The sovereign debt problems may ultimately be resolved through higher inflation achieved through maintaining low interest rates and further monetary easing. Should the US Federal Reserve announce a new round of quantitative easing in 2012, this is likely to be positive for gold. The possibility of a country leaving the euro zone means that financial markets are sensitive to the possibility that fiscal and political integration in the euro zone may not be successful leading to sovereign defaults. The volatility of and high correlation between asset classes such as government bonds, equities and FX means that gold has retained favor amongst investors. With this backdrop, gold is likely to continue its multi-year rally, and yet may still be subject to periods of intense liquidation when risk-aversion is particularly high. The fundamentals for gold are further supported by a limited response from new mine supply, the report said.
TAIB therefore believes that gold may reach $2,000 an ounce sometime in 2012 and thereafter may rise to about $2,300 an ounce, which is approximately the inflation-adjusted high reached in 1980. It may therefore be prudent to maintain exposure to gold over the time horizon of one to two years, which coincides with the period likely to be required for decisive resolution of the global debt and growth issues.
According to the World Gold Council, gold mine production has averaged approximately 2,500 tons over the past few years. Gold production does tend to be associated with relatively long lead times for new mines as long as five to ten years. This means that mining supply response is inelastic to changes in the price of gold. As such, even a sustained price rally will not necessarily translate into increased production. Global gold mine production is expected to grow in 2012-13, at an annual average rate of 3 percent, driven by historically high prices.
South Africa has fallen from the being the world's largest gold producer to being behind China, US and Australia. Its mines are becoming deeper and therefore much more expensive to mine. At the same time, ore grade is falling, making production costs very high. Over the past two decades, South African gold mining has been affected by a substantial decline in the grade of ore; lower ore grades require the miner to pulverize more rock to recover the gold.
Central banks became net buyers of gold in 2010 for the first time in over 15 years, adding 76 tons to reserves. Total central bank gold purchases in Q3, 2011 more than doubled from Q2, 2011 and almost seven times higher than a year earlier. This appears to be driven by a desire by central banks to diversify reserves away from the US dollar and the euro. According to the World Gold Council, central banks had purchased more gold in the first half of 2011 than in all of 2010. It is anticipated central banks may add as much as 450 tons to reserves this year. This was driven by the 93.3-ton purchase by Mexico. Similarly, South Korea made its first purchase of gold since 1998 adding 25 tons in June and July of 2011.
Investors have also bought gold through ETFs and in particular the SPDR Gold Trust ETF. The current market capitalization of the GLD ETF is $71.5 billion, an increase of 22 percent over the course of 2011. At the current price of gold of approximately $1,700 an ounce this represents the equivalent of 1,300 tons of gold. This makes the GLD ETF holding of gold larger than the gold reserves of Russia, Switzerland, the UK, India and China, at least according to official statistics.
Gold saw a sharp correction from its closing high of around $1,900 an ounce in early September, this being attributed to investors selling gold to cover margin calls and losses in other asset classes. This is not unusual in that we saw similar behavior in the price of gold in 2008, during a period of heightened risk-aversion after the collapse of Lehman Brothers. Another factor driving the correction in gold was the increase in margin required to invest in gold futures at the CME Group; it was announced on Sept. 23 that initial margin for COMEX gold futures would rise by 21 percent.
Despite the price declines, ETF holdings of gold have stayed firm and central bank buying continues apace. It was reported in the press that John Paulson had cut his holding in the SPDR Gold Trust in the third quarter, however Paulson remains the largest holder of GLD with a stake worth about $3.5 billion at the end of the third quarter. Some commentators suggest that any such selling may have been to cover losses in other markets and that long-term investors in gold are retaining their belief in the bull run in gold prices.
Furthermore, despite the reduction in holdings of the SPDR Gold Trust, the price of gold remains well supported. The TAIB report said that the recent fall in gold price is technical and the fundamentals for further increases in gold price remain intact.
