The world Gold Demand Trends report for the 2nd quarter 2012 was released by the World Gold Council (WGC) last week and it shows why gold prices are flat: Lack of basic demand and investor conviction that gold is on an upward path. If gold is a bubble, the loss of confidence that gold will always go up is death.
The recently reported (but at least 45 days old) purchases of Gold ETFs (GLD) by George Soros - who said gold was the ultimate bubble - is suppose to show that investor attitudes are changing and better times are ahead for gold as the world spirals into "Financial Armageddon". We'll look at what Soros and (perhaps) John Paulson might be thinking at the end of this article.
So how bad was gold demand in the second quarter? Bad enough that the WGC started comparing results to the "5 year average quarter" to get good news. The WCG analyzes things in a way that makes it almost impossible to get more than a vague idea from the report of what the exact supply and demand situation is for gold. To get a clearer picture of what's happening in the gold market, we've separated basic gold stock changes from investment supply and demand.
Basic stock increases/decreases are the net of new mine (basic) supply less actual manufacturing (basic) demand. This is a reasonable measure of whether there are basis supply shortages or excesses that might influence gold prices - Note that recycled gold is a secondary and less accurate data source that does not reflect a fundamental increase in the total amount of gold available for investment.
If basic supply is greater than basic demand, then any rapid changes in price are due to speculative investment flows, not supply shortages. (I know I know, it's not speculation because gold is MONEY, MONEY, I tell you. If gold were money things would be simpler but gold is a more complicated central bank reserve.)
The chart below shows the annual change in basic demand over the last 11 years, with the final year the 4 quarters ending 2nd Q 2012. Basic manufacturing demand has been dropping since 2005 and was exceeded by mine supply in 2009 - a pretty clear basic oversupply situation.
The trend has accelerated in the last year. Q2 '12 vs. Q2 '11 manufacturing usage plunged 13%, led by a 14% drop in jewelry and a 5% drop in technology. From Q1 to Q2, mine production was up 6% and manufacturing usage dropped -12%. In the last four quarters, mine production was up 2% while manufacturing demand decreased 12%. Details are in the table below.
As a result, gold available for investment rapidly increased in the 2nd quarter as the basic excess gold stock increased 176 metric tons which added to the 364 metric tons of recycled gold, resulted in supply that had to be absorbed by investment increasing 19% Q1 to Q2 and 21% in the last four quarters. The drop in the price of gold may have depressed the amount of gold being offered for recycling as it was down -8% Q1 to Q2 and -12% Q2 to Q2 - or it could be that the jobless in Spain, Greece, etc, have run out of gold to pawn.
Increased official sector (central bank) purchases of gold probably prevented a really serious drop in gold pricing due to excess supply - though the -5% Q on Q drop (-11% from the peak) was not pleasant to anyone who bought wrong in the 3rd quarter.
Private investment demand was up 14% on a 4 quarter basis due to the mania blowout purchases during the third and fourth quarter 2011 but dropped -23% Q2 to Q2 and -26% Q1 to Q2. Next quarter the drop will be even greater due to the comparison against the large 3rd quarter 2011 purchases.
As investment is done at the margin, the drop in private investment could have pushed gold prices down even more but central banks came to the rescue with increased purchases of 138% Q2 to Q2, 63% Q1 to Q2 and 144% in the last four quarters. Even with these large central bank purchases excess gold has had be absorbed by OTC investment and stock flows (the OTC number appears to be a plug that the WGC uses to balance supply and demand).
The central bank purchasers of gold appear to be doing this to (correctly) achieve diversification in their reserve portfolios with a target percentage of around 15%. Unfortunately, this means at some point central bank purchases will be done.
A major concern on future demand is China which now purchases more gold than the entire West combined. China investment demand dropped 4% in the quarter which the WGC attributed to a lack of "conviction". A typical quote is this explaining the 4% drop in China investment demand: "Chinese investors prefer to invest into a rising gold market, as a clear uptrend reinforces their conviction in the investment." Hmmm - so non-Chinese investors look for declining trends in gold? That's so stupid that only central banks would do it - oh, wait - Central banks are the only group still increasing purchases of gold.
A better explanation for the drop in Chinese purchases is that Chinese private investors now have more options outside of gold to invest in. In addition, the Chinese government seems to have switched from being concerned with inflation (where the drain of money by nonproductive gold investments is a positive) to growth, where gold purchases are a money draining negative.
The "confidence" issue or investor's conviction that gold prices are going up is important if you believe in Hotelling's rule on commodity pricing which concluded that as long as the price of a commodity was believed to be going up, the value would go up or down with changes in the cost of storage, that is, the real interest rate (interest less inflation). This rule was very good at explaining the increases in gold from December 2008 (a Hotelling moment) to February 2012 but seems to have broken down since then (a reverse Hotelling moment), possibly under the pressure of the basic oversupply.
The report supports the notion that investors have lost the critical belief that gold is on a sustained upward path. In this case, even further Fed easing of interest rates may not push gold significantly higher. (Note: I'm not saying that there will not be a significant gold rally due to easing, just that there is not a clear relationship with interest rates that would drive prices higher.)
If there's nothing to indicate that there will be sustained gold price growth in the future why is Soros buying gold?
The answer is in gold's proven performance as a "safe haven" asset that moves contrary to financial assets. Soros has completely sold his bank stocks and moved into gold to a limited extent. This makes sense if he believes that there's going to be a major fiscal crisis within his investment window (probably involving the breakup of the euro but possibly just the Grexit). In order to get benefit from safe haven investing, you must buy the asset before the crisis - even one day late and there's no financial advantage. (If you're going to get a vaccine against the plague, you need to do it before you catch the disease.)
In conclusion, it appears there is a short-term play for gold as a safe haven asset even though the long-term outlook for gold is poor. As Soros probably bought in the $1500s, there's some question as to whether safe haven investing can be profitable at current levels (probably) and what the time frame is for the financial crisis that Soros envisions.
The investing strategy is simple: 1. Buy SPDR Gold Trust EFT (like Soros and Paulson did - you need a large fund that can handle financial turbulence); 2. Sell shortly after the crisis when everybody else is buying. The complementary trade (that Soros seems to be doing) is to sell your financial stocks now and buy back after the crisis has knocked them down.
If we just had a clue as to when the inevitable breakup of the Euro was going to occur this would be an easy strategy. These things take longer than it would seem possible - Paulson had to wait years before the effects of the housing bubble made his investments pay off.
Perhaps the Troika will recognize that it's mathematically impossible for Greece (and the other PIIGS) to come out of recession with austerity? Probably not - the next Troika report is due at the end of September with a meeting of euro-zone financial ministers scheduled for October 8.