The Price of Gold and the Influence of ETFs

The surge in gold prices has encouraged debate as to the future direction of prices. It seems that every week there is a launch of a new Exchange Traded Fund (ETF) aimed at the commodity market. If someone is about to buy or sell a gold ETF or gold bullion, then it makes sense to try and understand the arguments. This article identifies four factors.

The section on emerging market demand relates mainly to Indian and Chinese jewellery & investment demand. Gold ETF demand discusses the growth in the ETF commodity industry and, provides some warnings over future demand. Investor demand focuses on Global investors’ rationale for favouring gold as an asset class. Finally, these strands are put together to create a picture of how someone using an approach based George Soros’ discussion of reflexivity in ‘The Alchemy of Finance’ might view matters.

Emerging Market Demand Boosting Gold in Q2

This is the strongest argument in favour of higher Gold prices. It sees emerging market growth in the context of the expansion of the middle classes in China and India. Both countries have populations disposed towards holding Gold. As their discretionary spending power increases, it is reasonable to expect strong growth in Gold demand. In fact, the trend is already in place.

According to the World Gold Council or WGC, jewellery demand made up 51% of total gold demand in 2009. Of this figure, India accounts for 25% India also accounted for 19% of total net retail investment and 17% of industrial demand in 2009. By early 2010, India was accounting for 29% of global jewellery demand and Greater China 20% It is a similar picture in terms of net retail investment whereby, India accounted for 27% and China for 11% of global demand by early 2010.

In addition, India and China do not possess sophisticated investment markets. There is a lack of other asset classes that their investors would feel comfortable with. Furthermore, the Asian Financial Crises of 1997 has psychologically encouraged them to hedge against currency risk. Gold is seen as a suitable solution. Similarly, both countries run large budget surpluses and have substantial US Treasuries. Gold gives them diversification from this currency risk.

ETF Demand in Q2

The expansion and popularity of commodity ETFs has fed through into Gold. According to the WGC, here is the percentage of total gold demand that is coming from ETFs:

2003 1.2%
2004 3.8%
2005 5.6%
2006 7.6%
2007 7.1%
2008 8.4%
2009 17.5%

The last figure looks dramatic but, should be seen in the context of the extreme levels of risk aversion prevalent in Q1 of 2009. However,the four quarter rolling level is back down to 4.8%

This strong growth is attributable not only to investor demand, but also to structural growth. ETFs are seen as new revenue generators for investment banks and, they have not been actively expanding them in the Gold and Silver ETF market. Increasingly, many have been structuring them with derivative instruments rather than physical gold. This should trigger alerts over the risks of leverage. Furthermore, the increasing use of derivatives will cause the figures for physical demand to be appear less than investment exposure.

The last point will be a concern at the margin, because most of the gold physically held by ETFs is held on a matched basis.For example, the largest single fund, State Streets SPDR Gold Trust, holds between 80-90% of the ETF total and they match physical gold with investor buys/sells. However, the knock-on effects of a liquidity problem with derivatives in gold ETFs should not be dismissed lightly.

Global Investors

Having touched on the specific emerging market investors’ perspective, it is worth considering global investors' rationale for buying gold. They have been favouring gold in a movement towards risk aversion and away from other asset classes. Gold is seen as offering diversification from increasingly correlated asset classes. It has also seen as an inflation hedge. Furthermore, currency volatility and sovereign debt fears have caused gold to be seen as a safe haven.

What about Soros’ Reflexivity?

How might one famous investor bring these arguments together? One of the ideas behind Soros’ book ‘The Alchemy of Finance’ is that asset classes can have self sustaining feedback loops. In this example, as gold prices rise they could cause some kind of underlying trend which then supports more price rises. This continues until the underlying trend rolls over and then the price follows in swift and violent fashion after, a point of inflexion has been passed.

This could be happening with gold. It begins with string underlying price drivers. As gold prices rise, it encourages gold to be seen as a safe haven, which encourages ETF sales and issuance. ETFs start using derivative products to gain leverage, then the price is pushed higher as new investors come in chasing higher prices. Ultimately, this might end as new ETF investors stop coming in for myriad reasons. For example, risk aversion might abate, asset allocators could move away from gold, or retail investment demand could dry up. Jewellery demand could decline due to high pricing or substitution.

As prices start falling, the leveraged ETF players using derivatives might then find themselves in trouble, and the fall could turn into a bust. With this in mind, it is worth noting from the ETF section above that, the share of demand from ETF’s fell to 4.9% from 17.5% from Q1 2009 to Q2 2010. Interestingly, the price of gold still went up 21% in that period, even though total demand fell 9%

Might this be Soros’ inflexion point? It is hard to say for sure, but this article outlines the way that investors could try and discern the underlying patterns.



"Sources"


Soros,George “The Alchemy of Finance” John Wiley & Sons 2003
World Gold Council “Gold Demand Trends” Q2 2010

China's Foreign Exchange Reserves and its Effect on the Global Economy

For foreign exchange investors one of the key issues facing the currency markets will be the future behaviour of China, India and the rest of the Far East. They hold huge foreign currency and gold reserves, particularly, if measured against their GDP. They maybe holding them in order to provide China stimulus. Similarly, it may be part of a movement toward a one world currency.

