Just a few months ago when the Fed announced QE3, there was near consensus among sell-side analysts that gold was on its way up, driven by the global central banks' open-ended money printing programs. However, the recent decline in gold (GLD) price has generated a stir among investors and analysts alike who have seen the yellow metal significantly underperform equities this year. As the price of gold declines, bears have come out of hiding giving all sorts of reasons as to what changed during these past few months that prompted the sharp drop in precious metals and why the price decline would continue. Among them are Credit Suisse (CS) and Goldman Sachs (GS), who have recently argued that gold's 12-year bull run is over. In this article, I will critically evaluate Credit Suisse and Goldman Sachs' bearish view on gold.
As with most bearish views on the precious metal, Credit Suisse and Goldman Sachs' argument is based on the following themes:
- Gold's valuation is extremely high relative to its long-term average price
- The fear trade which prompted a flight to gold is over as Draghi promised to do anything to save the eurozone
- The US economy is on the mend
- As the economy gets better, the central banks will stop their printing presses and real interest rates will rise which is a huge negative for gold
Credit Suisse's most recent reasoning for their bearish view on gold is not much different than their bearish view on gold in January 2010 when gold was trading around $1100. The recent CS note starts with a couple of charts showing how inflation adjusted gold price is at a historical extreme when compared to its long term average. That may be true; however, I don't understand the purpose of looking at gold's price relative to its long-term average on an absolute basis in absence of the context of the current global financial environment. In today's environment, the United States' monetary base is at unprecedented extreme levels; the interest rates are at record-low levels; the US national debt both in absolute terms as well as a percentage of our GDP is at the extreme and we have lost our AAA rating for the first time in 75 years. Moreover, there is no sign of improvement on any of these fronts in the foreseeable future. Since we are living in financial conditions that are largely unparalleled in history, there is a lot of uncertainty and fear about the unknown and unintended impact of these conditions. In my view, the extremely high price of gold, when seen in context, only reflects the extreme financial conditions that we live in.
Eurozone Fears Are Over
My response: No they're not. Credit Suisse argues that an important turning point in gold's Bull Run was Draghi's speech in July last year in which he promised to do "whatever it takes" to save the Euro. Since then, the Eurozone sovereign yields have dropped sharply to sustainable levels and remained relatively calm. However, it does not take much to reignite the problems, as evidenced by the recent Italian election. Although the result of the election has created a hung parliament, the message from the majority of Italians is quite clear: a big no to austerity. The election result will only give more heart to and intensify the anti-austerity sentiment in Spain and Greece where anti-austerity protests are becoming increasingly common. This is in addition to increasing political uncertainty in Spain in light of the corruption allegations on Prime Minister Rajoy. And the Italian experience has shown that it does not take long to dislodge a pro-austerity government when the majority of the citizens are against it. In my opinion, fears remain that investors will call Draghi's bluff on doing "whatever it takes" to save the Euro because if push gets to shove and the ECB is forced to buy Italian and/or Spanish debt to bring down yields, the German taxpayers would not paint a happy picture which would make ECB bond buying politically unviable for Chancellor Angela Merkel.
US Economy Improving?
Maybe it's just me, but I don't consider a 0.1% fall in US Q/Q GDP for Q4 2012 as a sign of an improving economy. But don't worry, that was a one-off due to the "surprise" 22% plunge in defense spending, they say. But then you should be ready for many more of these "one-off" surprises because fiscal austerity is coming to America. Both the Republicans and the Democrats recognize that the US national debt is not sustainable and that the budget deficits need to be reduced. Sure, they will probably kick the sequestration barrel down the road for now but for how long? Whether it comes in the form of tax increases or spending cuts (it will probably be a combination of both), ultimately, fiscal austerity is coming and it will have a drag on the already fragile US economic recovery.
