gold investing handbook

7/26/2019 Gold Investing Handbook

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1 Mourtaza Asad-Syed

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To Gabrielle, David and Sarah, my three golden nuggets.


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Foreword

Writing a book on gold in 2014 feels like writing Dow 36000!in 2001 after the market had crashed. Of course, market moves

during the past decade provided a strong motive to look in detailat the barbaric relic, remove misconceptions and present theanalysis to a large audience. Rather, the genesis of this treatisetraces back to a discussion in 2009 between an Indian-born eco-nomic geologist and a Swiss-based investment strategist. Simplyput, a gathering of a father and his son.

The love for gold has been universal except with economists. Ithas appealed to human beings irrespective of their origin, color,

race, religion, and sex. This book does not provide any justifica-tion for the use or the value of gold; the study here, rather givesan understanding as to role of gold in society and focuses in howits price is set, even if it often generates seemingly irrational be-havior. Indeed, irrational behavior is often denounced by theeconomists, who tend to see gold as being useless and unproduc-tive, creating no value, generating no income and even beingsimply barbaric. We believe and will demonstrate that there is

much more value in gold, which might be one of the very last,rationally priced financial assets.

We took pleasure in bringing a unique perspective on gold in-vesting. Indeed, this work should contrast with many existingbooks relating to gold investing, because

It presents an analytical framework for gold valuation,

It details winning investment strategies, and

It keeps a non-US centric international perspective.

On the contrary, most common approaches are done for US-based investors with a pure USD reference, and they often fail torationalize gold investing into a testable framework. As a result,gold prices are explained by anecdotal and un-testable randomfactors such as psychology, one-time events, chartist techniques,etc. This lack of rigor in the field of gold investing has open a void


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Gold investing handbook Full version availableHERE

6 Full version availableHERE Mourtaza Asad-Syed

for dubious rationale, most often flirting with conspiracy theo-ries, which in the end absurdly justifies purchasing gold at anyprices...

This book is presented in four distinct sections. The first partpresents the context of rising global liabilities that questions theresilience of traditional safe assets and highlights the currentrelevance of gold investing. In short, slow-to-moderate growth islargely supported by active public policies, generating large pub-lic deficits and negative real rates from easy monetary policies.By itself this backdrop is conducive to a medium term apprecia-tion of gold. Moreover, there are growing tail risks when con-

sidering all options. Indeed, it is also possible that governmentswill renege on their obligations. With the risk of being provoca-tive there is a distinct possibility that the US Treasury could de-fault1towards foreign creditors in the coming decades, with goldan undisputed hedge against it.

The second sectionexplains the dynamics of gold prices. Goldprices are set simultaneously on three separate markets:

1.

The commodity market,2.

The currency market, and

3.

The financial assets market, because its value is also de-fined as an asset relative to main asset classes.

We believe that the currency market matters the most becausegold is first and foremost a mean of exchange and a store ofvalue, which lends credence to John-Pierpont Morgans blunt

view that Gold is money, the rest is credit!The third sectionof the book is pragmatic, focusing on invest-ment opportunities derived from this unique asset. Practical ex-amples of successful investing are presented with simpleprediction-free frameworks for asset allocation, tactical, tradingand relative value investments. Then, major instruments for goldinvesting are listed and it concludes with a professional inves-tors perspective.

The fourth and last sectionof the book is mostly descriptiveand deals with the characteristics of gold. Gold is defined and de-scribed here from multiple angles: metallic, mineralogical, geo-logic, historic, social, economic and financial, enumerating its

1 Defaults is here be defined as the failure to meet the legal obligations and/or condi-tions of a loan, nor the failure of a government to repay its debt
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Gold investing handbook

7Full version availableHERE Mourtaza Asad-Syed

conventional and modern day uses. The numerous facets of goldhelp understand its place in society through time and geogra-phies with some amazing facts.

The author sincerely hopes that amateur geologists, journalists,economists, analysts, traders, portfolio managers, institutionalinvestors, retail investors and men and women fancying gold,should all find their subject of interest in some part of this work.To close, here is the best definition of gold: An ounce of which

provides a perpetual and universal insurance to acquire a year of

subsistence.


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Content


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1.Gold in a world of liabilities

Golds ability to protect wealth from government confiscation

or spoliation makes it imperative to examine gold investingover the next ten years. During the past ten years, gold ralliedagainst major currencies as real rates declined and remainedlow. Given current levels, real rates cannot go much lower, andhence cannot provide support to a gold rally of similar magni-tude as in the past decade. While gold has declined in 2013 by26 percent and may not have strong absolute performanceahead, we nonetheless see potential for gold to perform well

against OECD government bonds. In the coming ten years, ex-cess public debt in the Eurozone, Japan, the UK and the US willtranslate into capital losses on private savings. Indeed, the onlyfeasible end game for public debt sustainability is a forcedtransfer of the capital loss burden to households or to foreign-ers.

Gold investing is often anchored on distrust of government, be-cause governments abuse their right to print money. Currently,

economists are worried about deflation, but many long-term in-vestors are already speculating on inflation or even hyperinfla-tion, and while these are legitimate risks, a savvy investor needsto consider another risk that has not been highlighted in previ-ous discussions: Spoliation! Namely, the effective plundering offoreign holders of US assets and European pensioners! The start-ing point of these man-made-disasters is the dire state of OECDpublic finances. Indeed, the state of public finance and the fore-

seeable patterns for government liabilities are unsustainablearound the globe, and this imbalance clearly opens the door forunorthodox policies that could well impair investors.


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Dire public finances in the Eurozone, Japan, the UK

and the US

Following the credit crisis of 2008, public debt across the OECDexpanded massively to substitute for private sector deleveragingin an attempt to soften the economic recession. This would besound policy if public finances were not already impaired by off-balance sheet unfunded liabilities caused by pension obligations

and other benefits (such as health coverage) for a cohort that isbenefiting from an unprecedented increase in life expectancy,not offset by adequate population growth. Given the severely im-pacted public finance situation, adding additional debt is effec-tively kicking the can down the road to a future generation.

There are three ways for the government to reverse the courseof the public debt spiral:

A growth strategy: Induce growth to dilute the debt-to-GDP ratio with higher revenues,

A monetary erosion/inflation strategy: Create inflation,

to erode the nominal value of existing debt

A write-off/default strategy: Use default or restructuringto cancel or reduce the obligations promised either to itscitizens or foreign creditors

So far, Anglo-Saxon countries, chiefly the US, are aiming at the

growth strategy, pushing for a super easy policy-mix.(i.e. fiscal and

monetary policies) Continental Europe is pushing peripheral Euro

countries to default on obligations to their citizens in the form of

austerity policies that reduce the benefits received by citizens. Noexplicit strategy was discernible for Japan, until the recent change in

Bank of Japan (BOJ) leadership and Prime Minister Abes economicprogram that one might broadly categorize as their pursing a credible

growth or even an inflation strategy.