Whichever the reason, they are hoarding reserves and the implications are significant. The hoarding creates a global structural imbalance between countries that are savers and investors. As a consequence,many see the need for the Asian countries to start spending and stop saving, in order to bring the imbalance back.

China Foreign Currency Reserves and GDP. One World Currency?

This article explores the issues of how and why they are saving. Firstly, here is a selected table of foreign exchange and gold reserves as a share of GDP (trillions) courtesy of the CIA:

                FX & Gold Reserves                GDP       Reserves as % GDP
China                  2.42                               4.8                  50.3%
India                     .28                               1.1                  25.4%
Japan                 1.02                                5.1                    20%

S Korea               .27                                 .8                     33%
Brazil                   .24                                1.5                    16%
Germany              .18                                3.3                   5.4%
USA                    .13                              14.4                      1%

China is the outlier and will be the focus of attention. In addition, India reserves are large and growing rapidly.

The Growth in Emerging Market Banking

In 2009 the Financial Times ran a cover story about how Asian bank ICBC had recently become the world’s largest bank by market cap and deposits, but yet held only about half of the assets of JPMorgan. This illustrates the fact that the amount of credit available and savings rates, is related to the relative sophistication of banking systems.The Asian banks tend to have lower assets/deposits ratio.

Indeed, the ideal ‘halfway house’ solution to the banking crisis could have been extensive investment and involvement into the banks by the Asians. The banks get the cash, the Asians buy the expertise. Unfortunately, Lehman Bros failed to pull off the deal with the Koreans and, the rest is history.

No one would argue for a repeat of the sub-prime debacle in Asia but there needs to be some changes. The point is that spending/savings rates are directly affected by the availability of credit and the nature of the banking system. As Asian banks become more experienced at securitising loans, then it is likely that decreased savings rates will follow.

Culture & Demographics in China and Far East

Demographic issues are obvious issue, particularly with the population aging, in Japan. Japanese pension funds needing to match liabilities and older people require short term, low risk assets. If compounded with their conditioning towards bonds (in particular US Treasuries) after being in a long term deflationary economy, then the result is a willingness to save at low yields.

More subtle is the understanding that the continental Europeans and Asians have differing cultural orientations to the Anglo-Saxons. They are more egalitarian in wealth distribution, and the Japanese seem to be entirely happy to preserve their cultural predispositions at the expense of economic growth.

This facet of wealth distribution has implications for relative spending patterns between egalitarian & Anglo-Saxon economies. The evidence suggests that it is the wealthier individuals (who hold a larger share of wealth in the Anglo-Saxon economies) that take the larger part of debt, so it is hard to see a structural shift here, anytime soon.

The Asian Financial Crisis and Foreign Currency

The most problematic of the savings patterns is the Chinese and other Asian growth economies. Objectively, they are nuts to buy US Treasuries. Why would anyone swap investment in their own higher return economy for lower return US debt?

The first answer is that they are buying US Dollar assets in order to weaken their currency and thus support export demand for their industries. The second is in understanding the policy intent following the Asian Financial Crisis. China currency manipulation in order to peg to the dollar is a clear policy objective,made, in order to protect against the mayhem caused in 1997.

However, what happens if the Chinese get emboldened from the use of their reserves to generate domestic demand, as opposed to paying for the bail outs? What if they- in the face of slowing US consumption- decide to pull out of buying US Treasuries, and encourage the (increasingly economically interlinked) Japanese to follow them? Many see this is a possible scenario.

China Stimulus and Government Spending

Who is spending what is also a critical concern. For example, free marketeers believe that the private sector is usually more efficient. It is not just about matching savings and investment. It is also about who is doing the saving and investment. Economic liberals don’t like Government spending, whether it’s in the US or China.
They would see hiking public spending (at the expense of private) as a portion of GDP is a drag on growth, in itself.

The big China story is about realizing the nascent energy that was held back by Communism. In doing so, they allowed the influx of Western know-how and, Chinese consumer demand was critical in that process. The China story is not about how wonderful the central command economy was, so ‘let’s have some more of it.’

China Domestic Demand

In addition, what happens when the Chinese/Asians start generating significant domestic demand? Will they operate an open economy in this regard, and contribute to global growth, or will they replicate the Japanese corporate model? This involves internal competition, but also doing anything they can to avoid competing with each other in foreign markets. Meanwhile, the Government protects them from foreign competition, by engaging in restrictive trade practices. It is not clear that increased Chinese spending will boost western export markets.

Global Economy

So in conclusion, the global economy does need the savers to start spending, but the outcome of it, is far from clear. The west may have been free market oriented and universal in its outlook, but it doesn’t mean that the Asians will be. However, given the interlinkage in the global economy the likelihood is, of continued international coordination. The graduated shift in approach from the Asians (in relation to buying US debt) should enable piecemeal restructuring elsewhere, however it does suggest risks of low global growth over the next few years.


Source:
CIA "The World Factbook" CIA website