Analyzing Gold

 Gold as an investment has always fascinated people.  Its proponents claim that markets for gold are deep and liquid, which is also reflected in low bid-ask spread. Also, unlike all other forms of securities which are in some way a form of liabilities, it carries no credit risk. While its opponents often call it unpredictable and having long price swings, gold prices have continued to increase since July and gained over 17 percent to reach highest dollar price of $1,180 per troy oz (Nov 26) in history (not adjusted for inflation). Some analysts predict that it will reach $ 1,300 per troy oz while others are quite bearish over it. We have tried to analyze several factors which have a significant impact on gold prices.

The Fed’s policy of lower interest rates and continuous monetary expansion has increased expectation of future inflation and caused a historic fall in the dollar. In fact, correlation of gold prices with dollar trade weighted index has risen significantly from - .5 (year beginning until Sept 23) to -.7 (Sept 23 until Nov 18) once the dollar reached its 1 year low on Sept 23. The improvement in risk appetite of the investors has put more downward pressure on the dollar, as they are selling US Treasuries in favour of higher yielding assets overseas. It has increased investment demand for gold In the United States. The S&P 500 index rose by 15.0% in the second quarter. But P/E ratio of S&P 500 index companies at the end of October was 130 times (compared to a historical average of closer to 15 or 20). In other words, it may be already overpriced. Emerging markets have also regained interest of the investors as high growth long term investment. Net capital inflow in the emerging markets is expected to increase by around 50 % in the coming year to regain their 2008 level (IIF forecast).  In October 2009 World Economic Outlook, the IMF revised its 2010 growth forecast for emerging Asia to 6.8% from an estimated 5.3% just six months earlier. But developing countries may try to restrict capital inflows in anticipation of a rising exchange rate. Recently Brazil and Taiwan tried to control capital inflows. These may be good reason for investors to put their money in gold.

The falling dollar has also encouraged central banks to keep part of their reserves in the form of gold since it can provide a hedge against the falling dollar value of their sovereign reserves. Net official sales of gold in the first half of 2009 amounted to just 38.7 tonnes-the lowest half yearly figures in last 12 years; while Central banks outside of the CBGA (Central Bank Gold Agreement) have been net purchasers of gold since the second half of 2006. (GFMS data). In the final year of the CBGA2 (ending on 26 September 2009) signatories sold just 155 tonnes of gold, compared to sales of 358 tonnes in the previous year (IMF, National Sources WGC). The majority of central banks in the developing world have less than 10 percent of their reserves in gold and they can diversify their reserves.

Historically gold prices and inflation have a positive correlation as people use commodities as a hedge against currency or fixed income securities.Consumer prices in the U.S. increased to 0.3% in October. Excluding food and energy costs, the core index was 0.2 percent for a second month which is at par with the Fed's expectations but fuel prices rose by approximately 1.5% during the same period (Bloomberg: Nov 18). Because of rising fuel cost and the falling dollar, inflation is expected to remain over 2% until April of next year (forecasts:org data). Expansionary monetary and fiscal policies have fuelled expectations of inflation even further. Growing foreign excess capacity has provided limited protection against domestic inflationary pressures. Although inflation abroad has been lower than U.S. inflation, exchange rate changes have exerted significant influence on import prices.

By working out imputed inflation rate ( between 5 to 7 years) from 5-year breakeven rate and 7- year breakeven rate, it can be shown that it has declined from +1.01 percent to -4.11 percent between Nov 1 to Nov 25. Breakeven rate is the rate which equates treasury yield and TIPS yield. Clearly investors are either overpricing current expectations in inflation or under-pricing mid-term and long term inflation due to monetary expansion.  Thus current increase in gold prices may be lacking strong fundamental basis in rising inflation.

Demand and supply

A real point of weakness for gold is the jewellery market, which accounted for 57 percent of total gold demand last year. Demand for gold jewelery declined by 22% relative to the same period in 2008, though the demand for jewelery in the Q2 and Q3 during the previous years were very high (World Gold Council). Industrial demand has also been decreasing during the same period. The reduction in demand for gold jewelery was a global story with just one exception: mainland China, where demand increased by 6%. Though there was a slump in the investment demand in Q2 but it has almost doubled since their 2007 level.

Production volume has declined slightly from 2600 tons in 2000 to 2415 tons in 2008 (US geological survey). The gradual reduction of mine output in recent years, with only a small number of major gold findings by the mining industry, is constraining supply (as there is a long lead time between  exploration and production).The cost of extracting gold has also increased substantially in recent years (WGC report). But current production of gold has only a marginal share of the total market supply since most of the gold ever extracted can be brought to the market economically.

Thus we can conclude that there is a real possibility of gold prices reaching new heights.  A lot will depend upon Japan 's reaction as well since the Yen has risen significantly against the dollar driving down their exporters' margins. Also, emerging markets’ response to a likely investment inflow will also answer  the significant question of equity v gold.