Growth strategy: a risky dream

The growth strategy is the most seductive and the least painfulfor citizens, creditors, and politicians. This high return strategyis also high risk because if it fails, the country is stuck with aneven larger public debt (left by active fiscal policy) and has nomonetary lever left. In the US (and the UK), monetary authoritieshave even jumped into vigorous monetization of public debt, inthe name of quantitative easing (QE). Historical experience has


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shown that monetary misconduct is usually perpetrated for fis-cal motives and leads to inflation (or hyper-inflation). Once cen-tral banks have locked short-term rates at zero percent and

suppressed the entire yield curve below 2%, loaded their bal-ance sheets with Treasury bonds and become recurrent buyers,and provided commercial banks with immense liquidity facili-ties for any eligible collateral, it will be very hard for them to re-verse course! These actions put overall economic activity at highrisk and threaten the refinancing abilities of their own govern-ment. Recently, even an orthodox central bank such as the Eu-ropean Central Bank (ECB) had to reverse course in the wake ofthe government debt crisis, and had to decrease rates and evencommit to buying government debt. Interestingly, it was theECBs own tight policy in 2008-2011 that worsened Eurozoneperipheral financing conditions and endangered the solvency ofthe weakest. In the end, when the solvency of a government is atstake, notions of central bank independence or restricting themto a solely inflation mandate is more theoretical than anythingelse, and even the ever conservative Germans had to swallow thebroadened mandate of the ECB!

(Hyper) Inflation: a rampant nightmare

We explain below why inflation does not represent a govern-ment strategy per se, but could become an unintended conse-quence if the growth strategy fails.

An inflation strategy is not politically viable.Most of the in-

flation impact is domestic, especially for a country that is quiteclosed, like the US. External impact usually comes in lieu of a de-cline in exchange rates, but often only over the medium term.Domestic impact manifests itself either in a price-wage increasespiral, as rising cost of living can transmit into salary increase orsimply loss of purchasing power when wages fail to match theinflation increase. Inflation above 5% to 10% is very unpopular,especially within the older cohorts who have little hope for fu-

ture wage increases and are focused primarily on maintainingthe standard of living during retirement. Rising or simply highinflation is among the worst enemies for any political incumbent.Indeed even more than rising unemploymentan inflationaryenvironment has sealed the fate of most unfortunate politicalleaders of the 1970s in the OECD (Carter, Heath, Wilson, Calla-ghan, Giscard dEstaing, Andreotti), andstill dictates the win-ner in elections in emerging markets, in Latin America


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especially. Within developed countries, only military casualtieshave a greater effect on the popular vote2. In most cases, inflationis associated with impoverishment within the working class be-

cause it translates most into relative loss of purchasing power,and is perceived as a tax, since most blame government action(or inaction) for any rise in inflation. Any inflationary strategy tolower a debt overhang would carry high political risk, and woulddeter any public leader from pursuing this approach. It is no sur-prise to see that inflation is lowest in countries where leadersare more accountable to their people (i.e., the more democraticregimes). This is quite explicit in Figure 1.1 which demonstratesaverage inflation by political regime as defined by The Econo-mist. In 2010, countries with full democracy (Sweden, Norway,UK) experienced an average inflation of 2.2%, while authori-tarian countries (Nigeria, China, Azerbaijan) had on average7.4% inflation. As a political choice, inflation will not be favoredby any OECD government.

Figure 1.1: Inflation by political regime

Source: The Economist, World Bank, Wikipedia, Authorscalculations, Data as of 2011

A burst of inflation will not dilute the debt level as much as

expected. During increasing inflation, even with a lax centralbank that does not increase short rates, the yield curve tends to

2 SeeBread and Peace modelby Douglas Hibbs - University of Gothenberg

7.47.1

5.1

2.2

53 33 52 26

Authoritarian Hybrid regime Flawed democracy Full democracy

Average Inflation Number of countries
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steepen with rising long-term rates. The term premium then in-creases, and stays higher for a while, often at least long enoughto match the average public debt maturity, which means that the

entire debt will end up being refinanced at a higher cost. As aresult, during high inflation periods, long-term real rates arerarely negative and any gain from the dilution of debt by highernominal GDP is offset by higher interest rates. Active quantita-tive easing from central bank could maintain a depressed long-term rate and contain increasing debt service, but this wouldneed large amount of purchases at the issuance (primary mar-ket), which would breach all rules of sound monetary policy, andopen the door for monetization and absolute loss of confidencein the currency. The other issue with generating such inflation isthe side-effect on agents that have liabilities linked to inflation.For instance in the US, the Treasury issued USD800 billion of in-flation-linked bonds, and these bonds would not benefit fromsuch policies, but it amounts only to 5% of total debt outstand-ing. Second, US Social Security has defined benefit obligations tofuture pensioners, linked to inflation, worth trillions of dollarsthat is guaranteed by the government. The Social Security Trust

Funds current fund is about USD3 trillion (highly invested inTreasury bonds), which is about 20% of public debt. Thereforethe impact of inflation would be null in terms of reducing theburden of the government towards the beneficiaries. The privatesector too, has liabilities linked to inflation, which could createmore distress and distortions than it cures. For instance, UK pub-lic sector pensioners are protected against inflation, whereasprivate sector pensions scheme have inflation caps.

Inflation is not in the DNA of Anglo-Saxon (free-market)

countries.Market-friendly or capitalist countries such as the USand the UK do not favor inflation for philosophical reasons,mostly because it usually erodes value for owners of capital andforces redistribution of wealth, or at least equalization. It canalso be argued that inflation is a consequence of redistributionpolicies not the cause. Indeed, social spending and welfare usedto have a high multiplier effect on aggregate demand, which

would lead to upward price pressures. Regardless of causation,it confirms the notion that inflation is related to a crucial socialand political choice. Historical data displayed in Figure 1.2 (In-flation & income concentration) shows that in the US, inflationpatterns play a significant role in income distribution, second


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only to taxation3. As for advanced economies; high inflation hasbeen experienced more in continental countries, such as Ger-many, Italy, France and even Japan. It is surprising to see that no

Anglo-Saxon dominions (Australia, Canada, New Zealand, andSouth Africa) have experienced hyperinflation or simply veryhigh inflation, when major European ones have experiencedmultiple inflationary bursts. One conclusion from Bernholz(2003), and highlighted in Figure 1.3, is that hyperinflation hap-pens only in regulated (e.g. centrally planned) economies. Free-market economies might be prone to financial bubbles, crisesand deflation, but they seem immune to hyperinflation risks.

