By Sumit Roy
WGC’s managing director of investment discusses the outlook for gold.
Marcus Grubb is the managing director of investment for the World Gold Council, where he leads both investment research and product innovation, as well as marketing efforts surrounding gold's role as an asset class. Grubb has more than 20 years' experience in global banking, including expertise in stocks, swaps and derivatives.
After the release of the World Gold Council's quarterly Gold Demand Trends survey, HardAssetsInvestor’s Sumit Roy spoke with Grubb to get more details on the particulars of some of the report's more surprising conclusions.
Hard Assets Investor: Central bank gold demand looked strong again last quarter and seems on pace to exceed last year’s five-decade high. Which central banks are buying? And what influences their purchase decision?
Marcus Grubb: Yes, absolutely. On the face of it, central bank net purchases of gold fell 31 percent when compared with Q3 2011. But actually, 97.6 tons is a great number. And it means that through the end of September, this year is an even better year than last year; and last year was a record year. To the end of September, central banks have now bought 373.9 tons. Last year through September, they bought 343.9. So we’re looking at another 450-500-ton year for central banks, which is a record since the ’60s.
The most recent name that’s popped in, after many years of not buying gold, is Brazil. Brazil’s buying confirms a trend we’ve seen. If you look back over this year and in this quarter, the buyers are Latin American countries — Mexico, Bolivia, now Brazil; they are Central Asian countries — Russia, Kazakhstan, Ukraine; and Far Eastern countries such as Thailand, Philippines and South Korea. The developing country central banks are the ones doing the purchasing.
The interesting thing about them is, on average, their weightings to gold are much lower than the U.S. and European central banks — usually under 10 percent of foreign exchange reserves in gold. And, in many cases, less than 5.
The other conundrum to always keep in mind is that China has made no public statements about its gold reserves in three to four years. Ostensibly, they're still at 1064 tons, about 1.8 percent of foreign exchange reserves, which is extremely low by international standards. But we don’t have any new data on China currently.
The bottom line is that these central banks are diversifying away from the dollar. And they are diversifying away from the euro because of the sovereign problems and the currency issues in Europe.
Moreover, they are diversifying away from sovereign debt. We’ve seen the sovereign debt issue raise its head last year in the U.S and, of course in Europe, we’ve got countries that are effectively insolvent, being propped up by bailouts.
With the “fiscal cliff” and the debt ceiling debate coming back in the U.S., it’s clear that sovereign debt is no longer the safe asset class it used to be for central bankers. Thus, they are seeking to buy more gold.
HAI: Speaking of that fiscal cliff, why do events in the U.S. such as the fiscal cliff and the Fed’s announcement of QE3 have such a disproportionate impact on the price of gold? Isn't demand in the country a relatively small percentage of total global demand?
Grubb: Yes it is, and U.S. jewelry demand has been in decline. The investment demand in the U.S. is strong. But it’s not a key global driver other than through OTC investments and ETFs, which have seen strong demand.
That being said, what is catalyzing growth in investment demand around the world — not only in the U.S.— but in Europe and in the Far East as well, is the fact that the U.S. Federal Reserve and other central banks are seeking to continue to boost economic growth and avoid deflation by ballooning their own balance sheets and by effectively implementing quantitative easing, or OMT [outright monetary transactions] as it’s now called in Europe. Then they’ve implemented more easing measures in Japan, and even in China, to prevent the slowdown in those economies.
Although the total net demand from the U.S. is relatively small, it’s more the fact that it’s a leading indicator of central bank policy on an international basis. And as a result, the world market is being flooded with liquidity in Japan, the U.S., the U.K. and in Continental Europe. Putting aside the ups and downs of each quarter, what this is doing is stimulating investment demand, ultimately, both at the retail level for bars and coins, at the OTC level for institutions and private wealth, and in ETFs.
The interesting thing in this quarter is, if you add back OTC investments, investment demand is actually up 4 percent and not down 16 percent in this quarter. It’s also up through the end of September, compared with last year. It’s the ballooning of balance sheets in general among central banks, led by the Fed, that is causing this increase in investment demand.
HAI: Speaking of investment demand, we saw gold ETF fund inflows jump an impressive 56 percent year-over-year in the quarter, putting their holdings at a record level. How significant are ETFs in terms of overall investment demand?
