5 Factors Driving Gold in 2008
Supply and Demand
The single most important factor driving gold higher has been the global increase in investment demand. That investment demand has been broad-based around the world and shows no sign of fading, particularly given the current doubtful status of financial assets and markets.
Mine production is falling at the same time that demand is rising. In response, worldwide investment demand for gold will remain at historically high levels this year and next, significantly exceeding 40 million ounces. There will be a point in the near future when the gap betweens supply and demand becomes too hard to bridge and prices will react accordingly. As we said last year, don’t rule out the possibility of a full-blown mania in gold.
Central bank sales of gold, which served to depress the price throughout the ‘90s, have come to a screeching halt, with most central banks having already liquidated their gold reserves to a bare minimum. Instead of selling, central banks are becoming buyers.
The Dollar
Over the past five years, the dollar has lost 50% of its value versus the euro. Large institutions and central banks are moving their dollar-based assets into non-dollar based assets at a time when the U.S. economy is slowing to a crawl. In order to stop the U.S. economy from falling into a recession, the Federal Reserve has no choice but reduce interest rates in order to stimulate the economy. As rates decrease, the dollar falls. As the dollar falls, investors are moving their dollar-based assets into tangible assets such as gold – increasing demand and pushing the price even higher.
Institutional Buying
In recent years, there has been a tremendous increase in institutional demand for gold. In addition, although individual investment demand has been relatively muted in the U.S., there is plenty of demand from the flourishing middle classes in China and India and from central banks in countries that have enjoyed gains from foreign trade, such as Russia, the Persian Gulf oil producing states and China. The gold market continues to enjoy robust physical demand combined with fund-led speculative activity, particularly during periods of dollar weakness. That speculative activity is expected to increase as the flight from the dollar accelerates.
Oil / Gold Relationship
The positive correlation between gold and oil prices will continue over the next few years. Historically, the average oil/gold ratio has been around 15:1, meaning that the price of 15 barrels of oil equals the price of one ounce of gold. That ratio has recently dropped to around 10:1. To return to average levels, the price of gold would have to increase to around $1400 (or there would have to be a drop of similar magnitude in the price of a barrel of oil). In the near future, $1400 gold is more likely than $50 oil.
Economic Uncertainty
The uncertainty in the U.S. stock market has caused investors to move part of their savings into more stable assets, such as gold, which have provided portfolios with much needed protection and excellent investment returns. Today, we’re hearing much of the same language we heard in 1987, when Alan Greenspan said that the world was on the edge of a global financial collapse. The 1987 market crash precipitated a stampede to alternative assets. Much the same thing is happening now, as the credit markets go through the same sort of collapse that equities suffered in the autumn of 1987. The Fed and other central bankers have taken the first steps to inject additional liquidity into the markets, but trust has been damaged and will take time to repair.
The domestic backdrop is much less positive than it was in 1987, when the U.S. economy was in solid shape. Now the underlying cause of the crisis is the domestic economy and housing deflation. Real consumer spending is declining; payroll employment numbers are falling; and industrial production in the U.S. is losing traction.
The U.S. economic outlook has deteriorated significantly, and there is much talk of a full-blown financial crisis triggering a major recession. As a result, the Fed has reiterated its pledge to aggressively reduce interest rates and has also endorsed fiscal stimulus. The Fed funds rate is expected to fall to 2% within the next 12 months. The stock market has fallen off a cliff, and tangible assets such as gold will be the ultimate beneficiaries of deteriorating sentiment towards financial assets.
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