Figure 1.2: US inflation and income concentration

Source: Piketty & Saez, US Bureau of Economic Analysis, Authors calculations

3 "The Effect of Marginal Tax Rates on Income: A Panel Study of 'Bracket Creep'" Em-manuel Saez, Journal of Public Economics, 87, 2003, 1231-1258

20

2222

1514

13

10

99

1110

11

2233

45

9

7

5

12

1

201020052000199519901985198019751970196519601955

Top 1% share of national income (%) Inflation (%, 5-year CAGR)


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Figure 1.3: Hyperinflation episodes over the past century

Country Year(s)

High

inflation

per month %

Country Year(s)

Highest infla-

tion

per month %

Argentina 1989/90 196.6 Hungary 1945/46 1.295

Armenia 1993/94 438.04 Kazakhstan 1994 57

Austria 1921/22 124.27 Kyrgyzstan 1992 157

Azerbaijan 1991/94 118.09 Nicaragua 1986/89 126.62

Belarus 1994 53.4 Peru 1988/90 114.14

Bolivia 1984/86 120.39 Poland 1921/24 187.54

Brazil 1989/93 84.32 Poland 1989/90 77.33

Bulgaria 1997 242.7 Serbia 1992/94 309000000

China 1947/49 4208.73 Soviet Union 1922/24 278.72

Congo (Zaire) 1991/94 225 Taiwan 1945/49 398.73

France 1789/96 143.26 Tajikistan 1995 78.1

Georgia 1993/94 196.72 Turkmenistan 1993/96 62.5

Germany 1920/23 29525.71 Ukraine 1992/94 249

Greece 1942/45 11288 Yugoslavia 1990 58.82

Hungary 1923/24 82.18 Zimbabwe 2008/09 6.5 *1021

Source: Bernholz (2003), Wikipedia

As a result, an inflation strategy could largely materialize involun-

tarily. One can argue that unanticipated inflation could still be-come an issue in the US (and the UK!), in the form of unintended

consequences of current monetary easing. Indeed, it is very likely

current experiments in monetary policies will prove hard to re-

verse, especially in the wake of current over-confidence of policy-

makers. In the case of uncontrolled inflation, gold would have a

great future! The UK is the most vulnerable country for that situ-

ation, where the Bank of England (BoE) could at some point open

the Pandora box of inflation, with its aggressive monetization ina context of declining productivity and current account defi-cits. By mimicking the US, the UK seems to have neglected thefact that it does not have a major reserve currency. With a de-terioration of the currency and the standard of living, its owncitizens could themselves be tempted to flee their own cur-rency, without any natural external buyers!


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Write-off and spoliation: Dj vu

Is there truly a clear path to a write-off strategy? When oneconsiders the similarities between the balance sheet of UnitedStates of America and General Motors (in 2008) in terms of to-tal debt, unfunded liabilities, persistent need for funding, con-flict of interests and the way creditors were ultimately treated,any foreign holder of US treasury securities should be afraid.Given the past behavior of the US to preserve its own interestsabove all principles, it is hard to expect this country to play bythe rules and comply with its obligations to foreign creditors ifthis requires any painful sacrifice for its population (and vot-

ers!). In his 2004 book, Colossus, The Price of American Em-pire, historian Niall Ferguson presents a defining feature ofthe US: It is not a country like any other. It is an Empire! Whilepowerful abroad, with its unsurpassed military might, the UShas the typical Achillesheel of any empire: the need for exter-nal financing. The Chinese, Japanese and Europeans have beenwilling to purchase American Treasury notes and bonds to fi-nance this expensive military hegemony. While he sees infla-

tion as the likely exit to dilute debt, and he discards debtdefault, we see it otherwise. Indeed, we challenge the view thatthe US will not default because its debt is denominated in itsown currency. In fact, the US public sector has defaulted sev-eral times in the past, in one way or another, and clearly at theexpenses of some less powerful entities. Since Independence,a default has occurred about every 50 years. And the last time,the US declined to comply with its obligations towards credi-

tors was in 1971, just 42 years ago!A selective US default is on the cards because it is possible,profitable and is consistent with US conduct. The write-offstrategy carries many benefits for the US, regardless of thenegative impact overseas. Since America became the dominantpower of the western world after the two World Wars, it hasalways played by its own rules. It drafted major world regula-tions, but surprisingly the country has a strong record of not

applying them and not ratifying them, especially in the recentpast. The US has managed unilaterally its special status, evenoutside the field of finance and economics. For instance, it sup-ported the International Court of Justice for war criminals, butin the end the institution can try anyone in the world exceptAmericans. The US did not ratify the Anti-Ballistic Missile(ABM) Treaty, the Kyoto protocol on carbon emissions, or the


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Ottawa treaty on banning anti-personnel mines. The US agri-culture policy stance was also one of the major causes of thecollapse of the World Trade Organization (WTO) Doha round,

because America preferred protecting its cotton industry among others- at the expense of broader agreements on globaltrade. We see the same behavior on banking, where the US isnow deciding to delay the application on Basel III, whichmakes efforts of Europeans -including the Swiss- useless,when they are pushing hard on their own banks. The issue isthat it is well known that large banks are interconnected andthat the failure of one can impact many others even in otherregions. For other countries, having the US relax the standardson risk and capital requirements is like insulating the roofwhen someone has left the windows open.

America has defaulted often. Harvard academics Reinhart and

Rogoff (2010)4show how some countries repeatedly default, whileothers do not. Greece had such a record, that recent events should

come as a surprise only to ignorant of history They consider

only two US government defaults, and two state defaults since In-

dependence. Nevertheless, when using a more accurate andbroader definition of government default that includes any occa-

sion when the US government (Federal or State) did not fulfill its

financial obligation towards its creditors (i.e., when creditors lost

money!), we count seven defaults! The list is provided below, and

includes the liability on which the government defaulted, bonds or

currency.

1779: The continental currency default (Currency)

1790: The Continental bonds default (Bonds)

1841: 9-State defaults (Bonds)

1862: The Greenback default (Currency)

1873: 10-State defaults (Bonds)

1933: The Liberty bond default (Currency)

1971: The gold standard default (Currency)

1979: Debt ceiling default on treasury bills (Bonds)

The US only defaulted twice on its Federal debt, in 1790 (Con-tinental bonds), and in 1979. The latter was quite a non-event,

4 Carmen M. Reinhart & Kenneth S. Rogoff, This Time is Different: Eight-Centuries of Fi-nancial Folly, Princeton, NJ, Princeton University Press, 2009


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as it was mostly a technical default on its Treasury bills pay-ments, delayed by a couple of days. In fact, we consider 1933and 1971 much more critical defaults than 1979, but they tech-

nically affected the currency, not the bond repayment in nom-inal terms. These two cases will help elaborate further as towhat could be the roadmap for the next default. From the de-faults listed above, we see that at a Federal level, the US de-faults on its currency more often than on its debt, and thatcurrency defaults do not always mean inflation/hyperinfla-tion.

In 1779 and 1862, the US defaulted on a currency it created to

raise financing. Both currencies created for same purpose(military expenditures) ended the same way, they lost theirvalue and in the end were redeemable to the Treasury at a frac-tion of the issued parity, or not at all.

In 1933, the US retracted its commitment to redeem bondhold-ers in gold, or in gold-equivalent. Instead, it devalued its cur-rency by 40% and repaid its bonds exclusively in papercurrency. With all due respect to Carmen Reinhart and Ken-

neth Rogoff or any other academic citing no external defaultsfor the US during the Depression, this was a clear default, whenany foreign investor at a time of the Gold Standard would takea 40%-haircut! US debt at the time was about USD22 billion(USD360 billion in 2010 terms), representing 37% of GDP.This would amount to USD6000 billion relative to todays GDP,and a 40%-haircut would be quite a huge figure: USD 2.4 tril-lion!

