Gold - Is a Bear Market Coming? Interview with Philip Klapwijk

| About: SPDR Gold (GLD)

By Lara Crigger

Gold, gold and more gold: That was the theme when we sat down with Philip Klapwijk, executive chairman of GFMS Ltd., an independent, U.K.-based precious metals research firm specializing in silver, platinum, palladium, and, of course, gold.

With GFMS' gold research team since 1989, Klapwijk is widely regarded as one of the world's foremost authorities on gold. His expertise includes the general sector, investment and fabrication demand in the Americas and Europe. Klapwijk is also editor of The Outlook for Gold Investment, and helps oversee production of the annual Gold Market Report, which sets the gold market's tone for the year to come.

HAI associate editor Lara Crigger recently chatted with Klapwijk about gold's rising price floor, the demand difference between East and West, and why gold's headed for a bear market.

Lara Crigger, associate editor, (Crigger): The last time we talked, gold had just broken $1,000/oz. These days, it's hovering a bit below that. So where do you think gold's going, and why?

Philip Klapwijk, executive chairman, FGMS Group (Klapwijk): We're seeing a very powerful rally, from gold testing lows of around $905 a few days ago, to now, where we're pushing the $940 level. Following this brief excursion to the upper end of that range, we're probably going to come back down in the next couple weeks to test the bottom of that range, and potentially break through it briefly into the $890s.

That's because, at the moment, gold is being buoyed by a rebound in economic optimism. You've seen stocks picking up, we've got oil back above $60, and so on. But I think those factors are likely to reverse in the next couple of months. Personally, I'm not convinced there's much real recovery in the economy. I think there's been a fair amount of spin and selective interpretation of data, and the real situation remains pretty dire.

Also, we have a large long position on the COMEX, which I think is overhanging the market to some extent, and that will probably reduce in size. These things tend to go in cycles. So I think we're going to see a cycle of length reduction: growth in shorts on the futures market, and a long liquidation phase. That's going to also help us get temporarily at least below $900, or at least test that level very seriously.

So the most likely thing now, I think, is that we'll see gold in the short term move lower over the rest of the summer, which will then set us up for an autumn rally to see us move considerably higher. But we shouldn't lose sight of the big picture, which is that we're seeing a ratcheting up of the floor in gold. I mean, yes, I'm saying gold will test $900, but I do still feel this market is moving higher, and we'll break out of this $900-$950 range we've had for awhile. I just don't see why it should happen quite yet.

Crigger: How are the demand fundamentals looking?

Klapwijk: The underlying state of demand is poor, particularly for jewelry. That's being exacerbated by the seasonal lull we have in July and August, when across the world, the jewelry manufacturing industry is in its seasonally weak phase.

There are one or two points that are reasonably positive. For example, if you look at the floor for the price, which is still being set by physical buyers of gold for industry and jewelry, that floor has ratcheted up. Jewelry market buyers are now quite happy to concentrate their demand at around the $900 level, versus last year third quarter, when the price had to go down to $700/ounce before you really saw good physical demand. So you could argue that the floor for the price has ratcheted up $100-200. That's a fundamentally healthy development.

But that doesn't mean the jewelry demand situation is at all healthy - it's not. If we look at the market in general terms, the fact is that the high price and high volatility, coupled with the weak economy, has really damaged jewelry demand significantly. That means that this is now a market where demand is increasingly dependent on the investor.

Should that investor go away at some point, due to economic or financial circumstances changing radically, you'd require a fairly large fall in the price for the market to reach equilibrium.

Crigger: Is the supply side of gold looking as unhealthy as the demand side?

Klapwijk: The supply situation is not that dire. Even though gold prices have essentially quadrupled from 2001 to last year, mine production during this period has actually declined somewhat. We're also seeing central bank sales on a net basis have declined very considerably.

So those are reasonable positives. But these things tend not to be so black and white. In the first quarter, the price spike generated so much scrap supply - mostly in the form of recycled jewelry - that scrap actually exceeded mine production for that quarter, wiping out all jewelry demand and essentially blunting the rally in price.

So if you stack up supply from mine production and supply from scrap, and compare that with fabrication demand, you'll see this is a market that has moved into massive surplus.

