The Gold Triple Play - Volatility, Currencies and Europe

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

Resurgent investment lifted global gold demand 6 percent from the previous year to just over 1,000 tons during the third quarter of 2011, according to the latest Gold Demand Trends Report from the World Gold Council (WGC).* The ­­­potent cocktail of inflationary pressures in the emerging world and the European sovereign debt fiasco left investors searching for a safe haven—they looked for it in gold.

In an uncertain era where many asset values are declining, gold has thrived. Gold prices averaged $1,700 an ounce during the third quarter of 2011, 39 percent higher than the same time last year and 13 percent above the previous quarter, according to the WGC.

In total, investment demand increased 33 percent on a year-over-year basis to reach the third-highest quarter of investment demand on record, says the WGC. The increase was broad in scope. Investment in gold bars and coins jumped 29 percent year-over-year while holdings in gold ETFs reached an all-time high.

All global markets other than India, Japan and the U.S. experienced gains in investment demand; many of them (except Thailand and Saudi Arabia) saw double-digit increases.

While investment demand thrived during the third quarter, jewelry demand fell victim to the quarter’s economic fragility and price volatility—falling 10 percent on a year-over-year basis. Only four markets—China, Hong Kong, Japan and Russia—saw jewelry demand increase.

The WGC says a shift toward high-growth economies is “undeniably conspicuous in the gold market.” Nowhere in the world is this more evident than in China, where consumer thirst for gold appears unquenchable. China’s total demand, around 612 tons year-to-date, has already eclipsed that of 2010. In addition to domestically consuming every speck of gold mined in China, it’s estimated that the country’s gold imports could reach 400 tons in 2011. That’s roughly equal to the combined tonnage of gold demand for the Middle East, Turkey and Indonesia in 2010—and that’s just imports.

Consumer demand for gold in China increased 13 percent (year-over-year) during the third quarter as the country continues to close the gap on India. Chinese jewelry demand, also up 13 percent, eclipsed India for only the fourth time since January 2003. Combined, the two Asian giants account for over 50 percent of global jewelry demand.

The WGC says, “China’s increase in demand is being fueled by rising income levels, a by-product of China’s rapid economic growth.” This growth has given birth to more than 100 million gold bugs in China’s rural areas. China’s smaller third- and fourth-tier cities were responsible for the bulk of the increase in jewelry demand, the WGC says. In addition, the Gold Accumulation Plan (GAP), a joint effort from the Industrial & Commercial Bank of China (ICBC) and the WGC which allows investors to purchase gold in small increments, reached 2 million accounts in September. The WGC says GAP sales have already exceeded 19 tons so far this year.

Things weren’t quite as rosy for demand in the world’s second-largest jewelry market. Indian jewelry demand took a 26 percent hit as volatility in the rupee shook investor confidence. The rupee decreased 9 percent against the U.S. dollar during the third quarter, more than double the currency’s average quarterly move over the past five years.

Historically, Indian jewelry demand bottoms in July-August, before picking up heading into the Shradh period of the Hindu calendar. That didn’t happen this year because Indian consumers were discouraged by high and volatile prices. The WGC says:

 “Consumer confidence in India has been knocked by the persistence of high domestic inflation rates. Inflation of almost 10 percent, as measured by the Wholesale Price Index (WPI), adversely affected jewelry demand, through its impact on both disposable income levels and general consumer sentiment.”

 

Currency Effect on Gold Prices

 

The weaknesses of the rupee against the U.S. dollar also negatively affected India’s demand. This chart illustrates the dramatic effect currency fluctuations can have on gold prices.

The gold price in Indian rupees has appreciated over 31 percent since June 30, more than three times the price appreciation denominated in Japanese yen. This means that a consumer looking to buy gold in Japan would have three times the purchasing power to buy gold at their local dealer than an Indian counterpart.

The gold price in yen terms has lagged due to the currency’s strong appreciation against other global currencies. It’s a similar story for the U.S. dollar and Chinese yuan (pegged to the U.S. dollar), which investors have favored since fleeing the euro.

 

Gold's Volatility

 

Chaos in the currency markets amplified gold’s volatility to roughly twice historical levels during the third quarter, the WGC says. Our research also shows that gold’s recent roller-coaster ride is an anomaly. We sorted through 10 years of data to capture all of the 10 percent (plus or minus) moves selected assets have had over a one-month period. The results show gold experiences plus/minus 10 percent moves 7 percent of the time; about the same as the S&P 500 Index. In comparison, crude oil sees moves of this magnitude 30 percent of the time.

