Shorter Than Expected Recession Holds Gold Back from $ 1,000 Level

In February 2009, when the credit crisis reached its climax, the question was whether gold’s perfect storm above $ 1,000 would be halted again.

By now, with the world economy recovering earlier than expected, the undisputed answer is yes!

With regards to the impact of recession on the global gold mining industry, the impact on demand is significantly stronger than on production. In this respect there exists a widely spread misconception of gold being an ultimate safe haven in periods of a financial crisis and more specifically its culmination into a credit crisis, as has been demonstrated since the collapse of Lehman Brothers on September 15, 2008.

When in August 2007 the prime mortgage crisis commenced with the US and European Central banks pumping $ 323 billion into the financial markets, gold responded in a positive way reaching an all-time high of $ 1,030.80 on Mach 17, 2008. Since then, with the collapse of oil price (-70%) and industrial metal prices, led by copper (-67%) in the second half of 2008, gold showed a relatively good performance by losing 7% in value only, but 16% off its March record.

With the financial crisis deepening in the second half of 2008, and culminating into a credibility crisis from October 2008 when global equity markets collapsed, it is notable that the dollar within this period acted stronger than gold did by showing a recovery against the euro of 12% (€/$ 1.58 ?1.40).

This poor performance against the dollar clearly demonstrated that failing to benefit from the crisis and even touching an interim low of $ 692.50 on October 24, gold also failed to prove that it is the ultimate safe haven for investors. Also the high volatility of the gold price during the period of the credit crisis indicates a lack of instability.

This confirms my view over the years that Gold doesn’t run its own course and that its qualifications on being a hedge against the dollar and protection against inflation are based on myths rather than on hard facts. The same goes for gold being a monetary instrument being capable to influence the course of the dollar.

Fear for growing inflation is premature

Fear for growing inflation now the world economy is expected to recover in the second half of the year, is very premature since the collapse of world equity markets resulted in a real economy related capital destruction of more than $ 30,000 billion up to March 2009, compared with IMF’s estimated total losses of $ 4,100 billion from capital infusions and loan guarantees by the world’s leading economies ($ 1,400 billion) and stimulus packages of approximately $ 2,700 billion, it is a widely spread misconception that the relatively limited size of the credit crisis was the primary threat to a global economic depression.

With exorbitant uncontrolled speculation in toxic products by Western banks fully responsible for the chaos on the financial markets and resulting in the above mentioned losses of $ 4,100 billion, it should be noted that China did not suffer in a direct way.

China leads the way in recovery of world economy

China’s stimulus package of $ 586 billion was focused on a fall in economic growth of above 10% in preceding years to 6.1% in the first quarter of 2009 and appears to be successful considering a growth of 7.9% in the second quarter and estimates of a minimum growth of 8% for the full year.

Actually, the credit crisis has accelerated the shift of economic wealth from the Western world to Asia and more specifically China, supported by China having built up its monetary reserves of more than $ 2,000 billion within a period of eight years since it became a member of the World Trade Organization since November 2001.

In addition, Asia and Arabic Sovereign Wealth Funds collected more than $ 3,000 billion before being hurt by the crisis on the financial markets.

Consequently, the losses suffered by Western financial institutes were less than dollar surpluses created in Asia and the Arabic world.

In summary, the stimulus packages to the aggregate amount of approximately $ 2,500 billion compared to the real economy related global equity market losses of approximately $ 31,500 billion, including losses of approximately $ 6,500 in January and February 2009, could only be hoped for to have a positive effect on the investment sentiment as a driver for turning around the depressed economic sentiment.

This is what actually has happened at an unprecedented pace since March of this year, led by the stock markets in emerging countries, led by China (+70%) and also being followed by the commodity markets, thereby showing increasing confidence in the course of the world economy in the second half of the year.

Up to date global equity markets have recuperated 17% or approximately $ 7,500 billion of their losses based on the worldwide stock market valuation of US$ 36,000 billion as per year-end 2008 and approximately $ 14,000 billion including further losses of approximately $ 6,500 billion in the first two months of 2009.

The result is a boost to the worldwide economy, including funding facilities having improved to restore growth. As such, it doesn’t come as a surprise that the period of recession had a shorter life than widely expected, and modest positive economic growth figures being expected from the second half of the year.

Within this new economic scenario, gold has been one of the poorest market performers in 2009, not only compared to the equity markets and interest related investments, but also to the commodity markets.

While oil and copper showed a strong price performance of 76% and 193%, respectively, gold lost its luster with a modest price increase of 10% to date.

