Investors are facing a range of threats. Should you buy gold to prepare, and if so how much...?
INDEPENDENT RESEARCH commissioned by the World Gold Council and released earlier this month found gold performs relatively well compared to other assets in a high-inflation scenario as well as in a deflationary period.
In this interview, World Gold Council Managing Director of Investment Marcus Grubb speaks to Hard Assets Investor Managing Editor Drew Voros about the study – conducted by Oxford Economics – and its implications for investors.
Hard Assets Investor: Why don't we start off by having you briefly just tell us about the Oxford Economics report?
Marcus Grubb: Absolutely. With the current backdrop of financial crises in a number of places around the world, we started to see there are a lot of investors looking at different scenarios of strong recovery, weak recovery, inflation, disinflation, stagnation or even deflation.
We felt that there was a real opportunity to commission research that would deliver powerful insights into what kinds of scenarios investors might be facing this year, going into 2012 and beyond, and then adding gold into that mix.
HAI: What key fact should we take away?
Marcus Grubb: Let's assume a benign scenario, something akin to 2% GDP growth with 2-2.25% inflation, which investors would regard as a fairly favorable one that would be a return to a more normal world of lower unemployment, less output gaps, sustainable but moderate economic growth as well as sustainable inflation.
That's a scenario that many in the market might argue is not so positive to gold. The result [of the Oxford study] showed an optimal allocation to gold, even in that scenario, is 5% of a portfolio. While we have research that demonstrates that, this demonstrates it from an independent perspective.
There's a second conclusion, which is perhaps again surprising. When you look at the deflation scenario — which would involve some shocks to the world's economy — the study suggests that the allocation to gold in that scenario would actually be higher than 5%. It could be as high as 9% in an optimal portfolio, which would probably have a lot of fixed income, a lot of Treasurys, a lot of bonds, a lot of cash, but it would also have gold in it.
Analysts have always struggled to understand what deflation would mean in terms of asset-allocation strategy — in particular where gold is concerned, because the only real instance you have of that is in the 1930s when gold, of course, was not a freely traded asset and you had the gold standard. So you can't really look back in the past and try and find out what happens to gold in deflation.
This econometric model, with a backtested equation on gold as well as the other asset classes, suggests that you would actually have a higher weighting in deflation to gold than even in the benign scenario.
HAI: If gold is such a useful weapon in both inflationary and deflationary models, why wouldn't the allocation recommendation be a little higher than even 9%, especially in the times that we're at right now?
Marcus Grubb: The scenarios [regarding assets allocation] that we asked Oxford Economics to look at were quite clearly delineated. They looked at the base case, a sort of benign return to normalcy and that, as you heard, was 5%.
They then looked at a high-inflation case. It suggests an even higher weighting to gold. In that case, the gold weighting goes as high as potentially 17% in an optimal portfolio. They then looked at stagflation, which is less positive for gold, but it's more aligned with the base case. And then they looked at deflation.
So it means, as you rightly point out, the spread of potential gold weightings in an optimal portfolio is anything from 5-9% to up to 17%. And yet you could create scenarios where gold might be even more favored than that. But those scenarios probably would look pretty ugly.
HAI: What fundamentals for gold do you see as temporary right now, and which ones are the more long-lasting?
Marcus Grubb: This is where I would come back to a more fundamental view of the gold market, rather than discussing the findings of the report, because they aren't fundamentally related.
It's been clear for some time that gold is a traditional Western investment, and to some extent now there is an added element of fear in that trade, because of sovereign debt issues in Europe and because of the uncertainty of the economic growth in Western countries; in particular, the US, but also Europe.
But it's always worth remembering that it is an Eastern or Asian super-cycle or growth trade, because those are cultures that invest in gold. They Buy Gold jewelry. They have a strong cultural affinity with gold. And now together, China and India account for more than 50% of the annual physical demand for gold.
These are countries where the average household may well be 5-10 times richer in the next 10 years, where the urban population is going to increase by several hundred million just in China and another 100 million in India. The average age of the population in India is 25 and the savings rates are on the order of 25-40% of their income.
I think a lot of the time in Western countries, we're looking at the macroeconomic scenario, treating gold as a sort of macro-asset class as a hedge against risks, and a currency. But Eastern investors are seeing it as a savings and a wealth-accumulation vehicle on the basis of economic prosperity.
HAI: What are some of the temporary conditions?
Marcus Grubb: If you look at the state of public finances in Europe, it's now clear that a number of countries will be in crisis again in the future unless there's a comprehensive solution and transfer of wealth from the wealthy large economies to the smaller peripheral economies. I see that is a key short-term driver, but it's also a theme that is not likely to disappear in the next few years. I think it is a longer-term driver as well.