1971 is the classic case of US unilaterally deciding to forego itsobligations, especially towards foreigners that had been fi-nancing its twin deficits for a decade, with the explicit guaran-tee that the US dollar was as good as gold. The Great Society

programs and the Vietnam War were expensive, public deficitswere growing, while the current account deteriorated as rela-tively high inflation led to a loss of competitiveness relative tothe Japanese and Germans, whose currencies were not reval-

ued. In the end, foreigners simply lost their right to gold, over-night, mostly because they asked for it. At the time, foreignersheld about USD85 billion (USD460 billion in 2012 terms orUSD1100 billion relative to todays GDP), which were devaluedby about 10-20% depending on the base currency (Swiss andGermans were hit the hardest). More than money, they losttheir gold. These USD85 billion worth of holdings should have


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given owners a right to 75,000 metric tonnes (MT) in gold, aclaim to 86% of total gold available at that time! In orders ofmagnitude, this would be about USD4 trillion at todays gold

prices (compared to USD690 billion obtained from theseUSD85 billion placed on money markets) or USD7.5 trillion attodays share of world gold value. This amount is dramatic

compared to the current non-resident holdings of US treasur-ies. The recent US response to German officials asking to re-patriate their gold in custody at the Federal Reserve Bank ofNew York is additional evidence of the US being an abusivecustodian. It also provides additional fodder for conspiracytheory addicts! Indeed, if the US needs six to seven years tohand over to Germany its gold reserves, one can see the fasci-nation with the view that: They do not have it anymore! Thereis simply no more gold in the vault!5

This historical analogy makes us believe that if the US needs tobe relieved from its debt or at least part of it, the country willgo the route it has successfully experimented with in the past,through currency and at the expenses of non-residents. For-

eigners are by definition non-voting, which makes them par-ticularly vulnerable.

Today, the US is liable to the tune of USD12.4 trillion in theform of marketable securities to the rest of the world, 70% ofwhich is made of debt, the rest being equities and mutualfunds. Non-residents own USD4.8 trillion in federal debt(about a third of federal debt); they also own a substantialchunk of public-sector debt guaranteed by government (of

about USD1 trillion in agency bonds) and about USD3 trillionin corporate debt.

Since current liabilities to foreigners are very significant, theincentive for the Treasury to write-off this debt is obvious. Wesee a couple of scenario for the US to dismiss its current prom-ise of paying back its creditors:

Simple default: deciding to pay only part of its bonds

(e.g., 80-90% on the dollar of each bond issued). This

5 To add to confusion and raise further doubt on US gold position, it is worth noticingthat the US Federal Reserve Board is often credited to own 8,100 tons of gold(USD11billion in the balance sheet valued at USD42/oz.). In fact, the Fed does not ownany gold to back its currency; it only owns a claim on gold held by the US Treasury, viagold certificates. It is the Treasury that owns the eight thousand tons since 1934, andthe Federal Reserves gold certificates are as good (or as bad!) as Treasury bonds!


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would bring significant disruptions especially domes-tically within US banks.

Selective default though a new currency issuance: de-

ciding to pay only domestic investors, and creating adifferent currency to pay foreign creditors. Using the1971 roadmap, we see similarities between the currentUSD and 1971 gold reserves, and current US Treasurieswith 1971 USD reserves. The case for an internationaldollar to redeem debt held by non-residents wouldmake sense, in the case of fear of inflation from excessmoney supply and increasing velocity after successive

quantitative easing. To prevent this mass of dollars ac-cumulated outside the US (50% of money supply) com-ing home and thereby inflating prices, such a newcurrency would not be allowed to be freely tradable do-mestically in the US, or at least it ought to be fully dis-tinct from the original USD. Quite quickly, the value ofthe international dollar would fall below parity vs. USD.Foreign investors, who thought they had USD when

holding US Treasuries, would quickly realize who issupporting the cost of public deleveraging, without anyrecourse. This would be close to the platinum coin

gimmick6, which drew media attention in 2012. In es-sence, it is also fiat currency to repay debt, with no in-flationary cost, only reputational cost. The similaritieswith 1971, as highlighted in Figure 1.4, are striking:i) some export-driven countries are once again main-taining a cheap currency thanks to artificial measures(i.e., fixed exchange rates, with ballooning official re-serves); ii) foreign central bank assets are again beingcustodied at the Fed (gold in 1971, and US treasurybonds, which never left the country, even when Ger-man, Japanese and, more recently, the Chinese boughtthem!); and iii) the US again cannot deliver on prom-ises if creditors ask to be repaid (or simply if they lettheir bond expire without rolling them).

6 In the US, only the Federal Reserve has the right to issue currency, at the exception ofthe Treasury that has the right to issue commemorative coins in any denomination.The idea for reducing debt was for the US government (Treasury) to repay debt withsuch a coin issued at the value of 1 trillion. For instance, the treasury would repay thetrillions of US government bonds purchased by the Federal Reserve, with 2 or 3 of suchcoins.


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Figure 1.4: Historical comparison of US financial position 1971-2012

Items 1971 2012 Comparison

Total debt

(private + publicsector debt)

150% 350% Worse

External position

(% GDP)

Creditor (>0) Debtor (-15%) Worse

Public debt

(% GDP)

36% 104% Worse

Amount of foreign

claims on US gov-

ernment (USD)

USD 85 billion

(2012

USD 482 billion)

USD 4.3 trillion Similar

as a % of GDP 8% 27% Worse

Gold equivalent

(MT)

7561.1 8367.3 Similar

Alternative reserve

currency

DEM, JPY,

FRF, GBP, CHF

Gold, EUR,

JPY, CNY

Similar

Currency-exchange

rate dispute

Yes Yes Similar

Current account

balance

Deficit (largest in the

world)

Deficit (largest in the

world)

Similar

Undervalued cur-

rencies targeted by

the US

DEM, JPY CNY, Asian FX, JPY Similar

US Solvency ratio

on liabilities

Over-extended by 1:5 Over-extended by 1:2

(2 years of taxreceipts)

Similar

Main nation credi-

tors

European, Japanese Chinese, Japanese Similar

Main type of credi-

tors

Official institutions

(Central banks)

Official institutions

(Central banks)

Similar

Main custodian of

final claim

Federal Reserve of

New York, Fort Knox

Federal Reserve of

New York

Similar

Reserve currency USD/Gold US Treasury

bonds/USD

Different

Type of foreign

claim to the US

government

Currency Treasury bonds Different

Ultimate currency

owed to foreigners

Gold USD Different

Ultimate backing of

external liabilities

US Gold reserves US tax receipts Different

External investor

common belief

USD is the reserve

proxy for Gold as it is

'as good as gold'

US Treasuries are the

reserve tender of the

USD currency

Similar

Event (historical &

possible)

US suspended the con-

vertibility of USD to

gold

US Treasury suspends

redemption of US

bonds with USD, but

pays instead in Inter-

national-Dollar

?

Outcome (historical

& possible)

Gold squeeze, with

gold gaining 2000% in

10-year

USD squeeze? Any

large USD gain would

prove unsustainable

after 2-3 years

?

