan in its “Hands-On China Report.” Growth in this segment far outpaced clothing and footwear, household electrical appliances, and even food, beverage, tobacco and liquor, all of which experienced more modest growth.

J.P.Morgan says the bulk of the increase came from lower-tier cities “where income levels are rising the fastest and improvements in retail infrastructure have allowed for rapid store expansion.”

Increasing incomes coupled with government policies that support growth have been the main drivers for rising gold prices. Take a look at the chart below, which shows the strong correlation between incomes in China and India and the gold price. As residents in these countries acquire higher incomes, they have historically purchased more gold, driving gold prices higher.

We anticipated that the Year of the Dragon would spur an increase in the buying of traditional gifts of gold dragon pendants and coins. Gold buying did hit new records, says Mineweb, with sales of precious metals jumping nearly 50 percent from the same time last year, according to the Beijing Municipal Commission of Commerce.

This should serve as a warning to all of gold’s naysayers. Gold bullfighters beware—you now have to fight the gold bull while fending off a golden Chinese dragon.

 

Index Summary

• The major market indices were higher this week. The Dow Jones Industrial Average rose 1.59 percent. The S&P 500 Stock Index increased 2.17 percent, while the Nasdaq Composite gained 3.16 percent.
• Barra Value outperformed Barra Growth as Barra Value finished 2.49 percent higher while Barra Growth gained 1.90 percent. The Russell 2000 closed the week with a gain of 4.04 percent.
• The Hang Seng Composite finished higher, gaining 1.25 percent, Taiwan gained 6.10 percent for the week, and the KOSPI rose 0.38 percent.
• The 10-year Treasury bond yield closed 3 basis points higher at 1.92 percent.

 

Domestic Equity Market

 

The domestic stock market as measured by the S&P 500 Index rose by more than 2 percent for the week. The financial and technology sectors led the way, with both rising by more than 3 percent.

Strengths

• The S&P 500 Financials had a very strong week, rising by more than 4 percent as this sector continues to respond to positive economic and government policy developments.
• The S&P 500 Technology sector also had a strong week, led by strong results from Mastercard, a bounce back from the prior week for Corning and rising expectations for NetApp in front of earnings.
• Individual stocks that performed well this week include Whirlpool Corp., Marathon Petroleum, and Genworth Financial, all three stocks rose by at least 16 percent this week.

Weaknesses

• Defensive, noncyclical sectors underperformed as utilities, consumer staples and healthcare all lagged the market this week.
• The consumer & electronics retail industry group was among the worst performers as both Best Buy and GameStop fell for the week as Radio Shack reported disappointing preliminary results.
• Abercrombie & Fitch Co. was the worst performer in the S&P 500 after giving weak preliminary results and 2012 guidance.

Opportunities

• Earning results have been encouraging so far and the market has responded. We have another heavy week of earnings announcements next week.

Threats

• An escalation in concerns over sovereign debt obligations in Europe would be negative for stocks.

 

 

The Economy and Bond Market

 

Employment data released on Friday, which put the current unemployment rate at 8.3 percent, showed strong improvement. This is the latest in a series of data points that show the U.S. economy is continuing to make strides in the right direction. ISI Group says that this was the 18th straight week of stronger economic data in the U.S. We’ve recently seen upticks in vehicle sales, same store sales, homebuilding and manufacturing.

Manufacturing PMI rose during the fourth quarter of 2011 and ISI Group thinks that it will rise another 3 percent to the 54 level during the first quarter of 2012. ISI says that over the past two years employment in the manufacturing sector has posted its strongest increase in almost three decades. But it’s not just the U.S. Manufacturing PMI on the rise, data from Europe and China also exceeded most forecasts and global PMI has jumped considerably since November.

One other factor that is likely driving better economic results is the year-over-year increase in U.S. money supply, which is growing at a robust 10 percent pace. Nominal GDP growth in the fourth quarter was 3.7 percent compared with the previous year and the current rate of money supply growth greases the wheels for America’s economic engine. Adequate money supply is the lubricant that allows the wheels of commerce to accelerate.

An article in the Wall Street Journal this week highlighted that in 2011 U.S. corporate tax receipts as a share of profits were at their lowest level in at least 40 years. Corporations paid a tax rate of 12.1 percent on profits during the fiscal year that ended September 30, 2011, less than half the average rate companies paid from 1987 to 2008. Those figures grabbed a lot of headlines in the press, but they don’t tell the whole story. In addition to putting aside more than $2 trillion in cash over the past five years, many corporations have employed a tax incentive known as “bonus depreciation” that allows companies to deduct from their taxes the capital that they invest back into their businesses.

