## Worth its weight

The Panel
HSBC

John Levin, Managing director
UBS Investment Bank
Edel Tully, Director, Precious metals strategy
World Gold Council
Marcus Grubb, Managing director, Investment

Risk: The gold market has risen considerably over the past year, confirming its status as a safe haven in times of crisis. However, there was a significant sell-off in July, which some in the market have attributed to a return in confidence in the European financial markets as gold investors cut their holdings. Edel, could you explain what the drivers of gold prices had been over the past year?

Edel Tully, UBS Investment Bank (ET): The first four months were relatively quiet for gold. There was a lot more interest in platinum and palladium. In May, when the risk of sovereign default in Europe was heightened, gold in its safe-haven role then received renewed interest. From mid-May onwards, we saw a significant increase in safe-haven demand, be that through buying coins or small bars. The market obviously saw rising exchange-traded fund (ETF) investments. We also saw an accumulation of net longs on Comex, which lasted until the end of June. Over the last month [July], we’d seen a near-reversal in that sentiment. Gold’s safe-haven qualities have taken a back seat. There is no longer the risk, at least in the short term, of sovereign default. Investors have also been very cautious over the summer months and that is a reflection of seasonality. July, typically, is a poor month for gold. Because of summer trading conditions, any move becomes an extreme move because of the lack of liquidity. Yesterday [July 27], we saw long liquidation and gold broke through key technical support. We saw short selling as well. The sentiment has moved from a cautious stance over the last 10 days to an outright bearish position yesterday.

Risk: Marcus, are we seeing a return of some jewellery demand driving gold prices with investors pulling back somewhat?

