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Marcus Grubb: What Caused the Gold Crash

Gold demand and supply analysis of the April and June price slumps...
 
MARCUS GRUBB is the managing director of investment for the market-development organization the World Gold Council.
 
There he leads both investment research and product innovation as well as marketing efforts surrounding gold's role as an asset class. With more than 20 years' experience in global banking, including expertise in stocks, swaps and derivatives, here Marcus Grubb speaks to Hard Assets Investor after the release of the World Gold Council's quarterly Gold Demand Trends survey.
 
HardAssetsInvestor: Given the steep drop in gold prices during the second quarter of 2013, I noticed a significant divergence in the different demand categories. Was the spike in jewelry demand merely price-related, or is it a longer-term trend of some sort?
 
Marcus Grubb: You put your finger on it. Although we saw a fall in overall gold demand for the quarter of 12% from a year earlier, that was largely driven from the investment side. We saw a very big recovery and rebound in the jewelry market. Global demand was up 37% to 575 tonnes.
 
Quite a lot of that was price driven, and of course a lot of it was concentrated in the two largest markets, China and India. But outside that, you saw strong jewelry performance in smaller countries in Asia, Indonesia and Thailand, etc.
 
In the US jewelry market, you saw a second quarter of positive demand – the first such run since 2005. You're seeing a recovery even in some Western markets for jewelry, too. So there's more to it than the price drop.
 
Yes, in Asian markets, that was the key driver, because consumers felt that gold was cheap at these levels, and our surveys indicate they still do. But if you look at the US, that's not the main reason. You're starting to see an improvement in economic conditions, albeit very slow. Therefore, the increase in jewelry demand in the country is likely to be a longer-term trend.
 
HAI: In April and May, we kept hearing reports about the massive buying in Asia on the physical investment side. The final numbers seem to bear that out, don't they?
 
Marcus Grubb: They do; these numbers are pretty staggering. Total demand in India for Q2 was up 71% over last year – and last year wasn't bad! Total demand in China was up 85% on last year. If you look at the half year, total demand in India is up 48% over the last year at 566 tonnes, while total demand in China is up 45% to 600 tonnes.
 
It confirms absolutely that physical demand stepped up to the plate. Moreover, it confirms that the measures the Indian government has taken to reduce imports are not having a major effect on gold demand in India.
 
HAI: It looks like both China and India are on track for maybe 1,000 tonnes in demand this year...?
 
Marcus Grubb: Absolutely right. As a result, we're upping our range for these two markets. We now put our target for both markets up to 900-1,000 tonnes each. That is an expectation of a record year for China, because China has only ever been as high as 776 tonnes before. India has hit 1,000 tonnes before, so it's a less bullish forecast for India. Still, we do expect both markets could now end up near 1,000 tonnes by the end of the year.
 
However, it's very hard to call which will be the largest market this year. At the half-year mark, they're only about 34 tonnes apart.
 
HAI: We're seeing somewhat of a battle between the government and consumers in India. Who's going to win out in the end?
 
Marcus Grubb: That's a very difficult question to answer. We've seen a succession of measures now in India. There have been at least six or seven different measures including the increases in import duties, of which this week's was the latest one.
 
We know that these measures are designed to try and improve the current account deficit. India's problems are not really with the gold market. They're with the fact that the current account deficit is high as a percent of GDP, and the government is seeking to reduce that, by a number of different measures, of which these measures against gold are one.
 
The lesson so far is that it's not having any impact on physical demand. What you're seeing is that the market is being disrupted by these measures. The local premium increased last night [Aug. 13, 2013] to about $57 an ounce, but the demand remains undiminished. We're also going into the strongest period of the year for Indian gold demand with the Diwali festival coming and the stocking for Diwali coming in September.
 
At the end of the day, we just don't believe that these measures will ultimately affect demand for gold at the consumer level in India. It's too cultural, it's too religious, it's too linked to festivals. Also at these prices, even with the premiums, gold is relatively cheap for Indian consumers compared to recent history.
 
HAI: I would be remiss if I didn't ask about ETFs. It seems that one can trace the bulk of the gold price decline this year to selling by these financial products.
 
Marcus Grubb: In the physical market, that's true. And that has been the only source of supply into the market. The trigger for that, though, has been the reversal in positioning in the gold futures market, the nonphysical market.
 