The incentive has worked. Capital expenditures for American companies reached $1.5 trillion in 2011, up 10 percent from 2010. We believe this increase in capex has been a significant driver of the U.S. economic recovery. Corporate purchases of new fleet vehicles, machinery and data systems have created and maintained thousands of jobs for American citizens. It is unlikely the U.S. government would have achieved the same return on investment and multiplier effect on the economy.

 

Strengths

• The January employment report was much better than expected, with the strongest job gains since April and the lowest unemployment rate since February 2009.
• The ISM manufacturing index rose to 54.1 and the new orders component rose to a strong 57.6. JP Morgan’s Global PMI Index also continued to move higher, hitting 51.2 in January.
• U.S. auto sales rose 12 percent in January supporting the uptick seen in manufacturing data.

Weaknesses

• The Case-Shiller 20-city home price index hit the lowest level since February 2003. Prices have fallen 3.7 percent year-over-year.
• Consumer confidence fell sharply to 61.1 in January; expectations were for an increase.
• Fourth quarter productivity rose a very modest 0.7 percent.

Opportunities

• If the weekly oscillating trading pattern over the past couple of months is any indication of market direction, bonds could see a modest sell-off next week.

Threats

• Economic data has been strong and appears to be gaining momentum. This could be a threat to bond prices if the pattern continues.

 

Gold Market

 

For the week, spot gold closed at $1,726.25 down $12.82 per ounce, or 0.74 percent.  Gold stocks, as measured by the NYSE Arca Gold BUGS Index, fell 1.2 percent. The U.S. Trade-Weighted Dollar Index was essentially flat with a gain of just 0.1 percent for the week.

 

Strengths

• The Year of the Dragon Lunar New Year holiday in China set a new record for gold buying.  Sales for the two top jewelry sellers reached about 600 million yuan ($95 million), a nearly 50 percent jump over the prior year.  With many Chinese losing money in the stock and property markets last year, gold is emerging as one of the preferred investment choices.
• The China Gold Association reported that the country’s gold production for 2011 rose 5.9 percent in 2011 to 361 tonnes.  Five years ago, China became the world’s largest producer of gold. Most analysts believe that all of this domestic production is bought by the government to add to its reserve base, which is underweight gold relative to the size of its economy and its exposure to the dollar. 
• In addition, estimates for Chinese gold imports in 2011 are roughly 490 tonnes. The public has a large appetite for gold accumulation as a means to build wealth.

Weaknesses

• A recent study by South Africa’s ruling African Nation Congress (ANC) has rejected calls for mine nationalization, but has come out in support of higher taxes and royalties.
• The policy for nationalization lost political momentum after the prime instigator, Julius Malema of the ANC Youth League, was found guilty of sowing discord among the party. 
• Talk of nationalization has kept investors wary of South Africa, with higher taxes and royalties still issues.

Opportunities

• Don Coxe, in his latest edition of Basis Points, urges gold investors to invest in gold equities at the expense of bullion ETFs as the Fed continues its policy of nonstop money at zero rates.  Likewise, David Rosenberg, of Gluskin Sheff, notes the Fed policy of currency debasement means that, in his opinion, exposure to gold and gold mining stocks in a portfolio is an absolute necessity.   
• In a recent issue of Market Musings & Data Deciphering, David Rosenberg highlighted the Fed policy of keeping interest rates low with the potential for more quantitative easing to come, coupled with the current back-door QE program in the eurozone as being very constructive for gold. 
• Rosenberg suggested investors would be more highly rewarded if they bought gold mining stocks versus gold bullion.  He also noted that, historically, gold mining equities tend to dramatically outperform bullion in the later stage of a gold bull market.

Threats

• The Fed policy of extending low interest rates is making life much more difficult for insurance companies and pension funds that manage long-term liabilities and for retirees seeking income from their investments.  Corporations are keeping high cash balances, partly due to uncertainty over future tax policy. Perhaps some of the reserves will be needed to fund pension plan deficits, which rose more than 50 percent in 2011.
• Newmont Mining noted in its recent regulatory filing with the SEC that its Hope Bay project in the far north of Canada will be subject to impairment testing.  Back in 2007 when gold prices were trading around $800, Newmont paid $1.5 billion for a 55 million ton resource that is estimated to contain 10.1 million ounces of gold. This works out to a resource grade of 5.69 grams per ton of gold. Today gold has doubled in price, but apparently there is some concern that the $900 million in estimated capital requirements to build the project may escalate beyond where the project’s returns would not be robust enough to take the risks.
• Equity issuance has been heavy recently.  Detour Gold raised about $240 million in the prior week, while NovaGold raised as much as $333 million this week, diluting current shareholders by more than 10 percent.  While the NovaGold financing represents only a small fraction of the additional $6.7 billion it will need, financing of this magnitude cumulatively takes some of the momentum out of the market.

