Gold Mean Reverts, as ETF Outflows Overwhelm EM Physical Demand…

If you think about the intrinsic value of gold, there’s not a lot’

Reserve Bank of Australia Assistant Governor, Guy Debelle, speaking recently

Of course, its fervent believers would suggest that gold is the only asset with any intrinsic value because of its strictly inelastic supply, while skeptics might describe it as the world’s longest running Ponzi scheme, reliant on an ever increasing supply of credulous buyers. The real price of gold tends to mean revert over roughly 10-year cycles versus its own history and relative valuation to other assets, with marginal production cost providing the only credible floor on downside volatility. Keynes must be spinning in his grave at the recent popularity of what he termed 70 years ago as a barbarous relic, having seen the destructive effects of the ‘hard money’ gold fetish at first hand in the Depression.

And not just in deflationary economic terms; after President Roosevelt nationalized gold holdings in 1933, the US inadvertently saved Stalinist Russia from economic collapse as the Gulag gold mines exported every ounce their slave workers could produce at the new exchange price of $35/oz (which held until Nixon finally ended the gold standard in 1971). For all the policy errors of recent years, the idea of returning to a money supply dictated by the extraction rate of gold ore from the earth’s crust is ludicrous, but for emerging economies from Turkey to Vietnam and above all India, the gold addiction is retarding development by starving the formal banking system of deposits, an issue which policymakers are now seeking to address.

The price has since 2009 become increasingly detached from the wider commodity complex, and peaked as Indian and Chinese growth momentum faded in 2011, with a brief rally at the height of EMU implosion fears last year before resuming an increasingly violent downtrend. China produces about 25% of global gold output, and buys a further 800 tons plus annually on the open market while Indian gold imports dropped 11% last year to 860 tons from a record 969 tons in 2011, as the INR slumped and the government raised import taxes in an attempt to reduce a surging current account deficit.  Weak physical demand from the two countries that together account for about 40% of global gold consumption meant that sustained buying by ETF investors became critical to support the gold price. An uptrend in the USD since last summer, higher CME margin requirements since last November, and the possibility that Fed QE might end earlier than expected created a risky technical backdrop for remaining gold bulls.

For the past century, the price of gold in real terms has remained within a certain range of the real prices of US CPI, soft commodity prices, industrial metal commodity prices, real estate, equities etc. In recent years, gold completely detached from these comparative valuation reference points and its real price relative to virtually all assets reached the extreme upper end of its historical range at the recent peak. Chinese demand was largely flat last year amid weaker economic growth and despite last week’s bargain buying spree, physical demand has been stalling even in smaller emerging economies like Turkey, which according to its s central bank holds at least $115bn, versus the $1trn odd in India. Like India, Turkey is trying to move the nation’s store of gold from the biscuit tin to the banking system, where it can be used as reserves or collateral.

The secular bull case is rarely coherent; on the one hand it hinges on a central bank credibility crisis as QE leads to ‘hyperinflation’ and flight from paper currencies, on another it requires central bank buying driven by official reserve diversification from the USD (although the RMB is proving a more attractive candidate than gold). Generally, as a non-yielding asset, there have been three reasons investors traditionally buy gold: as a store of value, as a hedge against inflation; or as a hedge versus the debasement of currency. Historically, gold has been known as an effective store of value, but this status has gone in and out of fashion over the centuries.

The price of gold soared 600% from trough to peak since 2000, but in the 1980s and 1990s, gold certainly wasn’t considered a great store of value. About $150bn flowed into the gold market via Gold exchange traded funds (ETFs) between 2004 and 2011, and without the advent of ETFs, the parabolic rise in the gold price would never have occurred. This development provided an easy means initially for individual and more recently for institutional speculators (in particular hedge funds) to trade the metal. Larger institutional investors such as pension funds were increasing portfolio weightings in commodities generally pre the 2008 crisis as a source of (supposedly) uncorrelated return diversification.

Hedge funds, which performed poorly in 2012 because they were too cautious on risk assets, have led the selling in recent months as they added to stock positions. Their rationale was that the US economic recovery, led by housing and autos, will soon begin to become self-sustaining, a factor also behind the strength of the USD since last summer, and gold is essentially an ‘anti dollar’ trade. After a near 10% S&P 500 rally in Q1, investors have been switching to assets that unlike precious metals either generate income or have growth potential, in the absence of any evidence of a broad inflation breakout (for which gold would be a poor hedge anyway, see below) and in fact generally weak commodity price trends since mid-2011.

In recent weeks leading up to the massive two day April selloff, Japanese holders had already begun selling as the price reached a record in JPY terms (in line with a general repatriation of foreign investments), but the possibility that Cyprus would be forced to sell its gold reserves (a mere 14 tonnes) to fund a bank bailout sparked fears that far bigger holders in Europe would follow suit. Portugal owns 382 tonnes (90% of total FX reserves), while Italy, France and Germany hold about 70% of their FX reserves in gold. Part of the bull argument for gold has been that central banks (particularly in Asia) would raise the proportion of their reserves held in the metal to historic norms. Central banks already own 19% of all the gold ever mined, and the key for gold prices is whether selling by developed world will overwhelm steady buying from EM central banks; certainly, if we see a new crisis leg in Europe, peripheral banks will be under intense pressure to liquidate. Downside still predominates…