The role of gold as liquidity insurance...
WITH OVER 15 years of experience as a global economist and strategist, Nicholas Brooks is head of research and investment strategy for ETF Securities, the UK-based provider of more than 200 exchange-traded products in equities, currencies and commodities.
With Gold Price volatility making headlines with its recent sell-off and more recent recovery, Hard Assets Investor caught up with Brooks to discuss why gold is seemingly losing its safe-haven status and appeal during times of uncertainty. Brooks also discussed China's growing prominence in the gold market and whether the yellow metal will finish 2012 in the black for the twelfth-straight year.
NB This interview was first published May 23.
Hard Assets Investor: We've been seeing a sell-off in gold for the last week or two and now we are seeing a bounce back. Is this more of a technical reaction for gold?
Nick Brooks: The reason we saw the Gold Price bounce was a combination of macro and technical factors. From a macro perspective, the weakness of some of the data coming out of the US and Europe last week — along with some of the comments coming from some of the members of the Fed, as well as the ECB and as the Bank of England — are indicating that further monetary easing is more likely than investors were factoring in just a few weeks ago.
Clearly, any sign that there'll be a QE3 or more aggressive easing by the Fed, ECB or by Bank of England certainly is bullish gold. The main driver of the Gold Price on a medium- to longer-term basis is gold as an alternative to fiat currency. Investors who are concerned about the decline in the real purchasing value of the world's major reserve currencies are looking at gold as a hedge and looking at it as an alternative store value.
Then, technically, net-speculative futures positions were down to a level not seen since December 2008. Normally, traders will focus on things like that, recognizing that there's a little more upside than downside in the near term. Short-term traders were going to take advantage of that.
HAI: What can investors learn from gold's sell-off?
Nick Brooks: Investors have been moving to the sidelines, raising cash and buying G-3 [US, Japan and German] bonds. When they do that, they sell pretty much everything else. And that includes gold. We've seen that multiple times over the past 10 years. The most recent big episode, of course, was 2008, when the Gold Price dropped nearly 40 percent. There was massive deleveraging and a rush into cash and, you know, a rush to liquidate anything that was liquid. And gold tends to be very liquid.
But even during less-severe risk-aversion moments or events, we've seen this because gold is generally held in most investors' portfolios, as part of the so-called risky asset pool. It's that issue that causes a lot of confusion to investors who are new to gold, because they hear gold is a safe haven. Gold is where you go when the world is falling apart. And then, when the world falls apart, the Gold Price drops 40 percent. What's going on here? Something is wrong.
But it's just the nature of the markets. And again, I think a key point to make about gold is gold is not a substitute for cash — or, for now anyway, for G-3 bonds. Investors will generally liquidate gold during the initial phase of a risk-off event — as well. If this crisis continues on its current trend, if it looks as if Greece is genuinely going to leave the Eurozone, and it looks as if there's going to be some form of contagion to European financial institutions and possibly other sovereigns, then investors will start looking at gold as an alternative store of value to holding the Euro. Gold's price will likely bounce strongly in that environment similar to what we saw back in the early part of 2010 when the Greece issue really started to come to the forefront.
This environment is in my view frankly potentially a tremendous opportunity for gold investors, in that the Gold Price has sold off pretty aggressively. Net speculative futures positions are back at end of 2008 levels. And it seems pretty clear that the problems in Europe are not going to go away anytime soon. With gold generally viewed as the main "hard asset" alternative to holding the world's currencies — even by central banks — you'd think that gold would be a key beneficiary if things were to unravel a bit further in Europe. We're at quite an interesting point right now in the gold market.
HAI: Many gold investors are asking why isn't the gold going up with all this uncertainty? And what about the view that central bankers are keeping Gold Prices down?
Nick Brooks: Central banks are supporting the market, if anything. They have been large net buyers of gold since the second quarter of 2009 and they were buying in size in the first quarter of this year. It's the private investors who have been selling because they want cash as part of a general risk aversion move and because they want liquidity to cover losses in other parts of their portfolios.
Gold is a highly liquid asset. We saw that in the second half of 2008. People could sell gold without any issue. They were having trouble selling some of their other assets. So gold is also used as a place to get liquidity during a crisis. It's like your insurance money. You need it, you have to take it out and spend it. And then, when things calm down, you start building that insurance back up again.