Grubb: They are pretty significant. This year, they are a crucial positive. Because, as you see in our figures, consumer demand generally is quite weak in jewelry and retail investment, largely because of weaker bar and coin demand in the U.S. and Europe, and weaker jewelry and investment in India during the first half of the year. This is probably going to end up being a down year in tonnage terms.
But within that, the interesting thing is that more professional investors, especially in this quarter, have invested even more in the ETFs: up 56 percent in this quarter. If you look year-to-date, compared with last year, ETFs are up 134 percent compared with the nine months to the end of September 2011 — 189 tons versus 80 tons.
This is an indication that professional investors are concerned about the financial system. They're expecting that balloon in central banks’ balance sheets to occur into 2013. They're concerned about the fiscal cliff and the debt ceiling in the U.S. And therefore, they're using the ETFs as the way of increasing their allocation to gold.
Overall, it means that total tonnage in ETFs globally is something close to 2600 metric tons of gold. To put that in perspective, if that was a central bank, they’d be in the top five globally — a little bit bigger than Italy, which is one of the biggest central bank holders of gold in the world; 2,600 tons is a significant amount of gold.
HAI: Given that they're so liquid and accessible, have ETFs caused volatility in the gold market to increase?
Grubb: It’s hard to judge that one way or another. Overall, it doesn’t appear that volatility has changed that much, as far as gold is concerned. Currently, volatilities are higher than long-term averages. But that’s the case in a lot of other asset classes as well. Volatility has gone up a bit — from 12 to 14 percent to 16 to 18 percent or so.
But it’s hard to determine whether the ETFs have been a factor in that when you consider all the other things that have been going on in the world in recent years. The other reason to suspect that they haven't contributed too much to volatility is that, as the figures show, it’s quite rare that you get significant streams of redemptions in the ETFs. On a day-to-day basis, you will see redemptions. But overall, most quarters you see net additions to tonnage throughout the last eight years or so.
The profile seems to be, even when the price corrects significantly in the gold market, that you don’t get large redemptions. And when the price rises, you get significant new creations. So I think that these investors, generally speaking, are buy-and-hold investors. You tend to see more speculative behavior in the options and the futures.
I think the caveat to all that is we haven't seen a significant and persistent fall in the gold price in this decade-long bull market yet. We’ve seen 25 to 30 percent pullbacks, but they’ve usually been over within a few days or a week. I think it’s fair to say that perhaps the volatility hasn’t been tested yet, until we see a much more major pullback in the gold price.
But because of quantitative easing, because of continued strength in Asia — even with a slowdown in China — consumer demand is still underpinning the gold price. Fifty percent of tonnage is still going to India and China alone every quarter, every year. We don’t think you're going to see a major change in that dynamic of the gold market.
In our opinion, the bias is still higher because the supply is very constrained. Mine production fell in the third quarter; supply fell; recycling fell. And while demand has fallen overall, a lot of categories of demand are still high compared with their longer-term averages.
HAI: Speaking of China and India, what’s the outlook for those two countries going forward? Is the demand going to grow or hold steady?
Grubb: We forecast, at the start of the year, that China would be the larger market of the two. We’ve got a bit of a hit to that forecast because in the third quarter, China had another negative quarter as it did in Q2: a fall of 9 percent in demand terms, and a fall of about 12 in investment, and about 5 percent in jewelry. That’s a reflection of the slowdown in the country’s economy.
On the other hand, India saw a recovery in the quarter. After a very bad first half, India is up 9 percent in the third quarter, but still down about 22 on the year through the end of September. That means through the end of September, the two countries are running neck-and-neck. China is at 605 tons and India is at about 612, making India just a slightly larger gold consumer.
That’s a bit of a surprise to us. We would have expected China to be further ahead by this stage. It now all comes down to Q4. India is now recovering with the stronger currency. Consumers are coming back into the market for jewelry and investment products. You’ve got Diwali [festival] falling later in the year, in November this year, which is good for gold demand in India.
On the Chinese side, there are signs the Chinese economy is bottoming out already. Improved economic numbers are coming through, which will help gold demand again as the consumer comes back into the market in Q4. So we’re going to have a race in the fourth quarter.
I still think China comes out slightly ahead. If India, for example, comes in around 700 tons, I think China is going to come in probably at somewhere between 700 and 750 tons. The gap is going to be probably less than 50 tons between the two markets, which is a lot less than we thought it would be back in January. We thought China would come in probably at 850, and India would come in at 700 or 750. Now that’s going to look a lot tighter. And I have to admit, there is a chance India is still the winner — it really depends on the rupee [currency].