 

Volatility of Various Assets
	Number of +10% Moves	Number of -10% Moves	Frequency of ± 10% Moves
NYSE Arca Gold BUGS Index (HUI)	563	284	33%
WTI Crude Oil	465	325	30%
MSCI Emerging Markets (MXEF)	137	170	12%
Gold Bullion	128	52	7%
S&P 500 Index (SPX)	41	93	6%
Calculated over rolling 20-trading day periods. Based on approximately 2,600 total occurrences over the past 10 years as of 9/30/2011. Source:Bloomberg

 

Gold equities have been more volatile than gold bullion. The NYSE Arca Gold Bugs Index (HUI) experienced these swings 33 percent of the time. In a market with gold prices trending upward, this beta provides a potential boost for miners. However, this can also have a negative effect during volatile markets as investors overreact to downside swings.

 

Gold Outlook

 

“Gold demand faces headwinds in the near term because of the strength of the U.S. dollar,” Marcus Grubb, Managing Director of Investment for the WGC said on a conference call Thursday. “I still think the macro situation is very favorable to gold because we still don’t have a lender of last resort in the eurozone.”

Speaking of the eurozone, Nigel Farage—leader of the United Kingdom’s Independence Party—spoke some much-needed harsh words to the European Council this week. Farage is one of the U.K.’s most powerful conservative officials and is an unabashed Eurosceptic, meaning he does not ideologically believe in the idea of the European Union. I originally saw the video posted on Zero Hedge* but it has since gone viral.

Farage lambasted the group saying, “The Euro is a failure and who is actually responsible, who is in charge out of you lot? Well of course the answer is none of you because none of you have been elected. None of you actually have any democratic legitimacy for the roles that you currently hold with this crisis.” “You should all be held accountable for what you’ve done,” Farage continued later. “You should all be fired.”

Click here to watch the video.

I think Farage echoes the sentiments of many, who are exhausted, enraged and exasperated by the technocrat circus in Europe. Europe’s carousel of fiscal calamity will certainly keep spinning in the near term and will likely continue to be covered heavily by the media. This will continue to drive the Fear Trade, while China and the Far East power the Love Trade by feasting on gold.

Now that’s something all gold investors can be thankful for. I wish you and your family a very Happy Thanksgiving! If you happen to be in the San Francisco area November 27-28, come visit me at the Hard Assets Investment Conference* where I’ll be speaking about market supercycles.

 

Index Summary

• The major market indices were lower this week. The Dow Jones Industrial Average lost 2.94 percent. The S&P 500 Index decreased 3.81 percent, while the Nasdaq Composite was lower by 3.97 percent.
• Barra Growth outperformed Barra Value as Barra Value finished 4.10 percent lower while Barra Growth declined 3.57 percent. The Russell 2000 Index closed the week with a loss of 3.39 percent.
• The Hang Seng Composite finished lower by 3.17 percent, Taiwan fell 1.81 percent, and the KOSPI decreased 1.30 percent.
• The 10-year Treasury bond yield closed 5 basis points lower at 2.00 percent.

 

Domestic Equity Market

 

The domestic stock market as measured by the S&P 500 Index was lower this week by 3.81 percent. All ten sectors of the S&P 500 declined. The best-performing sector for the week was consumer staples which decreased 1.16 percent. Other top-three sectors were utilities and telecom services. Financials was the worst-performer, down 5.57 percent. Other bottom-three performers were materials and energy.

Within the consumer staples sector the best-performing stock was Reynolds American, up 3.11 percent. Other top-five performers were Philip Morris International, PepsiCo, Sysco, and Lorillard.

 

Strengths

• The construction materials group was the best-performing group for the week, up 5 percent, led by its single member, Vulcan Materials. The largest producer of construction aggregates in the U.S. made a presentation this week at the Stephens Inc. Fall Investment Conference.
• The tobacco group outperformed, gaining 1 percent. Reynolds American and Philip Morris International both advanced during the week.
• The gas utility group outperformed, rising 1 percent on strength in its largest member, ONEOK, which made a presentation this week at the RBC Capital Markets Master Limited Partnership Conference.