Source: US Treasury, IMF, Federal Reserve, Bloomberg


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Punitive taxation.Governments are sovereign on their tax reg-ulation, and thus have complete discretion on the tax treatmentof US assets (securities, real estate, etc) held by foreigners, and

very likely on the inheritance tax. The recent Foreign AccountTax Compliance Act (FATCA) regulation is going to make in-creased taxation easier and broader. It is the ideal Trojan horsefor the US to gather worldwide information and transform anyinternational financial institutions into US tax collectors.

FATCA, a Trojan horse: Spoliation and expropriation mostlycomes from changes in regulation and taxation. In that re-spect, the recent tax regulation introduced by Americas Inter-

nal Revenue Services (IRS) regarding foreign accounts of USpersons is to be monitored closely by foreign investors.FATCA will increase the amount of information required bythe IRS, largely on non-US persons (information on US per-sons were already provided under previous agreements), andwill turn any financial institution into an IRS-correspondent.It will be almost impossible for any major financial firm to re-fuse cooperation with the IRS as non-FATCA compliant finan-

cial institutions will be almost unable to deal with FATCA-compliant institutions. This framework, once all financialfirms are included, will be a fantastic tool for the IRS to moni-tor all beneficial owners of US securities throughout theworld, even non-US persons, and to eventually tax them. Non-FATCA compliant institutions could be forced to incur a 30%withholding tax on their assets linked to the US, if they enterinto any business with any FATCA-compliant firm. FATCA isseen as targeting the US persons overseas, but this view ismisleading. Regulations and enforcements on fiscal treat-ments of US persons are largely quite well in place, FATCA isunnecessary for that purpose. It would be consistent with thelevel of complexity required by FATCA that it aims at othersources of tax revenues, mostly non-resident holding US as-sets. If not, that would be a very sorry situation, where bu-reaucracy would have generate tremendous hassle; for no oneto benefit!

The European path to default

Europe sacrificing its own long-term savings.As opposedto the US, the Eurozone does not have a reserve currency, butit does not have any recurring foreign financing needs (i.e.,balanced current account). Its current debt crisis is mostly an


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internal imbalance between southern liabilities and northernassets. Basically, it was a case of German pensioners financingSpanish real estate developers that were hoping to sell their

newly built beach condos to the same German retirees! In theend, the Germans had no intention to retire en masse on theCosta Brava and the phony scheme went bust! We cannot helpbut mention another European circular system due to thecrash: European soccer! How sweet is it to see a Spanishmega-club, heavily indebted and financed by French, German,and Dutch pensioners, trouncing continental clubs over thelast decade! Only Spanish (3), Italian (3), English (3) and Por-tuguese (1) clubs have won the Champions league over thelast ten years. While correlation is not causality, to the casualobserver it seems that financial discipline has clearly not beena winning soccer strategy lately! By inflating the professionalplayer market, highly leveraged Mediterranean and Englishclubs even downgraded other national championships thatdid not follow the player arms race, which then fell out of fa-vor and led to a drop in relative TV rights. What an irony thatin the end, the same German, French, Dutch and Belgian fans,

whose local championships have lost their best players, havesuffered as their clubs have lost their titles (Germans, Dutchand French clubs clinched 4 titles in the previous 10years).These same fans even had to pay to watch Spanish andEnglish matches, and the ultimate irony will be when they willbe asked (or forced) to pay to bail out these clubs! No sub-prime crisis and no American banks to blame here, just plainmadness made in Europe.

As of today, Portugal, Spain (not to mention Greece) have90-150% of GDP in public debt, and 90-120% in external po-sition (Assets minus Debt to rest of the world). Figure 1.5highlights what we call the European Game of Death, andFigure 1.6 examines the solvency dynamics. The mere serviceof this external debt implies that a current account surplus of2-3% of GDP is needed just to stabilize the external balance.In the meantime, current cost of public debt (at 4-5% from

yield on most Bonos auctions) requires an equivalent rate ofnominal growth to stabilize the public debt once the primarydeficit has been eliminated! One word comes to mind: Impos-sible. It is impossible to stabilize external debt with the highgrowth required to stabilize the public debt. It is impossibleto stabilize public debt with the growth contraction requiredto achieve a 2-3% current account surplus to balance external


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accounts. The Euro currency is a straitjacket, pretty much likethe Gold Standard was for the US during the Great Depression.Inflationary monetary measures from the ECB, to benefit the

countries in southern Europe, are very unlikely to materializegiven political differences. Also, and far from the obvious,monetary channels from the ECB to local countries is impaired(like the Federal Reserve System across US states in the1930s). No growth strategy will solve the external debt circle.The end-game is clearly to relieve Spain from its external debtthat is in the form of government bonds due to other Europe-ans. Such a haircut would be supported mostly by pensionfund of northern European countries that have long-term sav-ings in the form of capitalized asset reserves (Second pillar).Such redistribution will be much easier than asking for directtaxpayer contributions to bailout overseas investors. Taking asilent haircut in German, Dutch, Belgian and French pensionfunds is a much more viable political decision for current lead-ers to solve the debt crisis, especially if the victims will under-stand the trick played on them only when they will becomepensioners in 15-25 years (1965-1975 cohorts). European

leaders will succeed in a perfect silent robbery. Of course, anexit from the Euro is a possible alternative, which meanschanging EUR-denominated debt owed to other Europeans,into a local currency. This equates to a monetary default as inthe case of the US (mentioned above), with probable conse-quences of an increased rate of inflation, a depreciation, andan ultimate loss for foreigners. There is no need for Spain tobear the high cost of exiting the Euro, when its northern

neighbors could save the day. This is highly likely, especiallyif the Spaniards push hard enough. Spain, Portugal and othershighly indebted countries could seek a Greek outcome;namely, benefiting from a debt restructuring and, a bailout atthe expense of European banks, insurance companies, pen-sioners, and even Russian depositors (via their offshore ac-counts in Cyprus, whose banks invested in Greek bonds)!


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Figure 1.5: European Game of Death

Source: Eurostat, IMF, Authors calculations, Data of 31 Dec 2012

Figure 1.6: Solvency Dynamics

Source: Eurostat, IMF, Authors calculations, Data of 31 Dec 2012

The end of the Japanese experiment

Japan all-in.We doubt if Japan, at this stage of population de-cline (which is already well in place with structural deflationaryimpact), will really be able to reach any steady structural growth,and/or positive inflation target. In case the current attempts bythe government and BOJ fail, it seems inevitable the country will

Aus

Bel

Bul

Cze

Den

Est

FinFra

Ger

Gre

HunIre

Ita

Lit

Lux

Net

Pol

Por

RomSlo

Spa

Swe

Swi

Tur UK

-200%

-150%

-100%

-50%

0%

50%

100%

150%

200% 0% 50% 100% 150% 200%

Netinvestmentposition

asa%GDP

Public debt

as a % GDP

Aus

BelBul

CroCze

Den

Est

Fin Fra

Geo

Ger

Gre

Hun

Ice

Ire

Ita

Lit

Lux Net

Pol PorRom

Slo

Spa

Swe

Swi

Tur Ukr

UK

-15%

-10%

-5%

0%

5%

10%

15%

-10%-8%-6%-4%-2%0%2%4%

Currentaccount

asa%GDP

Fiscal balance as a

% GDP

Deficit

Surplus

Surplus Deficit

Danger zone

Danger zone


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converge towards the write-off strategy through a smooth de-fault of its debt versus its own people. Given the high level ofwealth and the domestically-financed nature of the public debt,

Japan will not get into any typical debt crisis (such a balance ofpayment crisis). Japanese will sell foreign holdings in Asia, Eu-rope or the US before getting into trouble with their own liabili-ties. For instance, we could see the smooth write-off in one oftwo possible ways: i) turning all fixed-maturity JGB held by thepublic (including via life insurance) into perpetual bonds; and ii)imposing a 100%-inheritance tax on JGBs. This would maintainthe income necessary for pensioners through their life, and erasemost existing public debt over the renewal of a generation. Forinstance, the 1950-55 cohort, the largest in size, will slowly ex-pire starting in 2020. In any case, Japan will be interesting towatch because the country is at the forefront of all structural is-sues faced by other OECD countries, namely the decline of an ad-vanced economy caused by the aging of its population.