 

Energy and Natural Resources Market

 

Strengths

• CLSA reports that final oil demand numbers from China increased by 7 percent in 2011.  While this level of growth is below the 12 percent in the prior year, December data showed a strong recovery in gasoline and natural gas demand. 
• Commodity investments are expanding at the quickest pace in six years according to Bloomberg, as signs of rising economic growth gain momentum.  The number of futures contracts on 24 commodities including oil and copper rose 9 percent last month, the most since January 2006.
• Cummins, Inc. cited on its fourth quarter conference call with shareholders that it expects a solid year of growth for its engines and industrial products in its mining and oil & gas businesses.
• Barclays reports an “unprecedented synchronized surge” in LME cancelled warrants, which stand at an average of 15 percent of total LME base metal stocks (versus a 5-year average just below 5 percent), is telling the market that inventories are going to be withdrawn on a significant scale from warehouses in the near term.

Weaknesses

• Copper stockpiles monitored by the Shanghai Futures Exchange increased to their highest level in nearly two years, which typically implies weaker regional demand for the metal.
• According to Darren Gee, CEO of Peyto Exploration & Development, Inc., many energy producers with natural gas exposure are requiring $6 per MMBtu to break even; this is compared to a current gas price of approximately $2.50.  Even among low producers in North America, many companies are just barely “keeping the lights on” without any additional cash to reinvest reserve depletion.

Opportunities

• The beginning of 2012 has proved to be a rewarding period for risk assets such as commodities.  Deutsche Bank attributes this strong performance to global central banks which continue to provide abundant liquidity to financial markets, and better real economic data in the U.S., China and the eurozone.
• The U.S. economy created 243,000 jobs in January, the greatest one-month increase since April of last year.

Threats

• While the focus has been on the potential for Middle East supply disruptions with Iran, a dispute over transit fees between Sudan and South Sudan has resulted in realized production losses of 350 thousand barrels a day at the end of January. 
• UBS Commodities strategists remain cautious despite the recent market rally due to credit contraction in deleveraging countries, slower capital flows into emerging markets and ongoing signs of credit stress in the financial markets.

 

Emerging Markets

 

Strengths

• Emerging markets had a strong week as positive global economic data is boosting expectations on economic growth. Key outperformers included Taiwan, Turkey and the Czech Republic.
• Currencies played a big role this week with many emerging market currencies rallying strongly. The South African Rand rose 2.9 percent, the Mexican Peso rose 1.9 percent and the Turkish New Lira, Indian Rupee and Colombian Peso each rose more than 1.25 percent.
• China’s January PMI was 50.5, improved from 50.3 in December and higher than the market estimate of 49.6. PMI above 50 indicates economic activities are expanding. The new order index was up 0.6 to 50.4 from December, while the new export order index was down 1.7 to 46.9, indicating China’s economy is driven by domestic demand. China’s January HSBC flash PMI improved slightly to 48.8 from 48.7 in December.
• German luxury-car maker BMW AG said Thursday that sales in mainland China rose about 30 percent in January to around 26,500 cars.
• Chinese banks may extend 9 trillion yuan ($1.43 trillion) of new loans this year as policymakers allow expansion in formal lending to replace shadow financing and enable the nation’s powerful growth engine to keep humming, Fitch Ratings Ltd. said.
• Korean CPI rose 3.4 percent in January, the slowest increase in 12 months.
• Thailand’s CPI rose 3.38 percent in January as lower food prices offset higher energy costs. The result was down from December, but in line with estimates.
• Indonesia’s CPI rose 3.65 percent in January, slowing for a fifth month and leaving the central bank room to resume interest rate cuts.

Weaknesses

• Korean exports unexpectedly dropped 6.6 percent in January, the first decline in more than two years. Weakness in Europe and the Lunar New Year holiday were blamed.
• China’s official PMI for non-manufacturing sectors fell to 52.9 in January from 56 in December, the China Federation of Logistics and Purchasing said in a statement today. The sub-index of new orders fell to 48.5 from 50.5 the previous month, slipping into contractionary territory and reflecting the effect of the government’s tightening measures on the property market, the statement noted.
• Hong Kong’s forth quarter GDP growth decelerated to 3 percent from 4.3 percent in the third quarter of 2011, but was better than the forecast of 2.5 percent. 
• Taiwan has reported the advance estimate for fourth quarter GDP to be 1.9 percent year-over-year, below market estimates of 2.8 percent and lower than the growth of 3.4 percent in the third quarter. The real GDP declined 1 percent quarter-over-quarter, technically entering recession.

Opportunities

• The left chart below shows how the people in China spend their time on media devices, indicating 47 percent of time is spent on the internet and 22 percent on mobile phones. The right chart compares online time as a percentage of total time spent on media with online ads spent as a percentage of total ads.  It is clear that there is more potential to monetize the internet in China through ad sales.

Threats

• China’s food prices were up in January due to holiday and winter effects.

 

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