Surpluses in commodity markets generally point to lower prices. But that's not necessarily the case in gold, because investors have been willing to acquire a larger amount of gold at higher and higher prices. What happens when the music stops and investors are no longer interested in owning more gold - maybe even want to get rid of some of the gold they have? That surplus will have to be eroded, by the price falling sufficiently to regenerate demand.

Crigger: That's different than what some are saying, that gold will just keep going up and up and never stop.

Klapwijk: Yeah, but history tells us that's not the case. If you and I had been having this conversation in July 1979, someone would probably be trying to persuade us that gold's going to $3,000. Although I wouldn't say that's impossible, I'd also say you shouldn't bank on a 20-year bull market from here on.

At some point, there will be a renewed gold bear market. But that prospect has been pushed out further on the horizon, due to the Fed's actions and the unwillingness of other political and financial masters to face reality and go through a period of austerity. This is a very different response than the one at the beginning of the 1980s, where belt-tightening happened, and interest rates were raised in the recession - which obviously exacerbated that recession - and the result was that gold collapsed.

The same could happen again, but I just don't think that there's the appetite to go through it the same way, partly because the consequences this time around would be far worse. That's the difference: People are saying, "Well, there's a depression around the corner if we let things take their natural course."

But I think that's something that just has to be worked through. The logic would be to accept the fact that the U.S. probably does have to have 15% unemployment, and lose 10% of its GDP over the next two years. Inevitably there has to be a very significant correction. The U.S. authorities can try and defy it, but they'll just make it worse by creating more inflation and trashing the dollar to an even greater extent - which, of course, means they'll only create a bigger rally in the nominal price of gold.

Crigger: In your recent quarterly newsletter, you talked about the differences between what drives Western and Asian market buyers. Could you elaborate, and explain what impact each has on gold prices?

Klapwijk: Well, some of the differences have been blurred in the past couple years. We've seen behavior converge between Western and Asian investors and the vehicles that people choose.

On the investment side, in the past, in Asian markets, investors buy on price lows. On higher prices, their buying tends to dry up, or they even start to sell off. To some extent, that behavior still holds good for most of the Asian markets - but not all of them. For example, we've seen China behave in a different fashion, with Chinese demand tending to grow notwithstanding higher local gold prices. The reason for that is a secular change in the Chinese market, which has opened it up to investors to a greater extent than in the past. But also you have Chinese investors, much like investors in the West, concerned about inflation and buying gold as a hedge.

Likewise, in Western markets, where people have tended to favor paper gold products or futures, we've seen massive growth in ETFs and physical bullion purchases in the last couple of years. And in terms of reaction to price, Western investors have historically been the momentum buyers, or buyers of higher prices. But we're seeing a greater willingness of Western investors to come in on dips. So these traditional differences are maybe not as great as they used to be.

Crigger: India, the world's largest consumer and importer of gold, just announced it planned to levy much higher duties on gold imports. How will that impact Asian market demand?

Klapwijk: The initial impact has been rather negative, but I think that's mostly psychological. If you look at it in terms of the percentage of duty, it just takes us back to the situation prevailing a few years ago. Obviously, it's increasing prices a little bit, and therefore isn't terribly helpful for demand. But on the other hand, the scale of the increase is really relatively small, and it can be swamped by actual movements in the underlying gold price. Certainly we don't think these duty increases will be sufficient to lead to much smuggling appearing in the Indian market.

Crigger: There's a lot of people saying that it will.

Klapwijk: I don't think there's sufficient margin there to justify smuggling gold. These new rates don't take us to a situation where it pays to smuggle.

Crigger: There's been increasing talk of replacing the dollar as the reserve currency. Should that happen, what do you see happening to gold?

Klapwijk: Gold can only win from the dollar hegemony being weakened. If, with the wave of a magic wand, you were able to create a soundly managed global currency acceptable to all - a replacement for the dollar - then that wouldn't be good for gold. But I find it very hard to see how the world moves so cleanly away from a dollar-based financial system to something else. It would be a very protracted process, and I think that would be helpful to gold.

Crigger: The Chinese are certainly making a lot of ruckus about moving away from the dollar.

Klapwijk: Yeah, they have a very difficult situation there. China has $2 trillion in reserves - by far the largest share of which is in dollar-denominated assets - and $800 billion is in U.S. treasuries. So on one hand, they understand the problem better than most. On the other, their exposure is higher than most. They want to move to something they think is better, but hope that it won't disrupt the status quo too much short term, because, well, they'd end up being a big loser.