RBC GLOBAL INVESTMENT MANAGEMENT INC.
Report on Gold
Clearly, with gold stocks on a tear as the gold price moves
laboriously forward battling the fervent attempts to suppress it, one
must be comfortable with the notion that the gold price is going to
overcome the forces that are aligned against it. What is happening
today is no different than what was happening in the late '60s and the
very early '70s, when the Gold Pool was in existence and the gold
price was contained at $35 per oz. by a consortium of central banks
that dumped a considerable amount of gold to keep prices down. Today,
instead of the overt action of yesteryear, it is covert because the
market is allegedly free, and it has entailed a different mechanism,
which has resulted in a humongous physical short position. In
addition, there has been an enormous amount of derivatives piled on
top, which could make the ultimate upside explosion all the more
spectacular.
So the question obviously is: "Will the gold rally ever begin?" The
following arguments emphatically suggest that it will more than rally;
it will explode to the upside.
1.Unsustainable Supply/Demand Imbalance
Mine production has flattened out at 2,600 tonnes and is beginning to
fall due to a lack of exploration, falling grade at many mines due to
previous high-grading, and the closing of older mines as they run out
of ore. It has been estimated by Beacon & Associates in an exhaustive
study that if gold prices were to remain under $300/oz., production
will fall in the neighborhood of 25% over the next 5 to 7 years. Scrap
supply tends to average about 600 tonnes annually. Demand is currently
estimated to be roughly 4800 tons (primarily jewelry) without any
investment demand from the Western world. The present deficit has been
met by direct central bank sales (roughly 400 tonnes per year) and
central bank leasing for mining hedges and financial speculation.
2) Unsustainable Short Position
Central banks have ostensibly lent increasing amounts of gold to earn
interest on their reserves. However, when one lends at an rate (less
than 1% generally), the question arises as to whether there may be
another motivation. As a rising gold price stands as a direct
repudiation of their alleged responsible monetary policy, perhaps this
is the real reason they have been so aggressive in this area. Bullion
banks have borrowed gold from the central banks for their own accounts
and those of various speculators, such as hedge funds and financial
institutions (the carry trade) and for producers (mine hedging) and
have used derivatives to limit their risks and generate additional
income. The loaned gold has been sold into the physical market and is
now in jewelry, primarily in the Middle East, India, and other parts
of the Far East. The size of the short position, officially
acknowledged to be more than 5,000 tonness by the bullion bank
apologists, is thought to be well over 10,000 tonnes and may exceed
15,000 tonnes. To put this in context, this constitutes between
one-third and one-half of all central bank gold, and the vast majority
of it is no longer accessible.
3) Unsustainable Low Inflation
The gold price has a tendency to rise at the first whiff of
accelerating inflation. CPI inflation has been unrealistically low due
to the very strong dollar, which has underwritten vicious foreign
competition and removed pricing power in many sectors. However, in the
final analysis, inflation is a monetary phenomenon and the aggressive
interest rate cuts and monetary expansion to avoid recession/deflation
is expected to result in re-inflation. Year-to-date, the liquidity
injection is more than $1 trillion and MZM has grown by 16.5% in the
past year. To avoid debt default, the Fed must err on the side of
ease, virtually ensuring upside pressure on the CPI. In addition, the
"war on terror" superimposed on Bush's mammoth tax cuts and a
four-year government real rate of spending increases that is the
greatest since the '60s portends large U.S. government deficits, yet
another recipe for inflation.
4) Unsustainable U.S. Dollar
The U.S. dollar has been levitating for a long time, but the
underlying fundamentals continue to erode. The U.S. current account
deficit exceeds $400 billion annually, and the continuation of this
chronic deficit turned the U.S. into the world's largest debtor as
most of these deficits are being recycled into U.S. debt instruments.
However, foreign appetite for U.S. securities appears to be ebbing and
the chart on the U.S. dollar looks very toppy . Gold is already in a
bull market in U.S. dollars, and an established bull market in every
other currency. If the reserve currency, the U.S. dollar, falters,
gold could well be launched on the upside as people recognize its
status as the only "true currency."
5) Unsustainable Prices for Financial Assets
Western world investment demand will be the true fundamental that
drives gold much higher. Gold tends to be counter-cyclical and
investors buy it when financial assets begin to lose credibility.