HAI: Interesting. With gold prices trading at a historical premium to platinum prices, have you seen an impact on jewelry demand for gold at all?
Grubb: No. If anything, the decline in jewelry demand has slowed down, with only a 2 percent fall in the last quarter. At the margin in some markets, there has been some substitution. Demand for platinum in China has been good, obviously, because it’s now at a good price relative to gold.
But one has to remember, when you talk about gold, you're talking about a $250 billion market a year, in terms of dollar value at the end of last year. That’s roughly 4400 tons total demand in the gold market last year. The total size of the platinum market — of which over half is not for jewelry — is probably $10 billion to $12 billion globally. Platinum is a much, much smaller market and a much, much smaller metal than gold.
The challenge from platinum is at the margin in those countries that favor white metals like China, and some Eastern countries, where platinum jewelry has been giving gold a run for its money. In general though, we don’t see a significant challenge to gold from platinum.
HAI: You touched on the supply side a little bit earlier. But how do you see that shaping up for the year as a whole? Mine production rose 4 percent to hit a record high last year. How is that looking this year?
Grubb: Much less good this year due to missed targets and the unrest in South Africa that’s affected platinum and palladium as well. In this quarter, we saw mine production fall. We think there's a possibility that you see an overall fall in mine production this year. That is unusual -- we haven't seen that for some years. Mine production has been in a recovery from the mid-2000s.
That being said, if you go back a decade, gold is still bottom of the class in terms of growth in mine production, compared with other precious metals and base metals. For a long time during this bull market, mine production was actually still declining. Although you’ve seen some improvement in gold mine production in recent years, this year is not looking great. And on a 10-year view, we’re still lagging behind silver, platinum, copper, most of the other metals.
HAI: Do you see the gold bull market continuing for a 13th-straight year next year?
Grubb: I would hazard a guess to say that we see it continuing, certainly for this year, but also in 2013. India appears to be bottoming out and starting a recovery. It will all depend on the bigger economic challenges in India and the effect on the currency.
It is about the management of the Indian economy, foreign direct investment, strengthening the currency, controlling inflation, structural reforms, combating corruption. These things have to be dealt with in India, and in turn, they will benefit gold indirectly.
China is also likely to bottom out and look better into 2013. We are in the camp that believes China is still some way from the end of its bull market and growth in the economy. You’re going to see continued infrastructure spending in China next year. All of that will help demand for lots of products, including gold.
We’re also on the more bearish end of the market in terms of the debt overhang in Western countries, and the time it’s going to take for quantitative easing to have an effect. We’re not in the doom and gloom camp. We believe ultimately, economic policy will find a path through these challenges. But you only have to look at a chart of total debt and sovereign debt levels to GDP in Japan, France, Britain, Italy, Spain, even Germany and the United States to see that we are at all-time records in total debt in all of these countries.
We’ve really yet to see growth come back at convincing levels. Even Germany and France are now sinking towards recession. The U.K. is bumping along the bottom, probably going to triple-dip into a recession. Of course, in the peripheral European countries, it’s even worse.
Japan has just averted a debt ceiling problem, but they have the highest debt-to-GDP ratio in the world, of any major economy.
We think these problems are far from over. It means that you're going to see very low rates — negative real interest rates — for some years to come, as well as continued stimulus from central banks whenever the economy weakens. We expect inflation and higher rates in the long run, but in the meantime, we’re going to head towards an ultra-low interest rate world. Ultimately, we think that’s bullish for the gold price.
HAI: What would you say is the biggest risk to that forecast?
Grubb: For one, if supply perks up, that would change the balance in the market. But the biggest risk to the bullish outlook is that our economic view is too negative. If you see innovation and enterprise returning more rapidly; if you see the fiscal problems are solved and the balance of growth and austerity starting to deliver a path out of stagnation more quickly; if you see moderate inflation, with interest rates rising in a controlled way; if you see a return to prudent central banking, then we would certainly see a change in the gold market.
That’s the most threatening scenario for gold because it reduces risks. It means inflation remains under control, growth comes back and risk assets such as equities start to look better. In that case, investors may reduce their weightings to gold simply because risk has generally declined and there are better returns in other asset classes.
That being said, such a scenario seems an awfully long way off in most Western countries and Japan. I find it difficult to see that happening in the near term.