How does this relate to gold?

In the wake of this possible outcome, Eurozone and Japanesepensioners should immediately diversify away from their assetsthat their pensions are invested in (Sovereign bonds), and verylikely include gold in the holdings as a default-free asset, espe-cially if they want to secure any inheritance. Indeed, it is amazingto see how inspirational Enron has been to Eurozone pensionssystem! Enron was broke, but managed to look solvent with ac-

counting gimmick that hidden long-term debt and in the mean-time it tapped into its employee pension fund to refinance on-going operations (buying its own stocks and bonds) and stayafloat at the expense of future liabilities, and at the cost of ruin-ing all Enron retirees.

On the other side of the oceans, looking at the US, there are sim-ilarities between US public finances and GM balance sheet as wementioned in the introduction, therefore for non-US residents

gold should come in complement to traditional risk-free assetssuch as US Treasury bonds for their ability to remain free ofcounter-party risk and untouched by unilateral sovereign deci-sions that has always hurt foreigners.


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2.Valuing gold

Overview

Gold is relatively freely traded in most parts of the world. Forfour decades now, its price is fully set on financial markets, afteryears of gold being artificially stuck at USD 35/oz. In 1971, thedissolution of the gold standard brought liberalization of goldprices, and subsequent liberalization of trading made the goldmarket comparable to the market for marketable securities.

Gold gained 1,350% in the 1970s, to eventually reach its all-timehigh annual average price of $612.56 per troy ounce in 1980. Theannual average price for gold then ranged from $318 to $478through the rest of the 1980s. From 1990 through most of 2000,it ranged from $252 to $385. When adjusted for inflation, currentprices at the time were the lowest they had been since the early1970s as shown in Figure 2.1. Since then, gold ramped up four-fold to reach an absolute all-time-high at USD1922/oz in Sep-

tember 2011 and has subsequently declined to approximatelyUSD 1250/oz in November 2013. What forces are behind thesechanges in trends? How is the gold price being determined, whatare the drivers, and are there any valuation metrics for gold? Anattempt has been made to answer these questions in this chap-ter.


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Figure 2.1: Gold price in nominal and real terms (1900-2013)

Source: Bloomberg, BLS, Authors calculations, Gold prices as of December 2013

Given the historical, universal, monetary usage that we detail inthe last section of the book, Gold can be considered both as a

commodity and as a currency. This dual nature should be takeninto consideration when assessing its price setting mechanism.Also, given its growing popularity among diversified investors,we will also look at gold as an asset class in a comprehensive val-uation framework.

Analysis of the supply and demand dynamics of the com-modity framework reveals that: i) the long-term price ispartly a function of total supply related to long-term min-

ing costs; and ii) the total physical demand has no clearimpact on prices, except for short-term effects, typicallyseasonal ones.

In the currency framework, the price of gold typicallyquoted in US dollars depends on i) the inverse value ofthe US dollar versus other currencies; and ii) the attrac-tiveness of gold as a safe currency versus all other cur-rencies. This framework reveals that interest rates and

inflation are the most critical gold price drivers.

The asset class approach shows that relative attractive-ness of gold versus other assets is mainly driven by pes-simism, as opposed to equities, which are driven byoptimism of better days ahead. Gold turning points aresignaled by trends in the equity risk premium, which isthe risky assets opportunity cost, especially since 1971.

16

64

256

1024

4096

1900 1920 1940 1960 1980 2000 2020

Gold price ($/oz, log-scale) Real gold price (2012$/oz, log scale)


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This framework helps us inversely link gold with eco-nomic growth. Unsurprisingly, gold is the preferred assetfor investors in aging societies as these societies are past

their prime and favor safety and conservation overgrowth and creative destruction.

As we will see, the gold price is mostly defined as a currency.Perspectives of gold as commodity and gold as an asset class alsoplay an important part in the valuation picture, but remain sec-ondary to the currency perspective.

Indeed, gold transactions of the financial or secondarymarket dwarf the commodity or primary market, withnew supply representing only 2% of the total aboveground metal. As a result, its price depends, unlike tradi-tional commodities, more on its value perception than onsupply and demand dynamics of the physical market.

Gold remains very popular in financial discussions, but it re-mains largely a secondary asset. The entire stock of aboveground gold amounting to about 174,200 metric tons, -i.e. USD

7-8 trillion at current prices- is a relatively small figure as com-pared to other financial assets such as the total global marketcapitalization of bonds, equities and bank deposits (respectively,USD 100, 55 and 60 trillion). Of this amount, much less is availa-ble for trading in the market. About 60 percent or more is em-bedded in jewelry, dentistry, other industrial applications, andcentral bank holdings, leaving no more than 16-20 percent of theabove ground gold or about 0.5% of the total global stock of liq-uid wealth available for private investment.

Gold as a commodity

Fundamental analysis for gold price determination, from a com-modity perspective, naturally involves the study of supply anddemand on the physical market. First, we must assessed the ex-isting stocks because gold being indestructible commodity, it

never disappears and its stock is what is primarily exchanged inphysical markets. Second, demand can be separated in two keyscategories: financial demand (FD) and non-financial demand(NFD). Third, supply is based on: new supply coming from min-ing, existing supply returning to market (i.e., scrap) and existingmarketable holdings. To avoid logical pitfalls on causality be-tween prices and quantities, we also study of the price impact of


32/44



changes in supply and demand to validate or invalidate the pre-dictive power of demand and/or supply.

Gold stockThe total gold ever extracted is estimated at 174,200 metric tons.Being indestructible, and chemically inert, and having been care-fully preserved, and conserved, nearly all the gold that has beenmined in the last five millennia is still above ground, 90 percentof which is more or less locatable, and, in large measure, is eitherstill in use, retrievable or potentially available for use, and canbe accounted for. The above ground gold stock represents a cube

of 21-meter length, which is the most striking fact to grasp howscarce gold is. Divided by world population, it means that eachindividual can hold no more than 25 grams or about 4 rings asshown on Figures 2.2 and 2.3.

