Investment demand and real interest rates are the keys to understanding the precious metals markets...
FUNDAMENTALS are important in the long run, says Paul Walker, global head of precious metals at consultancy Thomson Reuters GFMS. Over the short run, however, silver and Gold Prices are being driven by investment and low or negative real interest rates, as he explains in this interview with MineWeb's Geoff Candy.
Geoff Candy: me live from the 2012 Mining Indaba in Cape Town is Paul Walker. He's the global head of precious metals at Thomson Reuters GFMS, and is according to his presentation a lapsed fundamentalist. What exactly does that mean in the context of precious metals?
Paul Walker: Well I think it means that when you look at the underlying supply and demand fundamentals – if you look at mine production, add in scrap and compare that to what's happening into demand, you won't always be able to explain the trajectory or understand the trajectory of the price. Take the people back to the 1990s when there was this thing called "the gold gap" which is this difference between what was coming out of the ground, what was coming out in scrap and where demand was. And demand was significantly larger than these other variables and if you looked at that gap you said "well there's a deficit in this market", to use the parlance of the base metals industry, you'd have expected Gold Prices to have gone up.
Quite the opposite was happening – Gold Prices were under relentless pressure in the 1990s. Fast forward to the 2000s and what have you seen – fundamentals that would in the case of say platinum, have dictated the price that should have if anything have been softer or under pressure, we suddenly saw platinum prices going to $2200. What on earth was underpinning that? It had actually very little to do with the core underlying fundamentals of these markets, and everything to do with investment flows into the market. And I think until analysts and the Gold Mining and the platinum mining industries can get their head around this conundrum, they'll never really understand why their product price does what it does and that's kind of what I was trying to address in my presentation.
Geoff Candy: What does that mean then for platinum prices and PGM prices in general, and Gold Prices as well because clearly prices are high in the gold sector and people are trying to guestimate now whether or not prices are likely to go higher, or not.
Paul Walker: Well in the case of gold, if you were to look at the core traditional underlying factors that drive Gold Prices – this is mine production and scrap versus say jewelry demand, which has always been – certainly in the last 25 years – the biggest consumer of gold. It's got nothing to do with that. The gold market now, as I say to people, is about investment and investment and investment.
Unless you understand why people are making the decisions to invest, not just in gold and people like to dress up in this kind of mythology of gold as "asset of last resort" and so on and so forth. I don't really buy that argument – there's an element of it, but the core underlying reason for people investing in gold is a search for yield, search for yield through capital appreciation in a world in which interest rates are close to zero or negative in real terms. And if you have a look at each of the single biggest markets in Gold Investment over the last 10 years – I'm talking about the US, Europe, the UK, China, India – what's the common denominator amongst all of these markets... its negative real interest rates.
And if you have a look at markets where you've had a very positive real interest rate environment, South Africa has had a positive real interest rate environment for much of the last 10 years, Gold Investment here has actually been fairly indifferent given that – as a lapsed South African as well as a lapsed fundamentalist – but as a lapsed South African as well I grew up with the Gold Price on the front page of the Argus and the Cape Times and every news broadcast.
Why is it that South Africa hasn't picked up the gold banner and run with it in the way that the Chinese and Indians have? And I'd argue there's a very simple explanation. It's not that we don't have an affinity for the metal – it's kind of in our life blood here. It's because people go "Hey I can put my money in the bank and get 9% nominal, whatever its going to be, 2% or 3% real interest rates, I'm not going to do that in the case of gold."
Because in South African Rand terms if the nominal interest rate is 10% the Gold Price has to go up by at least 10% in South African Rand terms, just to stand still. That's the big issue for me and I don't think we've really fully appreciated that these markets have now moved into a stage where the fundamentals are still, in the long-term, going to be important. Don't get me wrong, I'm not saying they're irrelevant, I'm saying they're not that important in terms of the short-term drivers of these markets.
To make one last point – take the PGM market in 2008 – I stood up in Joburg – and I don't regularly stand up and claim that I'm right, but I stood up in Joburg in April 2008 and said "platinum will be in a surplus this year and Thomson Reuters GFMS data consistently point to the market for platinum having been in surplus 2007, 2008, through to the current market place. Yet platinum prices rocketed in early 2008 $2200. Was that to do with the fundamentals? Absolutely unequivocally not.