The reason the futures market is important is that, in the short term, futures investors can have a big impact on the gold market. If you look at underlying futures trading on Comex relative to underlying physical trading on LBMA [London Bullion Market Association], it's still pretty small. But futures investors, in the very short term, do play an important role in affecting price. You can just see that by looking at the relationship between the gold spot price and positioning in the futures market. There tends to be a relatively strong positive correlation between the two. Of course, when positioning moves to extremes, say measured by standard deviations either long or short, often it is a signal that the market is ripe for reversal. We are currently on the lower side of the positioning spectrum.
HAI: Do you think gold is going to end the year in the black for the 12th-straight time?
Nick Brooks: If the situation in Europe continues to deteriorate and continues to develop the way it is currently developing, where it's looking increasingly likely that Greece may be forced to leave the Euro, or certainly come very close to that. Plus, we have potential problems in the US with the budget-ceiling debate coming back again, and other issues related to that in the US that could also raise sovereign concerns here. It would seem pretty clear to me that the Gold Price will benefit from either or both of those two events.
And, on top of that, I think that there are clear indications that the US, the U.K. and the European central banks are going to remain in very strong easing mode and potentially move to implement further quantitative easing. And that would also be supportive of the Gold Price. So assuming all those conditions remain in place, I think the Gold Price will likely come back later this year and end the year pretty clearly in the black.
HAI: What would prevent that?
Nick Brooks: If it appeared that the Greece problem was going to be solved decisively; and that the ECB or another institution was going to move very aggressively to guarantee European banks and other sovereigns in a credible manner, that European and global interest rates were about to embark on sustained, growth-driven uptrend, then I think the Gold Price would be smacked pretty hard. But I would put a relatively low probability on that.
HAI: Part of the World Gold Council report you mentioned earlier extrapolated that China is going to soon be the No. 1 gold consumer. How does the gold market work in China, in terms of pulling it out of the ground and where it ends up?
Nick Brooks: China is the world's largest gold producer and it's expected that this year, it will also likely become the world's largest gold consumer. Therefore, the bulk of production, gold production in China stays in China. Now a lot of that will go straight into the jewelry market in China itself and small bits of it, not large portions of it, do go into industry. The rest, of course, is used for investment purposes — such as their own domestically produced gold coins or gold bars; both of which see very, very strong demand in China.
Certainly, a portion of gold demand is from government-related investment bodies. The problem of course — and this is just not an issue in China — is you're not always sure how much sovereign wealth funds and other government-related institutions are buying and when they're buying it. Now in the West, of course, they're very transparent about central bank buying of gold, and the IMF releases those numbers regularly. In China, it's not always so clear when the central bank is accumulating gold. For example, in 2009, they announced a very large increase in their gold holdings. But that had been accumulated over five years.
So no one really knew what was going on in that five-year period, or where the gold was being held. But I think there is legitimate speculation that China's central bank, since it has very small amount of gold relative to total foreign-currency reserves [somewhere around 1.7 percent], is likely or would likely want to increase its overall holdings of gold, particularly if they want the Chinese yuan to become one of the world's reserve currencies at some point.
It's always hard to get clarity on precisely how much gold China is consuming. But one statistic often looked at is that China imports its gold through Hong Kong. Those numbers exploded in 2011 and, in the first quarter of 2012, have also been growing at an extremely fast pace. Certainly, part of that is going to meet growing demand from the man on the street in China, to hold gold as part of their portfolio, as part of their savings.
HAI: How do you compare China to India, where there seems to be a little bit of a different mood with how gold is being treated?
Nick Brooks: India earlier this year introduced an excise tax on gold jewelry, and they also raised the import duty on gold. And the excise tax, in particular, led to jewelers in India going on strike, which led to a very sharp slowdown in gold imports into India. This was also exacerbated by a weak rupee, which meant, of course, the Gold Price was much higher in rupee terms. So there was a very sharp slowdown in Indian gold demand, which I think certainly affected sentiment for gold, because India has still been the largest gold consumer globally.
However, the excise tax has now been removed. The import taxes are still in place. But that's been enough to get jewelers to stop striking. This should help shore up gold demand from the jewelry sector, particularly as there is likely to be some pent-up demand following the strike. Therefore, while the weak rupee may temper the increase, there would appear to be scope for a pickup Indian physical demand, which would also be supportive of the Gold Price later this year.
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