Eleven factors that provide strength to gold

By Jeff Nichols
The future price of gold is a function of past and prospective world economic, demographic, and political developments.


Gold’s Bullish Building Blocks

There is no simple answer or single reason why gold has been moving from strength to strength for some ten years now. Here’s my list of eleven factors fueling gold’s ascent:

- First, U.S. Federal Reserve policy characterized by low or negative real interest rates and unprecedented central bank monetary creation.

- Second, the U.S. federal budget impasse, rising U.S. sovereign debt, and eroding U.S. creditworthiness.

- Third, the ongoing and expected future depreciation of the U.S. dollar in world currency markets.

- Fourth, accelerating global inflation – with high and rising agricultural and industrial commodity prices leading the way.

- Fifth, fear of sovereign debt defaults and bank failures in one or more of Europe’s "periphery" economies. These countries, despite tax increases and deep spending cuts, continue to see their debt ratings and ability to refinance both government and private-sector bank debt deteriorate. Moreover a widening economic schism across the continent calls into question the viability of Europe’s common currency, the euro.

-Sixth, the continuing civil war in Libya and political unrest across North Africa and the Middle East – and the threat to future oil supplies.

-Seventh, the growing affluence of the emerging-economy nations and the associated growth in gold demand – especially the two big population countries, China and India.

-Eighth, central bank buying by countries under-invested in gold and overexposed to U.S. dollars.

-Ninth, the development and maturation of new gold investment channels, especially gold exchange-traded funds, that make it easy for investors to buy physical metal.

-Tenth, the legitimization of gold as an investment class and the expansion of investor interest among retail and, importantly, institutional investors – including hedge funds, pensions, endowments, and insurance companies.

-Eleventh, no more than marginal growth in world gold-mine production for at least the next five years – while some of the gold-mining nations, including China and Russia, absorb more of their own production for domestic jewelry consumption, investment, and additions to central bank reserves.

Together these bullish factors are responsible for a growing gap between new mine supply and aggregate demand – a gap that can be closed only by much higher prices in the years ahead.

US Dollar, QE 3
The U.S. economy still faces significant and painful adjustments in the years ahead following many years of profligacy, years in which our government sector and many private households simply spent more than we could afford, on things we didn’t need, with money we didn’t have.

To counter the negative economic effects of fiscal tightening, the Federal Reserve, for all its rhetoric to the contrary, will be compelled to step even harder on the monetary accelerator. For this reason, I think we are likely to see another round of quantitative easing (QE3) with implications for future inflation, the U.S. dollar exchange rate, and the price of gold.

In fact, I think the Fed and U.S. Treasury are intentionally targeting a weaker dollar (to stimulate the domestic economy through the trade balance) just as they are targeting a higher inflation rate (to erode the real value of our debt as a percentage of nominal GDP).

I believe we may move gradually toward a multi-currency system where an array of national currencies, possibly along with IMF Special Drawing Rights and maybe even gold, will function with much less dependence upon the U.S. dollar.

Interest Rates and Gold
Investors need not be worried about the increase in interest rates in EU,UK, China, India, Brazil or the likelihood that US may raise rates in 2012. Whenever policy rates begin to rise, it will be too little, too late, to stem the upward march in the yellow metal’s price. In the case of economies that introduced monetary tightening, the real 'inflation-adjusted' interest rates remain quite negative. So there is every reason to believe investors would continue to buy gold as their currency loses purchasing power.

Food Infation and Gold
Higher economic growth and higher disposable income in developing economies is sure to put pressure on agriculture and food prices creating a food inflation. These natioins will also be pursing commodity-intensive infrastructure development that utilises steel, copper, aluminium, cement etc. So, high and rising global food prices are, in part, a monetary phenomenon . . . and, in part, they are demand driven as millions of consumers eat better – but, in recent years, there is still more to the rise in food prices. At times of inflation gold continues to be safe investment bet.

Agricultural inflation is also a consequence of weather-related problems in some of the planet’s most important grain-, corn-, and rice-producing regions: Too much rain, or too little, combined with record heat waves in some places, has taken a big bite out of food production. Now, dryness and weather-related planting delays are threatening poor harvests again in the 2011-2012 crop year.

Oil prices

Many oil analysts had been warning that oil prices would be heading much higher even before the outbreak of political unrest and revolution in North Africa and the Mideast, due to the growth in demand for oil from both the emerging economies, namely China and India again, and from some of the oil-producing nations themselves.

So, it looks like households around the world – in the United States, Europe, India, China, Latin America, and Africa – will have to endure rising prices for food, energy, and other commodities for a host of complicated reasons beginning with but not limited to excessive monetary growth from one country to the next. Whatever its cause, accelerating global inflation spells higher gold prices ahead.

China, India and gold

Much of the growth in China’s gold demand over the past few years has been a result of the government’s liberalization of the domestic gold market, its encouragement of private gold investment, and the development of new investment vehicles and channels of distribution. Chinese demand for Gold ETFs could also rise after the launch of the first gold exchange-traded fund that invests in overseas gold ETFs. Despite monetary tightening, the real interest rates in China continue to be high causing demand to rise for the yellow metal.

As in many other countries, Indian gold investment is benefitting from securitization and the growth in gold exchange-traded funds. First introduced in 2007, there are now 10 gold ETFs with physical gold held on behalf of investors totaling more than half a million ounces (about 15.5 tons) when I last checked a few months ago – and holdings will likely grow as more mainstream stock-market investors participate.

India and China are very important markets for gold, in part, reflecting their huge populations and growing wealth. But there are many other countries across Asia and the Mideast that share an historical, cultural, and even religious affinity to gold as a traditional monetary medium for saving and investment. Even gold jewelry in many of these countries is purchased for its investment characteristics, as a symbol of wealth and social status, and as an amulet or talisman bringing good fortune to its owner.

Central Bank Buying

Cetral banks collectively have taken a much more positive view of gold in recent years. Just last week, it came to light that Mexico’s central bank, the Banco de Mexico, purchased some 93.3 tons this past February and March. That’s about 3.5 percent of annual world gold-mine output worth more than $4 billion at recently prevailing prices. After net sales of roughly 400 to 500 tons a year over the prior decade, the official sector (including central banks, the International Monetary Fund, and sovereign wealth funds) became a net buyer of gold in 2009. Net official purchases may have totaled as much as 100 to 200 tons in each of the past two years, even allowing for the IMF’s 403 ton gold sales program, which ended some months ago.

My Gold Price ForecastGold prices to hit $1700 by end of 2011. I believe gold’s fortunes remain very bright. To begin with, gold’s key price drivers all remain supportive . . . and there are so many of them, so many reasons to expect the long-term trend will continue upward for at least another few years. 

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