Marcus Grubb, World Gold Council (MG): That’s the ebb and flow of the market over the last few months, certainly since Christmas when we hit the then all-time high of $1,200 per ounce. You need to take a step back from the day-to-day flows because, if you look at investment demand, it’s been growing really since the advent of the gold ETF market more than five years ago. As a proportion of demand, despite the recent pullback, gold investment is relatively high as a proportion of demand versus jewellery. When you see the price pullback as we have done over the last few weeks, you’re seeing physical buying in Asia come back into the market, predominantly in India, but also in China. That has been the case in the last 48 hours. There is that balance between the paper trading of gold on Comex and physical buyers in Asia. What we’re seeing is a more structural re-evaluation of gold as a monetary asset and as an investment asset that is only partly driven by the sovereign debt crisis. Although some of that buying has now come out of gold, it was from a relatively high base of investment. Even with the pullback, you still see a large net long on Comex. You still have got strong investment demand in terms of the amount of gold that is now held in ETFs, which is nearly 10% of annual demand. This is a market that didn’t exist five years ago. Looking forward, the issue is whether that investment demand returns or whether there will be a resurgence in sovereign risk fears or fears of quantitative easing later in the year. Fears of inflation could also surface later on. There’s a bigger structural shift occurring in the shape of demand for gold. That’s unlikely to change, given the macro-economic scenarios that face us over the next few years. You’re going to see continued strong investment demand. Finally, it is partly driven by changes in investors’ attitudes to risk management. They are looking more for wealth preservation. If they take risk and pursue alpha, it’s in a more controlled way than in the past. Therefore, hard assets like gold and precious metals in particular are probably likely to be more highly weighted in portfolios than they were in the last decade. Risk: John, could you give us the view from the trading perspective – how are investors taking their positions in gold and how important is the ETF market? What sorts of strategies have we been seeing? John Levin, HSBC (JL): Gold has become a much more egalitarian market. In the past, it was really the preserve of the very high-net-worth individuals and funds that could trade futures or had over-the-counter agreements with trading banks. The big change to gold in the last year has been ETF flows. Anyone now who has a stockbroking account can own gold through an ETF. That has been the single biggest positive development for gold. The frames of reference have completely changed. The definition of the gold market six years ago was very different to the definition today by the breadth, the variety, the colour and the texture of the market. It’s actually becoming a very hard market to analyse because it has changed in so many different ways. There is no back-testing you can do on these new participants, you don’t really know how they are going to behave in a certain environment; whereas you can look at people’s performance in past stressful periods and how they’ll perform with their portfolios. The ETFs by nature tend to be unleveraged and that changes the characteristics of their behaviour patterns a lot. If you’re leveraged five or more times, a 2% or 3% move in gold becomes a 10% move, it makes one automatically very alert to that. But, if your ownership is part of a bigger portfolio and it’s unleveraged money, it becomes much more passive. We’re not seeing any sort of kneejerk reaction to that market. The markets that we’re seeing activity from tend to be the leveraged community because, by nature, they just need to be a bit more proactive with their positions and that’s all we’ve seen in the last couple of days. Risk: Is the ETF market primarily retail-driven? Does it depend on what side of the Atlantic you’re on? What sort of effect are the ETF flows having on supply and demand? Are investors very much keeping a hold of gold and not lending it out at all? ET: The most popular ETF is the GLD, which is US-based, which is a combination of institutional and retail investors. That’s one of the reasons why ETF holdings today have been so stable. They’re very much sticky investors with a buy-and-hold attitude. That does give gold some sense of stability and is not typically a highly leveraged play. While we do pay attention to ETF flows on a daily basis, it’s more a case of looking at the overall picture. Typically, gold is not influenced by supply and demand fundamentals on a short-term basis. Gold is very much influenced by external factors in the market, be they macro-economics, financials, and so on. In a way, over the last 24 hours, gold is coming back to the old-style market where jewellery demand is playing is much greater role. We’ve seen that play out through greater demand in India, China and Asia in general. The physical side of the market can prevent gold falling when you’ve got investors selling heavily. Once the investors stop liquidating and the weak longs are out of the market, then the physical market becomes a lot more important and helps to provide that floor. That’s what we’re seeing right now. Risk: Marcus, how do you see the ETF developing? While retail investors are stickier than some of the other leveraged investors, there are still concerns that, if there’s a significant change in conditions, those retail investors might sell out of the ETFs, which could create more volatility in the market. Do you see those dynamics at play? MG: What we’ve learnt from being involved in the inception of the ETF market since the early 2000s is that, first of all, these instruments are a securitisation of physical gold – they allow people to own physical gold by buying a share. They are not a derivative, they are making more accessible a commodity for which there was latent demand. The ETFs have made that demand executable. Once you understand it that way, you then realise a few other things. One is that – and I think it’s borne out by the redemptions and the creations of gold ETFs compared to other metal ETFs – there is a stickiness about the demand at both the institutional and retail level and the private wealth level. There’s a very large asymmetry between creations and redemptions. If you see a big rise in the gold price, you’ll see large creates or risk scenarios like the day Lehman fell in 2008 – a$1bn create in 24 hours of net new money flowing into gold. If the price drops by a similar amount, you see probably one-tenth the size of redemptions. There’s a clear pattern with the ETFs that, despite the fact that tonnage stagnates from time to time, you even get some redemptions, on average, over five, six years since inception; it’s a more or less constantly rising asset under management. That makes sense to us because gold is less volatile than other metals.

Second, thinking more broadly about investment and strategic asset allocations and the wrappers and the instruments that one can use, it’s not rocket science to think that ETFs as a product have a bright future. They are very liquid, they are very easy to use and, in general, they are very cheap in terms of cost and execution. As a wrapper, the ETF is a relatively young product, and I believe from an investment background that they have a bright future.

Risk: Edel, you mentioned that there was an acceleration in the interest in gold in May and June when the eurozone debt crisis was at its peak. Did you see new types of buyers coming in – people who weren’t traditional gold investors and were using gold as a macro hedge?

ET: To a certain extent, yes. We saw new investors taking a long-term approach to the market, certainly not as short-term play. One of the trends we saw emerging was a movement towards physically allocated gold, be that investors who are very much new to the market or investors who were moving from another gold product and simply wanted to eliminate as much as possible their exposure to paper assets, including paper gold. While that has been evident in recent years, interest kicked off dramatically in May and June. It’s taking a step back now, which is unsurprising considering where gold is trading. There have been some new investors, but there hasn’t been a rush of them. Compared to the size of financial markets in general, the gold market is tiny. Any small move towards diversification to gold could have big implications for this market. We have been seeing increased enquiries from pension funds, etc., towards diversification, but it’s still in the early stages.