Weaknesses

• The health care facilities group was the worst-performing group for the week, down 13 percent, led down by its single member, Tenet Healthcare. Health care providers are waiting to see what kind of budget cuts the “Super Committee” might make, or whether cuts would be made by sequestration. In September, Tenet Healthcare estimated that sequestration would result in a $40 to $54 million cut to its annual cash flow.
• The coal & consumable fuel group lost 12 percent. In a coal industry report this week, a major brokerage firm stated that, in its view, the stocks are discounting too high of a price for coking coal, and that thermal coal fundamentals are also showing signs of weakness that could surprise the market.
• The oil & gas refining & marketing group underperformed, losing 12 percent. U.S. refiners declined on an announcement that the direction of flow in the Seaway pipeline will be reversed. This may increase the cost of crude oil and thus decrease refining profit margins.

Opportunities

• There may be an opportunity for gain in merger & acquisition transactions in 2011. Corporate liquidity is high, thereby providing the means to pursue acquisitions.

Threats

• A mid-cycle slowdown in the domestic economy would be negative for stocks.

 

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

 

The Economy and Bond Market

 

Treasury yields ended the week mixed, with short-term yields rising modestly while long-term rates moved lower. Europe dominated the news again this week as market worries move from one country to the next, with the focus this week on Italy, France and Spain. The European concerns led to an exodus to the safest assets, including the U.S. dollar and Japanese yen which appreciated versus most currencies.

Negative headlines abound, but an interesting positive dynamic continues under the surface as U.S. economic data continues to be positive. This can be summed up in the chart below which depicts the Conference Board’s Leading Index. The index has resumed its uptrend, rising 0.9 percent in October, and is at the highest level in over a year. As a leading indicator, this bodes well for economic prospects over the next several months and confirms many of the positives that have come out of the recent third quarter earnings reports.

 

Strengths

• Weekly initial jobless claims fell again to 388,000, hitting a seven-month low, suggesting that hiring may be on the upswing.
• Industrial production rose 0.7 percent in October, ahead of the 0.4 percent expected. This was driven by a ramp up in auto related production.
• October retail sales rose 0.5 percent, possibly confirming the recent improvement in the job market.

Weaknesses

• The eurozone grew a very modest 0.2 percent in the third quarter and a recession appears almost a forgone conclusion.
• The European sovereign bond markets remain in turmoil as yields rose, and specifically yields on 10-year Italian and Spanish bonds approach seven percent.
• Chinese exports to Europe have taken a hit in October as manufacturing-centric Guangdong Province reported a year-over-year decline of 8.7 percent.

Opportunities

• After another good week of economic data, fourth quarter GDP estimates may begin to creep higher with a possibility of three percent growth.
• With the holiday-shortened week, data will be front-end loaded with durable goods orders, Federal Open Market Committee minutes and initial jobless claims key data points for next week.

Threats

• The situation in Europe remains extremely fluid and negative news is almost expected at this point. Unfortunately it is politically driven and difficult to predict outcomes and ramifications.

 

Gold Market

 

For the week, spot gold closed at $1,723.95, down $64.73 per ounce, or -3.62 percent. Gold stocks, as measured by the NYSE Arca Gold BUGS Index, fell 8.43 percent. The U.S. Trade-Weighted Dollar Index rose 1.44 percent for the week.

 

Strengths

• The World Gold Council’s Gold Demand Trends reported that investment demand for gold is still continuing to rise year-over-year, increasing 6 percent from the third quarter of 2010. Gold demand reached 1,053.9 tons for the third quarter of this year, valued at $57.7 billion, which is an all-time high in terms of value. Of particular note, demand soared in Europe, reaching a year-on-year increase of 135 percent, or 118.1 tons. Both statistics are very positive for the precious metal, after a sharp gold price correction in September spurred by investors profit-taking. Gold ETFs and similar products saw inflows up 58 percent, or up to 77.6 tons, in the third quarter of 2011 from previous year levels of 49.1 tons.
• Jaguar Mining closed up 44.71 percent Wednesday on news that the company received an unsolicited takeover offer. Reuters reported that China’s Shangdong Gold had made a cash offer to purchase the company for $785 million, or $9.30 per share. Chinese resource companies have been coming overseas for minerals to power China’s economy growth.
• Anglogold took a strategic 19.9 percent stake in London listed Mariana Resources through a private placement of approximately $8.5m at a 41 percent premium to the closing price yesterday. Mariana will commit to use 75 percent of this investment to develop its various epithermal gold-silver targets in the Deseado Massif of Southern Argentina.
• Lake Shore Gold was up 6.79 percent mid-week on news that the gold mine aims to double mining throughput at its Bell Creek mill in Ontario. Additionally, after an intense drilling campaign, the Thunder Creek project reported its first resource, attributing over a million ounces of gold. Lake Shore Gold reported 2.9 million indicated tons of 5.64 grams per ton and an additional 2.7 million inferred tons of 5.89 grams per ton at Thunder Creek. In addition, Lake Shore reported a maiden resource for the Fenn-Gib property of roughly 2 million ounces at just under 1 gram per ton.