Did it have to do with fear about South Africa? Sure. But it didn't have anything to do with the real fundamentals of what was happening on the ground. The market was in a surplus. There was more metal being generated from mining and from the above ground stock – talking scrap mainly than was actually being consumed in physical products like auto catalysts.
There was a surplus of metal and there's a surplus of metal in this market today. You would have expected prices, all other things being equal, to have gone down in 2008 – they didn't – they went up. Why, because of investors and you have to understand why investors are getting into this market and I think from the producer perspective and that's very relevant to this Indaba – until producers get their heads around the fact that the price of this commodity is not going to be dictated, certainly in the medium-term, just by the underlying fundamental drivers of whether China is going to put more copper into wiring, or put more steel rod into something, or use gold in gold bonding wire, or silver in contact or PGMs.
That's not what's going to determine where their price actually sets the level of that price over the next three or four years. It's going to be all about investments.
Geoff Candy: Where is this investment coming from because I think that's a large portion of the conundrum at the moment – if one looks at China for example, people talk about the rise of the retail investor in China for example, for gold. What is the make-up, what is the nature of these investors and what is the reason behind it?
Paul Walker: I think the answer is actually a fairly simple one. Your average Chinese punter, and the Chinese have an appetite for taking speculative positions in markets without wishing to cast aspersions – it's just a reflection of the reality there. The Chinese have lived in a world of negative real interest rates for much of the last 10 years. They've sought yield, firstly through property, through the massive rallies we've seen in equities there, and the ups and downs of that, most Chinese have recognized, as has the government, that there's probably bubble, there's probably peaking and is in the process of deflating.
How quickly it deflates remains to be seen, but people are searching for yield. And I saw this interesting presentation in Dubai a couple of weeks ago during an investment conference I was speaking at there. One of the guys from a hedge fund stood up and said "we're about yield; we need yield, that's what is our kind of life blood."
How do we seek out yield in a market like today? And it's about a market in which you can't get rate of return from putting your money in the bank, equities depending on how you want to value equities, I can spend a lot of time speaking about why I think they're over-valued. Bond markets – we're in the midst of the biggest, trust me, the biggest bond bubble ever in the history of mankind. I wouldn't go anywhere near a bond if you paid me and I think other investors think "well where do I get my yield?"
You look at other asset classes and the hard assets started with housing. Housing is the most natural conduit for this because we're all familiar with it. The Chinese to the South Africans to whoever – we're all familiar with it so we invest in housing. So we get yield through that and we think we're wealthy, and then that starts to reach a peak and you say well where else do I get it.
Commodities have been a natural conduit for these flows and there's been a feedback cycle here. As the commodity cycle has improved, so people have seen this coming onto their radar screen. People have been pushing at ETF products, investment products have come out, so what do you end up with?
You end up with a market that becomes self-perpetuating. But it's all about investing and positive expectations being fulfilled and as long as interest rates stay low and before anybody again accuses me of being a bear in these markets, I repeatedly say this. I've been bullish on gold for 10 years – Thomson Reuters GFMS and GFMS before Thomson Reuters bought us – we've been consistently bullish on gold since 2002, but there is an underlying dynamic in these markets that tells me that it's not sustainable. And that's the key thing to bear in mind here. It's all about yield and people seeking out yield...
I know I'm rambling here, but it's something I feel quite strongly about. If you look at the intersection of the supply and demand – the real fundamentals that most people talk about – where does investment play a role here? Well at the margin, $500m investment into platinum or a $200m investment into palladium or a $10bn investment into gold can move the price by 10% or 15% in either direction. Because at the margin, yes – again I think people misunderstood some of what I was saying yesterday. I'm not saying that the supply and demand fundamentals for platinum are terrible – I'm saying the market is in a mild surplus. There are relatively large stockpiles that have built up relative to where they were in 2008, but the key driver of the price dynamic here is whether investors are willing to pick this metal up or not. And in a surplus market there's only one thing that can happen if investors are not willing to pick up that surplus metal – the price has to go down.
Geoff Candy: I suppose the big question then is what is your view on real interest rates and this ties into what's happening in the US and indeed what's happening in Europe as well.
Paul Walker: Well the real interest rate environment in our view is not going to move in the medium-term. Statements from the Federal Reserve, European Central Bank, you have to believe the real interest rate environment is going to stay fairly subdued for a while.