JL: I agree with Edel. On my last few trips to the US I’ve put myself entirely in the hands of our equities team. This is new for me. This was seeing very large money managers, equity funds, pension funds that hitherto I had no clue about. For all the talk about gold, the actual expression level is very low. Not many people actually own it. During these trips, I get 10 or 12 people wandering into these meeting rooms – and these are multi-billion dollar institutions – and they are clearly spending a bit of time analysing this market, trying to get to grips with it. That’s what a lot of these new investors are struggling with. They’re used to doing a lot of back-testing, a lot of modelling and calculating fair value, but gold is actually quite a difficult thing for which to find a fair value. These are very big ships and, once the bow turns, they tend to keep turning. That’s why I think this flow of money will continue for a while.

Risk: Marcus, if you were talking to a pension fund, for example, what arguments would you give for them turning to gold?

MG: It’s a lengthy process by which you put forward the argument for gold as an investment asset, an asset class and as a monetary asset. There are two answers to the question. One is the fundamentals surrounding gold as a commodity. One of the ways you can get some idea of fair value is looking purely at supply and demand fundamentals. You have to understand the cultural significance of gold in different countries; you have to understand that Indian households probably own more than twice as much as the Federal Reserve. You have to understand that China and India are the two biggest demand markets that are very diverse on the supply side. A lot of people still think that South Africa is by far the largest producer, but that’s not the case anymore. You have to understand gold’s volatility. The volatility of gold on a trailing basis is actually surprisingly low compared to other commodities and individual equities. There is a stability around it and there’s a diversity of demand and supply; there’s a physical and non-physical market, which interact to determine the price. If you understand all of that, you’re better equipped to understand where the fair value is.

The other side of the argument is that, if you’re assured that it has stability as fair value in some range, it’s then about understanding what it can do in the context of a broader portfolio where you’re investing strategically in the asset classes that large funds tend to invest in: equities, fixed income, property, other asset classes. We’ve done quite a lot of work using portfolio optimisation techniques where we’ve effectively back-tested the presence of gold in a portfolio for institutional investors in different currencies all around the world using a benchmark portfolio that a traditional pension fund or an insurance company would have. The bottom line is, because of the combination of real return, covariance, correlation and volatility, gold scores very highly in a portfolio context. It actually has an insurance and wealth preservation property and a lack of correlation with other asset classes in general and especially in extreme scenarios. That means a weighting of somewhere between between 2% and 10%, generally averaging something like 5%, which would be borne out by most optimiser models if you use them over a 20- to 25-year history in most currencies. That is a surprising result. If you take that result to institutions, they’ll tell you they certainly haven’t had that weighting in gold over the last 20 years. It is an under-owned asset class. There’s a lot of work to be done in educating investors to better understand gold.

Risk: John, how do you see gold in the inflationary environment, particularly as gold has been seen traditionally as a good hedge for inflation? There are a lot of different opinions on the direction of inflation, a lot of investors are going out there buying inflation floors as a hedge against deflation – do you see these dynamics having any impact on gold?

JL: There are three outcomes that people are thinking of. They are: inflation, deflation and the third outcome is that everything returns to normal. What I’m hearing and I subscribe to is not so much that gold performs well during inflation, but that gold performs well when inflationary expectations are there because it’s more about what the policy response to that is going to be. To me, gold is reacting to what the policy reactions are going to be. Inflation is not necessarily good for gold because if it is attacked with monetary policy, that kills of some of the reason to own gold. What people think though is that, if inflation is coming, central banks around the world – particularly the G-7 ones – are going to let it go. They want inflation, they desperately want to claw out of this hole they’re in.

Once inflation gets a hold, we know that it’s very hard to nip it in the bud, but they are not prepared to do that right now. They’re not prepared to kill growth.