And in the US, although the bonds market doesn't seem particularly perturbed, the debt-ceiling debate and the austerity package are coloring the debate. Weakness of the US economy, whether or not growth is sustainable and unemployment will fall, are issues, too, I believe are having an impact [on Gold Prices ].
HAI: Speaking to that, there was an interesting piece in the Wall Street Journal, the gist of which was that a logical response to a US default would seem to be a broad Treasurys sell-off. But some argue that buyers would resurface if the nation's debt problems stoke enough of a broad base reduction and risk appetite. A sell-off would likely push interest rates up broadly, which could spark selling in alternative safe havens like gold. Do you agree with that hypothesis?
Marcus Grubb: No I don't. I think the only thing that might mitigate the attractions of gold in that hypothesis is if there's a clear resolution to the issues in the United States around the federal debt ceiling and a longer-term path towards a more manageable debt-to-GDP ratio in the United States.
A spike in rates would actually be bullish for gold, not bearish. The bigger concern for gold is a policy shift occasioned by a return to growth that reinstitutes a positive real interest rate. Then, of course, gold is more challenged because it has no yield. And it wouldn't only be challenged in that scenario, but clearly it would be less attractive.
HAI: What can ETF investors take away from this study?
Marcus Grubb: I'll confine my comments to the 100%, physically backed ETFs. I don't see any dichotomy here, or splitting of the conclusions. The findings of this report really concern physical gold, and what this is saying is very much that it's a physical gold investment that seems to be positive in a portfolio context in these different scenarios, not a synthetic one.
HAI: We recently had an interview with Steve Cunningham, who's the director of research for the American Institute for Economic Research, and he talked about how gold and silver are no longer in the same asset class. Do you agree?
Marcus Grubb: I would say that's always been the case. They are substantially different. The reasons are both from a fundamental perspective in terms of demand-supply dynamics and drivers in diversification. If you look at mine production in silver, it's up 50% in the decade and gold is flat. If you look at reserves underground, there's a lot of supply of silver to come.
Gold is in deficit in that sense. Those demand-supply fundamentals are very different for gold than silver. Silver is also a heavily used industrial metal, gold is not. That is different. There are also some big differences in that silver is very much a leveled asset to gold and it has a higher volatility. In terms of liquidity, silver is a thinner market as well. So I would absolutely agree on every level, both fundamental and technical, that they're different asset classes.
HAI: Do you think it's a mistake to buy silver in hopes that it will follow gold?
Marcus Grubb: Yes. They have very different risk-and-return characteristics. That would be a potentially dangerous assumption.
HAI: What kind of impact have peak Gold Prices had? You've touched on the flat production and exploration. Have peak Gold Prices changed that atmosphere at all? Are the miners and others feeling that this record-price territory is fleeting?
Marcus Grubb: My interpretation is that the gold market is a metal in deficit, not in surplus. And that is based on the fact that although mine production is rising currently, it's rising at a slow rate. On a 10-year basis, it's flat, which is very different from other metals.
Even with a record price and very high levels of exploration spending, you are not seeing the level, the size of discoveries that were seen two decades ago in gold. There doesn't seem to be a lot of new supply coming down the pike, as it were, as a result of the high price and high exploration spending.
Equally, you're seeing the cost of gold, in terms of the mining costs, remaining elevated because other commodities used to mine gold are expensive. Admittedly there are producers in surface mines and newer properties where the gold is accessible. But with a lot of the large deposits and the deeper mines, your marginal costs of production are much higher than that.
I see a market that struggles to meet demand. And that's why, for example, roughly 40% of gold demand is now met from recycling. And recycling last year fell by 1%, even with high Gold Prices.
Many observers look at that and say, "This is a market where a lot of supply could come on very quickly." I think the fact is that recycled supply is actually quite inelastic. And therefore, I look at it differently. I say no, this is a market where there's latent demand, and you need 40% of the supply to come from recycling because mining production cannot keep up with the demand.
HAI: What spurs gold production? Is it a lower Gold Price, because a higher Gold Price doesn't seem to be doing it, right?
Marcus Grubb: I do think the constraint is, to a degree, a geological one. In a sense, it's independent of the price. If the reserves of gold were more flexible to the price, you would actually see that in the response in the mining sector, just as you do in oil and other commodities. As the price rises it tends to make more discovered reserve economically viable. Therefore, the level of reserve increases, and those get brought into production, and production increases.
First of all, there's geological constraint in gold. They're not finding enough of it. And secondly, as far as I'm aware, every available source of new supply is being brought on as quickly as it can be where it's economically viable; for example, exploiting deposits of old mines, reopening old mine shops that were not economic before. There's a great deal of activity in these areas, but it isn't delivering the rise in production necessary to meet demand.
HAI: Thank you for your time, Marcus.
Looking to build your position in gold? Cut out the middleman – and cut down your costs – when you buy direct through BullionVault...