Throughout history, gold has spent a large portion of its time serving as a safe haven in the face of geopolitical anxiety, as a hedge against currency fluctuations, and as a hedge against inflation. Over the last 20 years gold has been primarily dominated by flight to quality issues that rose from crisis events, with only a small fraction of its time focused on classic supply and demand fundamentals that are usually associated with physical markets. Gold is responsive to sudden events that increase anxiety and roil markets, but it is possible that over the coming years it will return to its classic, physical-commodity market roots.
Recent reports pegged the world physical gold trade at roughly $190 billion, with world gold demand trending above 4,000 tons annually due to the growth in off of developing-country demand. Some might categorize demand from emerging markets as “new demand” that would seem to require growth in production in order to prevent demand from overwhelming supply. Global production has struggled to stay on an expansionary track, with large mining facilities generally showing declining output and scrap supplies playing a more important role in meeting demand.
Furthermore, supply trends of the past might be somewhat misleading, as the world is being forced to depend more on deep mining, which is taking place in the face of historically high energy costs and increasing labor costs. South African mining wages have in some instances reached 50% of total mining expense. According to some analysts, some operations are claiming their cost of production to be above $1,200 per ounce! In the face of these increasing costs, it appears that without higher prices, it could be difficult to sustain even current production levels, much less expand them.
Several South African gold mining companies signed labor deals in 2012, but some of them were short term in nature. Furthermore, platinum mining workers in South Africa recently waged the longest work stoppage in modern history in an effort to secure a “living wage” for entry-level miners. The South African platinum mining companies have reportedly lost more than $2 billion, and they have indicated that severe job cuts will be necessary unless the flat price of platinum rises sharply to compensate for escalating costs.
The world is having difficulty securing physical supplies of many precious metals, and tight profit margins have resulted in a dramatic scaling-back of exploration and investment in equipment. This suggests that supply flow could become even more precarious in the near future.
Fundamental Understanding of the Gold Market
While it appears that the gold market’s focus could be shifting back toward classic physical supply and demand forces over the near future, it is likely to remain periodically sensitive to financial issues, especially with many countries still holding a massive amount of debt as a percentage of GDP as they recover from the financial crises of the past seven years. Many central banks have left significant stimulus in place in an attempt to bring back self-perpetuating growth. Some economists are arguing that the world is currently in the midst of its most significant total global stimulus effort in history and that inflationary prospects are not as far down the road as some might think.
With China and India both looking to play an increasingly important role in international trade and commerce, their central banks are attempting to build credibility and respect. For many, that respect will only come after those entities have established “street credibility” by increasing the backing of their currencies with gold reserves. While the Federal Reserve remains the preeminent holder of gold reserves, China’s desire to be “the” world financial powerhouse suggests they are already seeking to build their official reserves from an understated 1,200 tons to something on the order of 3,000 or 4,000. This would still be less than half of current US reserves. From 1989 to 2009, the world saw central bank net sales of gold for 21 straight years, but since in 2011 central bankers have become net buyers again.
Understanding the Dynamics of the Gold Marketplace
The day-to-day fluctuations in the gold market are typically the result of events and developments that fall under the catch-all phrase of “market focus.” These periodic driving forces can include major economic numbers (particularly from the US and China), geopolitical events, the ebb and flow of risk appetites, physical production disruptions, pre-holiday/festival demand from China and India, and any event that results in a significant reversal of sentiment. Traditionally, gold has held an “inverse” relationship with the US Dollar, although in periods when safe haven concerns are extremely high, gold and the US Dollar can trade in tandem.
To ascertain the current focus of the gold market, it is important to note its reactions to headline events. In the coming environment, gold prices might react positively to consistent improvements in economic readings, gains in equities, and reports of increased physical gold demand in India and China. Changes in Indian import duties, signs of increased premiums for gold coins and bars over spot gold prices and expansionary readings from US PPI and CPI reports might become more frequent drivers ahead.