Weaknesses

• John Paulson, a well-known gold bull and hedge fund manager, reported this week that he sold a third of his gold holdings in the third quarter. Paulson & Co. cut its holding in the SPDR Gold Trust to 20.3 million shares from 31.5 million at the end of second quarter, according to U.S. regulatory filings. He is, however, still the biggest holder of the gold trust.
• Avion Gold reported third quarter earnings that sparked more than a 12 percent fall on Tuesday. The Toronto-based miner with operations in West Africa reported earnings of $7.2 million, which is half from what the miner was last year, when it was $14.4 million. Production during the quarter was impacted by low equipment availability and costs rose due to hiring contract miners to substitute for fleet downtime.
• Fear regarding European debt expanded this week as other countries within the region, such as Belgium and the Netherlands have seen their financial credibility come into question.

Opportunities

• “Generation AU” is a term that’s recently been used to describe the popularity of the precious metal amongst youth. Mineweb highlighted that a new vein of investors in their 20s and 30s has attracted to gold’s spectacular, ten-year run along with the most recent global sovereign-debt crisis worries. Over the past two months, about half of the hundreds of new accounts at Gold Bullion International, a seller of physical gold in New York, has been from the “Generation AU.” Younger investors are “increasingly sophisticated” and do not want to repeat others’ mistakes.
• Despite higher gold prices, the precious metal demand has been soaring to new highs in India as wedding season gets underway. Gold jewelry sales are set to go up in India, entering into its strongest time of the year. Historically, Indian buyers have been a good indicator of the sustainability of gold prices as they tend curb their purchases if prices are unsustainable.
• Bloomberg highlighted that Morgan Stanley has gold as its top pick as European debt spurs demand. According to the firm, gold will lead a rally in commodities in 2012 as Europe’s sovereign-debt crisis continues to roil financial markets. Peter Richardson, chief metals economist at Morgan Stanley Australia Ltd., said that, ‘there’s a very strong chance that gold will re-challenge successfully the all-time high. Bullion may climb to a record $2,200 an ounce in the first half.”

Threats

• Resource nationalism is now viewed increasingly as a threat to the mining industry, with news more frequently pertaining to more and more violent opposition to major mining projects around the world. Even while in so-called “safe” environments, resource nationalism is seen as a potential cash cow for profligate governments. Resource nationalism is threatening mining infrastructure investment, and in some areas, seems to be turning dangerous in terms of “affirmative action” by locals and sometimes by governments themselves.
• Globally, there are many examples where government attitudes to foreign mining investment turn contentious and domestic disputes and violence result. Philippines, Colombia, and Peru have especially suffered with demonstrations and opposition.
• According to the 2012 budget delivered to parliament on Wednesday, Africa’s second-largest gold miner, Ghana, is proposing an increase to its corporate mining tax from 25 percent to 35 percent. This would bring Ghana’s corporate tax rates up to roughly the same level of many of its peers. The IMF has been aggressively urging Ghana to look into possibilities of increasing tax revenues from the mining sector which is one of the largest contributors to their GDP.  

 

Energy and Natural Resources Market

 

 

Strengths

• The Global Resources Fund’s exposure to paper & forest stocks helped performance this week and was one of the better performing industry groups in our natural resources universe.
• The China Iron and Steel Association reported that crude steel output has continued to decline over the start of November, falling to an annualized rate of 607 million tons per annum from 627 million at the end of October. Accordingly, Chinese mills have responded quickly to weaker pricing and reduced production by more than 50 million tons per annum over September-October. This has helped bring the physical market back into balance, allowing steel prices to stabilize and market inventory to fall.
• Royal Dutch Shell said that it has achieved the world’s deepest well completion on record in the Perdido development in the Gulf of Mexico. Shell said the Tobago field well was drilled in water depths to 9,627 feet and has started production.  