If they detect any deflation, they’re going to come at it with every tool in the arsenal, expanding monetary supply, quantitative easing, everything that we’ve seen in the past. Deflation is very bad for running a debt. Again, it’s policy response rather than the actual event. Is deflation good for gold? Not really. It’s a wealth preserver, but it’s the policy response that people react to. What we’re seeing right now is the in-between. The stress tests out of Europe were positive, we’re seeing a bit of economic data that’s positive, the world is benign right now. A lot of our hardcore investors in gold are looking over the horizon a bit. They’re trying to position themselves for an event that ‘might’ come.

ET: The inflation trade was very strong in 2008 and prevailed throughout 2009, but took a step back at the beginning of this year. If you’re an investor and you buy gold as an inflation hedge, you would have had to extend your horizon out in terms of when that inflation could be on the cards. It’s the expectation of inflation that is hugely important for these markets. There are investors in this market who have bought gold as an inflation hedge, but to play that role you’ve got to have a long-term horizon, and that can’t be a short-term trade.

Gold may not perform in a deflationary scenario. But, if you attach the tag of gold being a store of value, then you can carve a thesis for gold’s role in a deflationary scenario. Right now, we’re probably somewhere in the middle of inflation and deflation. We’re probably touching towards inflation, even though right now we have a lot of parallels with Japan. But, as John said, it comes back to the policy responses.

Risk: Edel, there seem to have been some changing dynamics in the gold market over the past years, specifically with regard to lease rates. Are you able to describe the trends we’d been seeing on that front and what they mean?

ET: One of the key changes to gold over the past 12 months has been the increased presence of investors and the falloff of the presence of the jewellery sector. In 2009, the investor portion of the market was more dominant. In one way it indicates that gold may be vulnerable because there’s so much investor participation, but it also indicates the changing fundamentals in this market during different time periods. We’re seeing now the jewellery side trying to play a greater role than it had in the past, simply because prices are at a more attractive level. One of the other changing dynamics in the market is the changing role of the official sector. Last year, the official sector was the net seller of 41 tonnes. This year, it’s shaping up to be that the official sector could be the net buyers – the first time since 1988. That is an important shift in the market. The movement of the official sector from being net sellers to net buyers is an important underlying support for the market. If you look at the central bank gold agreement, selling through that platform has been very quiet this year. We know that the International Monetary Fund (IMF) is selling gold that’s largely priced in. But, outside of the IMF, actual selling through the central bank gold agreement has been very limited. We’re seeing buying in the wider official sector space from the likes of Russia. On a net-net basis, it’s looking like it will be on the buying side but, in aggregate terms, it’s not going to be as significant. The sentiment behind that behaviour will be important. The market is paying attention to that, it never forgets its fundamentals – they always return to the fore during certain periods.

Risk: Where do you think the gold price is going to be at the end of the year?

JL: The way I see the world playing out, the macro view and the response to that, I can’t help but think we are going to see higher prices. It’s a perfectly rational and orderly market. There are valid reasons to own gold. The way I see the macro environment playing out, I don’t think we are through this crisis. Based on my opinion of that alone, I think we will revisit higher prices. $1,500 per ounce is not beyond imagination within 12 months. MG: In line with our earlier conversation about the macro-economic situation, I think all of that favours a relatively strong market. Although recently you’ve seen hedge fund investors and other paper investors come out of the price, what I understand from the market is that a lot of the selling recently has been in that more speculative end of the market. Ultimately, the core holding of gold from an investment perspective is still unchanged in the sense that the ETF tonnage is still very high and you’re seeing institutional investors who have a very much longer view of gold. ET: UBS’ average forecast for 2010 is$1,205 per ounce, which we just recently increased by close to $100. We’re trading just beneath that right now. Gold will reach new highs as we get towards the end of the year. As we get higher, our attention then turns to the other side of the physical market, and that’s scrap supply. There are certain factors that can lower the price of gold, not just from investors selling. We saw that in May as gold was going through$1,250 per ounce, we saw a lot of scrap coming through Asia while the West was content to buy. With the expectation that gold will move higher in the fourth quarter, we need to be alert for scrap supply. Also, with gold prices higher, we expect that jewellery demand will be somewhat lower than we’re seeing now. By and large, it’s a positive outlook but it’s not a one-way street. I wouldn’t be surprised if gold was north of \$1,300 per ounce by the end of the year.

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