Ownership and pricing (P/E) of financial assets are at historic highs
and if inflation accelerates, the U.S. stock market is extremely
vulnerable. The ratio of the S & P 500 Index to the price of gold
reached an all-time high, by a considerable margin, in 2000, but this
parabola have been broken and a downward trend is in effect. At the
margin, if a small amount of money is moved from financial assets into
gold, the price effect on gold will be dramatic and the ratio will
continue to move in gold's favor.
6) Increasing Evidence of Unsustainable Gold Price Manipulation
a. Aggressive gold lending, which from an economic perspective is
indefensible, has filled the supply/demand gap.
b. NY Fed gold has been mobilized when the gold price is rising.
c. Timing of Exchange Stabilization Fund gains/losses corresponds to
gold price movements.
d. Audited reports of U.S. gold reserves show unexplained variances.
e. Minutes of Fed meetings confirm officially denied gold swaps.
f. Rules on gold swaps revised but subsequently denied. However,
individual central banks have repudiated the denial.
g. U.S. gold reserves have recently been re-designated twice,
initially to "custodial gold" and latterly to "deep storage gold."
h. Statistical analysis of unusual gold price movements since 1994
indicate high probability of price suppression. The invalidation since
1995 of Gibson's Paradox -- that gold prices rise when real interest
rates fall -- suggests that the real manipulation began then.
i. NY gold price movements versus London trading defy odds.
j. Timing of huge increases in bullion bank gold derivatives is
consistent with gold price declines.
k. Rapid decline in U.S. Treasury holdings of gold-backed SDR
certificates is not explained.
One or two of these factors could be viewed as random, but the full
body of evidence is overwhelming.
It would appear that gold is beginning to be viewed as money again.
Gold is the only monetary asset that doesn't represent somebody else's
liability, and with U.S. real short-term interest rates now in
negative territory, there is no disadvantage in holding gold. Those
with a vested interest in containing the price of gold -- central
banks, bullion banks, heavily hedged gold companies -- will not die
easily, but the tide is moving strongly against them and the embedded
short positions could catapult the gold price higher while imperiling
the future of those holding the short positions.
The great rallying cry of the bears is the mobilization of even more
central bank gold to the tide. Recently, Ernst Welteke of the
Bundesbank has spoken publicly of the Germans selling gold after the
initial Washington Agreement limiting European central bank gold sales
to 400 tonnes per year expires in late 2004 with the intention of
redeploying into stocks and bonds. Formerly, commentary and action of
this sort by central banks (the announcement of Swiss sales, the
initiation of English gold auctions, etc.) devastated the gold market
but this elicited little more than a yawn. An astute gold analyst in
South Africa postulated the reason why, perhaps. There are strong
rumors that Deutschebank has borrowed an enormous amount of gold (more
than $10 billion worth) from the Bundesbank over the years to
facilitate the carry trade, producer hedging, etc. and it is becoming
apparent that there is no way they will be able to pay it back.
Perhaps, to make good on their gold loans, they will reimburse the
Bundesbank with stocks and bonds and Mr. Welteke is readying the
German public for with his statements.
In addition, there are enormous dollar reserves building up in the Far
East, particularly in China, and the Far East has acknowledged being
significant buyers of gold. So the flow of central bank gold is not
only one-way. Even the Russian Central Bank is on the buy side. The
shibboleth of central bank sales will undoubtedly be trotted out
again, but it is losing its sting, particularly if the possibility
that as much as half of all the central bank gold may already be in
the market starts to become more widely recognized.
In addition, in the '70s, when gold was rising sharply in price,
central banks, after having been heavy sellers at $35/oz., sold little
or none at higher prices. Central bankers are no different than the
momentum players; if the price is rising, they are more likely to be
buyers than sellers.
One last observation concerns the gold share price action prior to the
explosion of gold prices in the '70s. Then, as now, gold stocks rose
to prices that made no sense to observers who had a static view on
gold prices, but the stock buyers knew that sharply higher gold prices
were inevitable. I suspect that is the case today, particularly when
one examines the foregoing evidence.
7) Gold Stocks
Gold stocks are perceived by many to expensive, but, in fact, they are
considerably cheaper than they were in the late '90s. The central
banks' overt attempts to bring the gold price down (Swiss sales,
British auctions, etc.) at that time removed the premium in gold
shares and it is now gradually being restored as confidence returns to
the sector. In fact, if the gold prices were to rise sharply, I would
not be surprised if the price to NAV continued to rise due to a
shortage of viable gold stocks. |