The 20th century has seen rapid and sustained increases inworld gold production as seen on Figures 2.4. The output fromold and new gold fields has been augmented by the development

in mining methods and equipment and in metallurgical extrac-tion processes, yet future supplies appear quite limited. TheUSGS estimates world underground resources of gold at about100,000 metric tons (only 50,000 of which are economic re-serves7). According to these estimates, in 1998, the 50% thresh-old was crossed with more gold being extracted than still inrecoverable reserves. This would also mean a 60%-increasefrom the existing amount and such an increase is typicallyreached in 30 years. And in the end -say 2050- when this amounthas been retrieved, total gold would only amount to a cube of 24-meter length.

By coincidence, gold per capita, has been quite constant through-out history at about 20-25g per person, as population grewabout as fast as gold was retrieved, as seen on Figure 2.5. Inter-estingly, this possible end of gold accumulation could almost co-incide with the peak of human population. Indeed, United

Nations demographic projections increasingly make mention offast-declining fertility rates, and lower-bound estimates of pop-ulation see a population decline starting in 2050 (while medianscenario expect this for 2100). Of course, both estimates on re-serves and population trends at a 50-year horizon are subject to

7 Economic reserves are defined as reserves that can be currently accessed at a profitgiven current gold price and extraction costs.


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caution Forecasting is hard, especially about the future! -Yogi Berra.

Figure 2.2: 40 Centuries of gold per capita

Source: Gold Money Foundation, GFMS, US Census Bureau

Figure 2.3: A century of gold per capita

Source: Authors calculations

4

8

16

32

64

128

Lo

g-scale

Total gold inventory/ World population (grams per person)

18

23

2726

24 23 24

25

23

1.72.0 2.5

3.04.0

5.06.0

7.0

12.0

1900 1927 1950 1960 1974 1987 1999 2012 2050est.

in oz/person (grams) World population (Bil)


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Figure 2.4: A century of production and reserves

Source: Authors calculations,Gold prices as of 31 Dec 2011

Figure 2.5: Population and gold stock have grown at a similar pace

Source: Gold Money Foundation, US Census Bureau, Authors calculations

Breakdown of gold demand

Change in demand for gold especially change in financial de-mand is often cited by commentators and analysts as a keydriver of change in prices. Unfortunately, for investors, we findthat physical demands impact on prices is temporary and be-

yond this short-term effect, it is the demand that is driven by

100

1,000

10,000

0%

50%

100%

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

log-scale

Cumulative gold production (% of total disposable gold)

Gold reserves (% of total disposable gold)

Annual world production (in MT, RHS)

0.7%

1.8%

1.4%1.3%

1.6%

1.8%

1850-1950 1950-2000 2000-2012

Population growth Gold stock growth


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prices. Not to the contrary! It is precisely what is seen in histori-cal data over a century in the United States: gold consumptionper capita drops when prices rise and increases when prices fall.

Interestingly, the per capita gold consumption has remained sta-ble over time at 1 ounce per 40 years, independent of rising pur-chasing power. Therefore, over the long run, population growthhas been the main driver of greater gold demand.

Non-financial demand

Non-financial demand (NFD) represents the lion share of cur-rent global demand, with about 76 percent of gold consumed an-

nually, but not in gross transactions dominated by financialdemand as will be described later. Jewelry is the dominant non-financial demand category; others account for some 15% of theNFD as highlighted in Figure 2.6. The next NFD is related to den-tistry followed by the electronic industry using 250 tons of goldfor its conductive properties. Evidence across geographies overa period of time displays similar trends of gold consumption.Gold demand for jewelry had been strong; amounting to 3250

tons in the late 1990s when gold was less expensive, but declinedby a third, over the last decade as shown in Figure 2.8 and 2.9,with the increase in the price of gold. Based on this divergingtrend, highlighting the inaccuracies of the popular explanation ofthe gold bull market, that the growing Indian middle class appe-

tite for gold is driving prices.

Figure 2.6: Breakdown of total non-financial demand per sector in 2012

Source: World Gold Council

Jewellery

81%

Electronics

13%

Dentistry

2%

Others

4%100% =2,336 MT


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Jewelry, is negatively affected by high prices, and tends to act as a

price buffer. India is the largest gold jewelry manufacturer andconsumer. It has its own unique cultural, economic and financial

basis. India is also the world's top exporter of jewelry, despite thefact that gold and gems are often intermediary components of Indian

exports that are not counted as metallic exports but rather are countedas manufactured goods. India's domestic usage of gold may have

perhaps been a bit overstated as India is nowadays more of a major

jewelry producing platform than a few decades ago, exporting itsjewelry to the US, EU countries, and the Middle East. The majority

of jewelry manufacturing establishments worldwide consist of small

shops and individual artisans. According to the USGS publication,

Gold Fields Mineral Services Ltd. estimated in the early 1990s thatperhaps 2 million goldsmiths were working in India, and 400,000people employed in the jewelry industry in China.

Figure 2.7: Breakdown of total jewelry demand by country in 2012

Source: World Gold Council

It is the cultural aspects that make India the prime holder of goldand silver jewelry as shown in Figure 2.7. There are reasonsother than the clichs of Maharajahs jubilees and the mysterious

Maharanis lust for sophisticated jewels8Gold and precious arti-cles act as secure store of value for Indians, mostly due to the

8 Maharaja is a king and Maharani is a queen in South East Asia.

India

29%

China

27%U.S

6%

Turkey

4%

Saudi Arabia

2%

Rest of world

32%

100%= 1,908 MT


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absence of a dependable banking system and the lack of trust inits currency, as India has suffered from inflation in excess of 7%per annum, and the strict state control over currency converti-

bility.Most marriages in India have long been organized weddingswith economic reciprocity where the brides jewels serve as thedowry to ensure her future. The artifacts are traditionally andculturally popular, rather essential for a respectable marriage, aswell as a necessity in the rural areas where these ornaments actas secure savings to dig out in times of need. In the absence ofbank branches, the omnipresent 'mahajan' or 'banya, (local

money lender and merchant), is ever ready to buy or mortgagethese artifacts. Of course, there are cases where many menmarry women only for their jewelry and gold ornaments andmany young women marry rich old men for gold!

Figure 2.8: Annual jewelry demand (MT)

Source: GFMS, World Gold Council, Bloomberg

0

500

1,000

1,500

2,000

2,500

3,000

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012


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Figure 2.9: World jewelry demand versus real gold price

Source: GFMS, Bloomberg, Authors calculations, Gold prices as of 31 Dec 2012

Figure 2.10: U.S. per capita gold consumption and gold price

Source: U.S. Geological Survey, US Census, Federal Reserve, Authors calculations, Gold

prices as of 30 April 2013

When prices rise, the NFD declines. This reflects the normal cau-sality of price to demand, in a market where supply is somewhatrigid and consumers are price takers. This is relevant with NFDactors given the fragmentation of the buyers (especially in thejewelry segment). Over the medium to long run (one-year andbeyond), there is no evidence that NFD has driven prices; there

0

500

1,000

1,500

2,000

1,500

2,000

2,500

3,000

3,500

1990 1995 2000 2005 2010 2015

World jewellery demand (MT) Real gold price (US$/oz, RHS)

0

500

1,000

1,500

2,000

0.00

0.02

0.04

0.06

0.08

0.10

1900 1920 1940 1960 1980 2000 2020

Per capita consumption (oz/year) Real gold price (US$/oz, RHS)


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is even evidence that prices managed to rise when NFD declinedstrongly (Figures 2.9 and 2.10).