Weaknesses

• Both precious and industrial metals stocks underperformed our benchmark this week, which negatively impacted fund performance.
• The price of natural gas fell to a 52-week low of $3.32 per million british thermal units, as inventory levels reached 3,850 billion cubic feet, or 6 percent above the 5-year average.
• Despite breaking the $100 per barrel level, crude oil prices fell week-over-week to approximately $97 per barrel.
• According to industry analysts, aluminum prices have dampened because of high inventories and weak growth prospects. Aluminum prices have tumbled nearly 20 percent in the past three months to around $2,165 per ton.

Opportunities

• Mineweb highlighted that Peru’s regional government said that progress was being made in wage talks between Freeport McMoRan’s Cerro Verde and striking miners, who have just recently extended the strike to the third month. The regional government now believes the dispute at the mine that produces 2 percent of the world's copper can be solved without government intervention, a possible sign President Ollanta Humala wants to stay out of the conflict.
• Minter Ellison, a legal firm, has stated that the removal of the ban on uranium exports to India will present new opportunities and have huge implications to Australia. President Barack Obama visited Australia this week, leaving Australian Prime Minister Julia Gillard to put some hard lobbying into place to overturn a ban on supplying uranium to India.

Threats

• Mineweb reported that BHP Billiton was wary on the commodity market outlook. The world’s biggest miner warned that some customers are starting to face tighter access to trade finance and some are cutting production. “The heightened volatility and uncertain economic outlook are expected to continue to weigh on sentiment in the markets” for commodities.

 

Emerging Markets

 

Strengths

• China’s foreign direct investment growth accelerated to 8.8 percent year-over-year in October from 7.9 percent in September, as the country’s competitive labor productivity and public infrastructure continued to attract multinationals.
• Indonesia sold $1 billion 7-year Islamic bonds at a yield of 4 percent, less than half of the yield in its 2009 sale and 200 basis points lower than Italy’s, as the country’s credit quality continued to improve toward investment grade.
• Malaysia’s third quarter GDP growth surprised on the upside at 5.8 percent year-over-year, accelerating from 4.0 percent in the second quarter, driven by commodity exports and domestic investments.
• Colombia’s current account deficit, which is 3.4 percent of GDP, has been largely financed by foreign direct investment rather than portfolio inflows.

 

 

Weaknesses

• Growth in Philippines’ overseas workers remittance, which accounts for around 10 percent of GDP, slowed to 8.4 percent year-over-year in September from 11.1 percent in August, and led by intensifying European crisis.
• Hong Kong’s unemployment rate rose to 3.3 percent in October from 3.2 percent in September, which is the first increase in six months, as volatile global markets started to affect business sentiment and corporate hiring plans.
• Singapore’s non-oil domestic exports declined by a larger-than-expected 16.2 percent year-over-year in October—the deepest slide in 30 months—as electronics shipments contracted 31.2 percent from a year earlier due to dampened demand from Europe and the U.S.
• Central and Eastern Europe’s economic outlook worsened in November as the euro-area debt crisis undermined growth prospects in Turkey and Poland. The growth will slow to 2.5 percent next year, according to the International Monetary Fund.
  Opportunities

Opportunities

• According to McKinsey’s 2011 Annual Chinese Consumer Survey, 91 percent of Chinese consumers receive product information from TV commercials, and only 28 percent from internet advertisements, a far cry from the 73 percent penetration of internet advertising in the U.S. Tremendous growth potential of online advertising, coupled with China’s plan to spend RMB 1.6 trillion through 2015 on broadband network infrastructure, should benefit established internet companies in China.

• Hungary’s government has started negotiation on an agreement with the International Monetary Fund and the European Union, according to the Economy Ministry in Budapest.

Threats

• In October, new home prices dropped in 34 out of 70 major cities in China on a month-over-month basis, and existing home prices witnessed sequential declines in 38 out of 70 cities. Average home prices registered a 0.14 percent decline for the first time this year, as a result of the continued stringent government policy dampening property and credit. Investor sentiment towards property-related sectors such as construction and materials may stay cautious.
• Headlines raised the prospect of copper and silver mining royalties in Poland. The government is looking to raise as much as 3 billion zloty under the scheme.

 

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