Rising Real Interest Rates
Another theme that is common in both Goldman Sachs and Credit Suisse's view on gold is that gold price is highly dependent on the real interest rates in the US. Since the US economy is improving, the Fed's QEternity would end early and thus the real interest rates would rise substantially over the coming years especially given the recent hawkish tone in the FOMC minutes, the analysts argue. I disagree with this notion for two reasons:
1. Real Interest rates are not going to rise anytime soon
Just a couple of months ago the Fed gave a clear indication of open-ended QE until the unemployment fell below 6.5% or inflation exceeded the 2.5% mark, none of which would appear to happen in the foreseeable future. However, January's FOMC minutes released earlier this month were a strange reading as "many" FOMC members seem to be worried about potential risks from further asset purchases. Where were these members when the Fed was promising open-ended QE in December? In my opinion, this discussion of risks of additional bond purchases is merely a discussion at this point and there is no chance of QE4 ending prematurely especially in light of the looming fiscal austerity and the risks that it poses to the US economy. My argument is further strengthened by Bernanke's recent testimony in the senate in which he defended the Fed's policy and downplayed any risks from the monetary stimulus while drawing attention to the policy's purported benefits, all but confirming that the Fed isn't going to cut down on the bond buying any time soon.
2. Real interest rate in the US is not the primary driver of gold prices
The notion that the real interest rate in the US is the primary determinant of gold prices, one of the primary arguments in both Goldman Sachs and Credit Suisse's bear thesis, is outdated and flawed. Gold is now very much a global commodity of which the US demand forms a small part. According to the latest statistics from the World Gold Council, India and China accounted for a combined 53% of the gold consumer demand (jewelry + investment) whereas the US accounted for just 5%. Indians do not buy or sell gold in response to changes in interest rates in the US or even in India for that matter; they buy gold as a part of a centuries old tradition of owning gold as a status symbol and a display of wealth especially in wedding ceremonies. Gold is also a very significant part of the Chinese culture where it is considered to be a sign of good luck as well as lavishness. Moreover, gold is very simple form of saving for people in both these countries where investing in equities is still considered to be too much of a gamble by most. Therefore if the global economy is actually improving, as both Goldman Sachs and Credit Suisse claim, this will make the Indians and the Chinese wealthier and prompt them to buy even more gold which should drive gold price higher.
In addition to the consumer demand in India and China, the global central banks have also been strong drivers of gold demand with central bank demand for the precious metal hitting a 48 year high in 2012. The G20 was afraid to admit it openly but the currency wars are ongoing with most developed nations intervening to devalue their currencies. Both the US and Japan have virtually un-payable levels of national debt which has made global central banks increasingly wary of using the US dollar, the Yen, and all fiat currencies in general as reserve currencies. In the midst of the currency wars and all this debt, the only real winner is gold. Therefore, in my opinion, as the confidence in fiat reserve currencies erodes, central banks worldwide would continue to add gold to their reserves no matter what happens to the real interest rates in the US.
Goldman Sachs also argues that falling bullion demand from the Gold ETFs would accelerate the decline in gold prices. However, in my opinion any fall in the physical gold holdings by US ETFs will be more than offset by the potentially huge demand for the bullion from Chinese gold ETFs that could be introduced as early as this year.
In light of the arguments presented above, I don't think that Goldman Sachs and Credit Suisse's bearish view on gold makes much sense. The fears of an economic collapse, especially in the Eurozone are still very real; the US economic recovery is still quite fragile, and the Fed's monetary stimulus doesn't appear to be ending any time soon which should keep the real interest rates in check. Moreover, the major drivers of gold demand, India, China and the buying from the global central banks should continue to support gold prices even if the real interest rate in the US starts to rise. Therefore even of gold prices continue to face short-term pressure due to over-excitement about the US equities, the long-term fundamentals for investment in gold remain intact. In my opinion, the superior growth in emerging markets including China and India would be the primary drivers of gold prices. In fact, I would recommend a position in silver (SLV) along with gold because silver's industrial demand should continue to strengthen along with its investment and jewelery demand as the Indian and Chinese economies gain traction.
Additional disclosure: I own physical gold.