Analysts and forecasters would be misled if they explained any

durable changes in gold prices with NFD, especially jewelry. Byextension, any gold forecast based upon projections of NFD isuseless. Rather, industry analysts can consistently forecast jew-elry demand and NFD for gold based on its expected price action.

Short-term effects and seasonal patterns

There is one caveat to the notion that there an absence of NFDimpact on gold prices: we do believe NFD can consistently im-

pact prices over short-term (1-month), and this has broughtsome significant seasonal patterns in gold prices. The proposedexplanation may be building a thesis on a spurious correlation,but the consistency of the evidence deserves to be considered.

Timings of festivals and religious calendar reveal a seasonal ef-fect on gold consumption and prices. In fact, since 1984, goldperforms significantly better in the last four months of the year

and in January than in other months as shown in Figure 2.11;September being its best month, registering prices upward of3 percent, on an average.

Figure 2.11: Seasonal profile of gold performance

-2%

0%

2%

4%

6%

8%

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Average monthly return since 1980 Cumulative year to date return


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Source: Bloomberg, Authors calculations, Gold prices as of 31 Dec 2012

September marks the end of Indian monsoon period and Indianagricultural cycle. The harvest having been completed and mon-etized, the peasants and farmers have money on hand, and theystart converting their cash into gold, given the lack of sound fi-nancial savings system, especially in rural areas (i.e., inflation,unsecure banking system). This season also marks variousHindu festivals, Durga, Puja, Saraswati Pooja, Dassehra, and Di-wali, falling in the period from October to December, whichcould also tends to be an auspicious time for weddings. This end-

and turn-of-the-year also coincides with Christmas and NewYear celebrations in the Anglo Saxon world as well as the ChineseNew Year and leads to an exchange of gifts and presents.

These seasonal occurrences are likely to support the idea thatgold prices can be affected by NFD in South Asia on a short termbasis (1-3 month) during the last quarter of the year (includingJanuary). This end and turn of the year also coincides withChristmas and New Year celebrations and exchange of gifts andpresents, as well as with the Chinese New Year. This idea wasalso tested with the Muslim religious calendar, which would alsotend to push up gold demand, resulting in price hike during thefestivities at the end of the fasting month (Ramadan) and the re-start of weddings that follows the month of Ramadan. The chang-ing date of Ramadan across the Julian calendar would thereforebe a test of whether the previous explanations (i.e., reli-gious/seasonal festivities) were spurious about the end/turn-

of-the-year effect.

The analysis, highlighted in Figure 2.12, shows that prices do in-crease during the month of Ramadan by about 2 percent. Theother months display a merely 0.3% average increase since1980. For this statistical test, the Muslim lunar calendar of 354days, rolling over the solar calendar of 365 days, brings themonth of Ramadan revolving over all the solar months duringthe study sample. This out-of-sample test strengthens the casefor seasonal patterns on physical gold demand and its short-term effect on prices.


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Figure 2.12: Monthly returns of gold since 1980 sorted based

on Ramadan

Source: Bloomberg, Authors calculations, Gold prices as of 30 April 2013

Financial Demand

Financial demand (FD) represents only about a quarter of totalphysical demand, but thanks to its high volatility, it has remained

the dominant driver of changes in total demand. FD has beengrowing and its impact has often been denounced for jackingup gold prices. Traditionally, FD was dominated by central bankmoves; but recent financial demand has been fueled by inves-tors appetite for commodities, and by increasing supply of gold

tracker funds (such as exchange traded funds), which often usegold futures and physical backing in their holdings.

Figure 2.13: Breakdown of financial demand in 2012

Source: Bloomberg, World Gold Council

1.0%

1.7%

0.5%

Month After Ramadan Ramadan non - Ramadan

Bar and coins

81%

ETFs

18%

Comex

1%100% =1,525 MT


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As shown in Figure 2.13, financial demand consists of trackersfunds also known as ETFs; future and derivative instrumentsbacked by gold (exchanged on the COMEX in New York) and

other private investments, which include gold bars and coinsstored mostly in vaults. The first tracker was launched in 2003and the demand has rapidly grown to reach almost a quarter oftotal FD. More details on trackers are provided in the section onInvestment vehicles in Chapter 3. 'Other investments corre-

spond to the holdings of gold bullion and coins by individualsand private sector. Central banks are not included because theywere net sellers in 2008, as they have been since 1989, but thiscould change with emerging central banks building up positionson gold, and could reappear in the financial demand calculations.

The financial demand for gold, as compared to non-financial de-mand, is growing and can be very volatile. Although financial de-mand constitutes only 29% of the total demand, its highlyvolatile behavior makes it potentially a significant driver of goldprices in the short term.

Financial demand has to take into account the negative impact of

hedging from the gold mining industry, whether in futures or inoptions (which act as financial supply that hits the market beforeits physical supply). By selling futures or option contracts for de-livery of gold at a future date, producers are able to reducedownside price risks, and in some instances, when the price fallsmore than anticipated, actually make a profit from the hedging.Also, by hedging several years production, producers forego thepossible profit to be made should the gold price rise. For this rea-

son, several producers in the United States and some other coun-tries have been reluctant to hedge.

Gold trackers currently represent in excess of USD100 billion incapitalization or about 75 million ounces in gold. Exchangetraded funds (ETFs) replicating gold have been very popularamong retail investors, but also with institutional investors. Forinstance, John Paulson, the famous hedge fund manager hasheavily invested in gold through the GLD tracker. The evolution

of global gold tracker funds from 2004-2012 is provided in Fig-ure 2.14


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Figure 2.14: Global ETF demand (2004-2012)

Source: Bloomberg, Authors calculation, Gold prices as of 30 April 2013

Given the recent trends, especially in the private financial de-mand, it is hard to understand the precisely impact financial de-mand will have on prices. Unlike other categories of buyers ofphysical commodities, investors are buying gold in a rising mar-ket: higher prices usually trigger more buying as a result of theherd or momentum effect. Increases (declines) in trading vol-ume on the gold ETF were seen after price increases (decreases).Therefore, there is no tangible evidence of causality, that finan-cial demand is really behind gold price dynamics, as is oftenmentioned in media or research analysis. Popular headlines suchas: Investor rush on gold ETF fuels gold bull markethave no em-pirical backing. In the light of available evidence, the causalityeven appears reverse, but given the lack of a significant sample,we leave this as an open question. It is plausible that an exoge-nous change in financial demand could impact gold prices by cre-ating a scarcity on the physical market thus pushing price up. We

consider that such an impact is similar to one on any security,which would remain only temporary and can be classified as ashort-term catalyst. Such short-term perturbations, caused bybehavioral patterns, have often been found in academic researchon equities. We will see in the last part of the book, how investorscan take advantage of it.

0

500

1,000

1,500

2,000

0

20

40

60

80

100

2004 2006 2008 2010 2012

ETFholdingsinMoz

Gold trust (SPDR) Gold bullion securities (Lyxor)

NewGold iShares gold trust (COMEX)

ZKB gold (SWX) ETF securities

Julius Baer


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gold investing handbook

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