Deflation of course does enhance the real interest rate environment which is one of the reasons – go back to one of my earlier points – the only significant disinvestment market in gold in the last four years, has been where – and I'll challenge any of your listeners to answer that question – it's been Japan. And what's the feature of Japan over the last three or four years, positive real interest rates because you've got deflation admittedly in a zero interest rate environment. But deflation gives you positive real interest rates, so that's the kind of environment you find yourself in where people exit gold and look for other investments. And that has been very much a feature of the Japanese market.
So I don't foresee real interest rates moving quickly. The joker in the pack here of course is what the bond market decides to say about this and we've already seen signs of what happens – stress in these market places. Italian bond yields, 10-year yields going up to 6%, Greece of course is the basket case. You can ignore that, but in terms of mainstream interest rates, one of the largest sovereign issuers of debt in the world, the Italians, look at where their yields are going and suddenly you're moving into territory which becomes materially positive, and that's a game changer.
And I suspect that we may find that the game changer here comes from left field. It's when this bond bubble finally bursts, and trust me, it's going to burst – it's going to be spectacular. The yields that we see at the moment – who on earth in their right minds is going to accept 1.8% for 10-year US government debt. It is, as I repeatedly say, the economics of a madhouse. Sooner or later that has to change and if the yield curve across the US Dollar, Euro and all the sovereigns within the Eurozone, if we see a sharpening of that when we see the bond market say no more, we're not willing to fund this at these rates, and the central banks, through their credibility limitations, have to eventually pull back from these markets.
They cannot continue to expand their balance sheets in the way they have been. They will for a while, but the moment the Federal Reserve stops doing the twist and stops doing its monetary easing. As soon as the ECB finds itself in a position where just from a pure credibility perspective, they can't do anymore. If the yield curve sharpens, as I think it will, and it will come out of left field. This is one of the things I love about these markets, we talk about it endlessly and the defining kind of turning point of these markets is always difficult to identify. But when it hits us, we all go "sh...of course, why didn't we see that coming. Look at the US property market – why didn't we see it coming. To me it was pretty obvious, but I talked about it five years ago. I was a little ahead of the curve and I was wrong in terms of the turning point. But that's what is going to happen. Somebody will be coming out of left field and all bets will be off, interest rates will go up and when gold faces a positive real interest rate environment, I'm sorry, its game over.
And that's true, not just for gold, but for the entire commodities complex. Gold will be most hit by this, but it will hit platinum, it will hit palladium – palladium with the stocks, it will hit copper – all of these asset prices have gone up because of investment. Once we get our heads around that, then we understand the dynamic of these markets.
Geoff Candy: I suppose, just to close off with then, is there any way to gauge what sort of timeline we're looking at, or is it an impossible question to answer?
Paul Walker: I would imagine that we're talking at least a year before real interest rates start to move, but the joker in the pack I still think is going to be what happens to the yield curve. And if the bond markets finally decide enough is enough and they're not willing to fund it, just in the same way – one of my favorite examples...what change in the information set that we all knew about Greece between Greek bonds trading at a 40 to 50 basis point premium to the Bund, and an 8000 basis point premium to the Bund.
What changed in our information step that was that dramatic? Well actually not a lot. The information is there, the data is there, the economic reality is there and sooner or later this has to change and I think as a base case, it's got to be a year. It could even be two years depending on how aggressively the Federal Reserve and the ECB want to carry on with this policy. But there's an endgame that will be played out and when it does get played out, the whole commodities complex will suffer.
Geoff Candy: But until then commodity prices are likely to rise?
Paul Walker: I'm absolutely convinced. Gold is struggling at the moment because the requirement here and the metric is an inflow of cash all the time. It's a point I've repeated for the better part of four to five years now, when the gold market went into surplus, platinum went into surplus. For these markets to maintain their prices, somebody has to be willing to buy the surplus metal at the market clearing price. That's what determines it. Economics 101 – it's what the marginal demander wants and the marginal investor, who is driving these prices in my view, is the investor.
The guys who are out there, putting PGMs on their catalyst or gold in their gold bonding wire, they're just in a sense price-takers, and they'll do whatever. The price in elastic takers over the market reality – it's the investors who are going to dictate this at the margin, and those are the guys you have to look at. The question is when are they in and out of this market, it's all about real interest rates.
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