recently at Incrementum Liechtenstein AG.
This edition of the report is characterized by a focus on the monetary aspect(s) of gold, a subject which remains highly underexposed in almost every report of major financial institutions. Because of the unprecedented global monetary policy experiments the need for monetary insurance has never been greater. The consensus could be convinced that the gold bull market has ended but In GOLD we Trust 2013 points to the fundamental arguments why the gold bull market remains intact.
Furthermore, this edition is the first which contains a quantitative model of the gold price. The model justifies a considerable risk premium to current price levels, even if small probabilities of occurrence of extreme scenarios are modeled. Based on conservative assumptions, the long-term price target is $2,230.
In this article we present the key highlights of the In GOLD we Trust 2013 edition.
Summary of the report
In the course of the recent gold crash, the market has once again demonstrated to holders of gold its tendency to maximize pain. The cascading price collapse beginning in mid-April had a standard deviation of more than five. Since trading volume was extremely high, the sell-off fulfilled all the requirements for a ‘panic low’.
We think that the correction that has been in train since September 2011 exhibits strong similarities to the ‘mid cycle correction’ of 1974 to 1976. That phase was similar to the current one, especially with respect to the marked disinflation backdrop, rising real interest rates and extreme pessimism regarding gold-related investments.
Since 2008 there have been more than 500 interest rate cuts around the world. Never before has there been such a low interest rate framework on a worldwide basis. Due to the level of debt reached in the meantime, the level of real interest rates is bound to remain negative, respectively low. This means that there is a solid foundation for future gold price increases.
The gold mining industry is currently going through a major period of change. It appears as though the industry is in the process of altering its priorities. We believe that the new commitment to transparent cost reporting, greater financial discipline and shareholder value is a crucial – if quite late in coming – insight by the sector. From a sentiment perspective, gold mining stocks are probably “the ultimate contrarian play”.
Due to the clearly positive CoT data as well as extremely oversold conditions we assume that a bottoming process will soon begin. Regarding the sentiment situation, we see anything but euphoria in gold. Skepticism, fear and panic never signal the end of a long term bull market. We therefore judge that our long-term price target of $2,300, first stated several years ago already, continues to be realistic.
Reasons for the recent gold price decline
Ronald Stoeferle attributes several factors to the latest violent gold price decline:
- the outlook of QE being tapered and eventually exited
- rising real interest rates
- partly declining money supply (especially ECB)
- record high short positions
- backwardation since April 5, which has intensified
- rising opportunity cost of owning gold due to the rally in stocks
- ETFs: the majority of the outflows were from the SPDR gold trust ETF, in order to switch to rallying stocks
- tightening credit spreads
- cascading sell orders by trend-following systems once technical support of $1,530 was violated
- increasingly negative analyst opinions (among other s, Goldman Sachs, Credit Suisse, etc)
Furthermore, the correction that has been in train since September 2011 exhibits strong similarities to the mid cycle correction of 1974 to 1976. That period is similar to the current one specifically on account of marked disinflation, rising real interest rates and extremely high pessimism regarding investment in gold.
Disinflation is being cited as an important driver for the gold price decline. The following chart shows a monetary disinflation. It represents the combined balance sheet totals of the Federal Reserve, the ECB, the Bank of England and the Bank of Japan.
The long term downtrend of most currencies relative to gold has flattened recently. The following chart shows how the downtrend of the equal-weighted currency basket has moved away from its trendline. A similar phase was already in evidence in 2003 and 2004. Nevertheless, the relative weakness of gold versus the basket must be monitored closely going forward.
Gold’s role in a portfolio
Since August 15th 1971 – the beginning of the new monetary era – the annualized return of the gold price amounts to 8.95%. The real appreciation of gold versus the dollar amounts to 4.7% per year on average. The attractive risk-return profile can also be discerned in the graph below. What can also be gleaned is that productive assets – such as for example the S&P 500 Index – exhibit a stronger return over the long term than gold. In our opinion, that is definitely to be expected over longer periods of time, due to the value-adding characteristics of companies. In the short to medium term however, the risk-return profile can easily turn in favor of gold – especially in times of monetary policy uncertainty.
Re-monetization of gold in the financial and monetary system
The renaissance of gold in classical finance continues. Recent evolutions as cited by the report:
- OMFIF , a global think tank for central banks and sovereign wealth funds, argues in favor of a remonetization of gold.
- A growing number of initiatives demand repatriation and a credible audit of state-owned gold reserves.
- The demands for gold-backed bonds are growing ever louder.
- A study commissioned by the European parliament points out that gold-backed bonds would be far more transparent, attractive and fair for investors than government bond purchasing programs.
- Central bank gold purchases amounted to 534 tons last year.
- China is the most important critic of the dollar’s currency hegemony today. China wants to establish the renminbi as the dominant currency among emerging markets. This assumption is confirmed by statements made by Chinese officials.
Western economies are not able to achieve surpluses even in times of economic prosperity. This is a systemic problem as compound interest makes debt grow exponentially. As soon as debt and debt service costs rise faster than income, the vicious circle of over-indebtedness begins. Currently the industrial nations continue to be faced with the highest levels of public debt in peacetime. In the US, the Government Accountability Office sees fiscal policy on a path that is intractable in the long term .
The strongly declining marginal utility of additional units of debt can be seen in the following chart. While from 1947 to 1952, every additional dollar of debt still created $4.61 in GDP growth, this has declined to 8 cents since 2001. This also explains why stimulus programs can by now only produce anemic growth. As soon as the doses of debt are no longer progressively increased, and even reduced, the withdrawal symptoms will be painful.
Going forward, financial repression in all its different facets is expected to gain in importance. That should be regarded as a terrible long term strategy, as it will only achieve redistribution and will not bring any solution to the problem.
A quantitative model of the gold price – scenario analysis
The report takes a unique approach in calculating gold price targets based on the two most important monetary parameters: “central bank balance sheet” and “implied gold coverage ratio.” All details are on pages 40 to 47. The forecast is based on four different scenarios related to the future trend of Quantitative Easing (QE):
- Exit QE according to plan (25% probability): Fed puts the brake on QE (‘tapering’), then stops QE and begins with the exit.
- QE tapering and stabilization (30% probability): Fed tapers QE, subsequently stops it, but leaves the balance sheet stable thereafter.
- QE continues (30% probability): The asset purchases continue for at least the next 24 months at the current level.
- QE accelerates (15% probability): Negative economic developments and/or problems in the banking sector result in an increase of the current level of QE purchases.
Using the described scenarios and probabilities, the model calculates a long term value of $2,230 for an ounce of gold. The underlying assumption is that there will be a gradual increase of gold’s monetary role.
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