With the economic climate expected to further improve, the course of the gold price will be determined more by fundamental factors based on supply and demand, rather than on external factors related to the credit crisis. By saying so, it is also to be expected that the gold price will be significantly less volatile as it had been since the beginning of the crisis in August 2007 until March of this year.

Price sensitivity of gold puts demand under pressure

According to “Gold Demand Trends” being recently published by the World Gold Council, the volume of total identifiable gold demand in the second quarter of 2009 was down 9% on the levels of a year earlier. This was attributable to weakness in jewellery and industrial demand (-22%) offset to a considerable extent by a significant increase in investment demand, but a decrease in retail demand.

In this respect, it has to be considered that jewellery demand represents approximately 60% of total demand and retail investment (bars and coins) and ETF’s approximately 20% and 10%, respectively. Based on these data most gold market watchers are not fully aware of the relatively low impact of growing retail investment in the last few years.

The drop in retail demand investment in 2009 doesn’t come as a surprise to me considering the price sensitivity of gold.

Specifically as a result of the worldwide financial and economic crisis, particularly in India, the world’s largest gold consumer, demand has fallen dramatically since last year, including a decline of 38% to 109 tonnes in the second quarter of 2009. While only two years ago it was expected that gold demand from India would increase to well above 800 tonnes, it is expected to almost half in 2009 and possibly being exceeded by China where gold demand shows to be recession proof showing an increase in demand of 9% in the second quarter of 2009.

While particularly Exchange Traded Funds (ETF’s) have been a major driver for demand until lately, because of a growing appetite for higher rewarding risky investments, ETF demand also came under pressure in the second quarter of 2009 dropping to 56.7 tonnes from 465.1 tonnes in the first quarter.

Increased supply has negative impact on gold price

With demand under pressure, supply is increasing in 2009, having a negative impact on the gold price. While primary supply from mining is showing a minor decline in the last few years, but will show a modest plus this year, according to Gold Demand Trends recycled gold showed an increase of almost 50% to 900 tonnes in the first half of the year as a result of the price sensitivity at gold prices above a level of $ 900.

On the other hand, according to Gold Demand Trends official sector sales declined from 146 tonnes to 38 tonnes, well below the ceiling of 500 tonnes per year under the second Central Bank Gold Agreement (CBGA2), with the ceiling of the CBGA3 for the next five years up to September 2014 to be reduced to 400 tonnes per year.

The planned sale of 403 tonnes of gold by the IMF, with the revenues to support the world economy, will probably be included in the structure of the new agreement.

Hopes that the selling of gold by Western central banks would be compensated for by Asian central banks, led by China, are idle because of economic priorities in emerging Asian countries to secure future economic growth. While China announced by surprise that it had increased its gold reserves by 75% to 1,054 tonnes from 600 tonnes, the accumulation of 454 tonnes was effectuated over a five year period and gold still accounting for less than 2% of total reserves.

The last element in supply is net producer hedging, which since 2002 had a bigger impact on the recovery of the gold price from a low of $ 252 than increasing retail investment demand. This was the result of ongoing liquidation of hedge positions causing huge losses. Hedge books are almost closed now with in the first half of 2009, dehedging having fallen to 19 tonnes compared to 250 tonnes in the first half of 2008.

In conclusion, I expect the combined elements of gold supply to be in balance for the time being. Mine production is shifting further from traditional countries including South Africa, the United States, Australia and Canada to emerging countries in West Africa, Latin America and Asia, led by China having overtaken South Africa in 2007 as the world’s premier gold producer (It is a misconception that there might be a shortage in future primary supply as the reserves of the world’s ten largest gold producers, representing approximately 45% of total global production, correspond with an average of  more than 17 times their annual output (Appendixes 4 and 5).

With the course of the gold price becoming less volatile and the dollar stabilizing, I expect a trading range of $ 920 – 980 for the remainder of 2009.

Considering the price increase of 40% over a period of just two years and the cash costs of many gold operations not exceeding $ 500 per ounce, in my view, investment in the gold equity markets is to be favored, offering attractive leverage opportunities.

Editor, Gold Letter International

Marino G. Pieterse has been an independent financial analyst and gold specialist for more than 25 years. He is the chief-editor of Goldletter International, the only gold investment market letter in English in Europe focusing on emerging gold regions in the world, as well as reports on individually featured companies and special reports on other metals, including uranium. You can receive Gold Letter International’s reports for free by clicking on the “Subscribe” button.