You've seen a 20 million ounce net long for 12 years decline to about 2 million ounce net long until a few weeks ago. What that meant was the longs were still long in Comex, but there was an almost equal number of traders who felt that they wanted to be short gold, i.e., they had a bearish view of the gold price. For 12 years, that wasn't the case. For 12 years, the short was about 3 million to 8 million ounces; the long about 20 or 25. The long stayed at 20 million, but the short has gone right up to about 18 million. That's the main trigger for the selling in the ETFs.
 
Also, to some degree, the ETFs have become a source of physical gold for the market. If you have backwardation in the gold futures, the ETFs almost become a cheap source of physical gold for consumers who are prepared to pay a premium in Eastern markets. Not when the gold price is flat or rising, but when it's falling, then is that the case. In some ways, it means some of these ETF redemption activities are not necessarily as negative as it might appear.
 
I do think it was essentially triggered by the reversal in sentiment in futures. And the third level of that is the driver for the shift in sentiment – this belief that the US economy is strengthening, that things have improved, and that the Federal Reserve therefore will start to taper QE in September. But with a 30 percent-plus drop from the all-time high, I think all of that is priced into gold.
 
My final comment on that is that our analysis shows that even if real interest rates are positive in North America, that can still be bullish for the gold price. But that's not the perception of a lot of people. They think that the minute rates start to rise, that will be negative for gold. It isn't that simple. If inflation rises as well, and real rates [interest rates minus inflation rates] stay relatively low, that is actually not bearish for the gold price. 
 
The last thing I'd say is we've had 400 metric tonnes come out of ETFs in the second quarter. We've lost about 650 tonnes year-to-date. It's our view that the gold that's come out in the first part of this year – which is roughly 650 tonnes – is probably those investors who went into the ETFs with a hedge against the financial system collapsing. They weren't necessarily buying gold as a long-term, strategic investment.
 
The remaining investors now are very much those who see gold as core holding in a portfolio, as a strategic diversifier and a hedge against risk.
 
HAI: It's interesting that you said the shift in speculative sentiment in the futures market precipitated the decline. For gold to rebound, would we need the speculative investors to come back into the market?
 
Marcus Grubb: We need the ETF redemptions to cease. That is happening. They've slowed now to pretty much a trickle in recent months. But the key to a return to balance in the market is two other things: It is the physical market rebalancing itself with a big increase in consumer demand, and a fall in supply, which is what you see in our latest figures.
 
Also, ultimately, you need the short position in Comex to be reduced. You need those shorts to decide that, at this price, with this market outlook, with this view on other asset classes, they no longer see gold as a short. And then they will do what has happened in the last few weeks – they will close out those short positions and you won't see such heavy downward pressure on the gold price.
 
HAI: One surprise in the report was the reduction in purchases by central banks in the quarter. What happened there?
 
Marcus Grubb: I'm a little surprised at that as well. Overall, it was still a net purchase of 71 tonnes, which is pretty good by historical standards. But we have reduced our target for central banks this year. We're now looking for about 350 tonnes for the full year. Our view is that nothing much has changed. Prices were very volatile and there was a lot of uncertainty in the market.
 
On the one hand, you'd expect central banks to come in and buy because they're on the bench just waiting for the opportunity. We know that and we don't think that has changed. Those emerging-countries central banks are still buyers. They still want to maintain an increase in their gold holdings for all the reasons we've pointed to in the past.
 
But the gold price volatility was one thing that put them off coming in during the quarter. If we're right about that, I'd expect to see central-bank demand pick up again in the latter part of the year, provided the market remained stable or even if we have a further rise in the gold price.
 
HAI: We saw supply fall by 6% in April-June compared to last year. How was the split between recycling and mine production? And how do you see mine production reacting to these lower prices?
 
Marcus Grubb: The other key to the market is restoring physical balance again, and that will also entice the shorts to close out and go elsewhere in the futures market. On that score, the 21% drop in recycling was very positive. If that's maintained throughout the year, you'll see probably 300 tonnes less supply this year overall.
 
Heading through to the end of the year, we're going to see more restructuring by the mining sector, reductions in developments and exploration, and cost cutting on an operating level. All of this is going to have an effect on mine production. Obviously that will take time to come through, whereas recycling adjusts very quickly because it's directly related to the gold price. We do believe you'll see gold mine production flatten and even decline. We don't have a formal forecast yet for the full year, but we would expect to see the second half be weaker. I wouldn't be surprised to see mine production flatten in Q3 and even drop in Q4 as the mining sector adapts to this lower trading range. That all helps restore balance for the market.

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