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The gold market in Q2 2011

The bubble to worry about is sovereign debt. Gold is the barometer pointing at how worried markets are about it and its consequences.

Article also available in : English EN | français FR

On the demand front

Jewellery proved very resilient (+12.3%) despite the much higher gold price. In India (30% of total jewellery demand at 139.8 tonnes), demand grew by 17% while it went up by 16% in China (to 102.9 tonnes). Together, these two countries now account for 52% of global jewellery demand.

In contrast, jewellery demand was very weak in Japan (-14% to 4.2 tonnes), as the country is still suffering from the after effects of the March earthquake and tsunami. Demand kept its downward trend in North America and Europe, due to high unemployment and dull economic prospects.

Within industrial applications, dental applications pursued their downward trend (-12% to just 10.9 tonnes), whereas electronics showed a healthy 4% rise. Buoyant sales of tablets and smartphones should keep this gold application growing.

Central banks continued to provide real support for demand. Mexico (5.9 tonnes), South Korea (25 tonnes), Russia (26 tonnes) and Thailand (17 tonnes) were the main sovereign gold buyers. Gold is a diversifi cation asset not only for retail and institutional investors but also for central banks. With gold remaining at a low weight of total reserves, further offi cial purchases can be expected.

Investment demand in Q2 2011 was not as strong as one year ago (-17.9%, due to a demanding basis of comparison, as European sovereign debt concerns surged in Q2 2010) but it remains at very high levels by historical standards. More and more investors are turning to gold as the sovereign debt crisis festers. Within this segment of demand (table below), bars and coins remain the favourite investment vehicle to gain exposure (even though gold ETF infl ows turned positive after the net outfl ows seen in Q1 2011). Retail is the main force behind gold investment fl ows, ahead of traders’ fl ows through futures and other fi nancial instruments.

Unsurprisingly, China and India dominate the market for bars and coins, accounting together for more than 50% of the total demand (India: 108.5 tonnes +78%; China: 53 tonnes). In contrast, demand from developed economies was surprisingly weak, despite the accumulation of bad economic news and downgrade risks. However, stronger investment fi gures can be expected in Q3 data, due to a spike in fears this summer over a European meltdown and the US’s loss of its “top solid” AAA credit rating.

On the supply front

Mining production benefi ted from the start-up of a few new mines but the overall production number (708,8 tonnes) was just in line with the average quarterly production in H2 2010. Despite high prices, the mining industry therefore still appears incapable of signifi cantly hiking output.

Recycling fell year-on-year despite the 26.1% rise in the gold price. The trend points toward gold holders’ keeping their gold holdings as protection against the diffi cult prevailing economic and fi nancial market conditions. Recycling in developed markets was steady but weaker in emerging markets, due to higher living standards and fears over accelerating infl ation.

The gold price going forward…

Gold was erratic in August, surging to a new record of 1913 USD/oz before correcting back towards 1700 USD/oz. As seen above, the fundamentals of gold remain excellent and after the correction of some excessive fears on the state of global fi nance, we will see gold continue its already 11 year-long ascent.

What happened in July and August (US AAA rating downgraded by S&P, fears of a euro meltdown, Swiss and Japanese central banks massive intervention on foreign exchange markets to reduce their currencies’ values, Venezuela gold repatriation order) led to several heavy purchases pushed beyond reason by momentum players.

What has driven the price of gold higher these last few years (sovereign debt bubble, negative real interest rates, and need for diversifi cation) is still very much present and will continue to drive gold.

Gold has clearly been a star performer over the last 11 years (grey line) but the rate of increase is weak compared to past bubbles like the gold bubble of 1980 (orange line) or the tech bubble of 2000 (blue line). Before peaking, these two bubbles rose by 391% and 193%, respectively, over a period of two years. Gold, in contrast, has “only” risen by 99% over the last two years. If there is a gold bubble, it still has a long way to go before it peaks.

A few more arguments point for a higher gold price going forward:
- Every commodity has set new infl ation-adjusted records over the last few years except gold! The 850 USD/oz reached in 1980 would be equivalent to 2400 USD/oz in 2011 USD terms.
- Under Bretton Woods (which ended 40 years ago), the US debt was fully backed by the gold of the country; today at current gold prices, the 8133,5 tonnes held by the US are worth only 450 billion dollars, which is barely 3% of the public debt of the country.

Once again, the bubble to worry about is sovereign debt. Gold is the barometer pointing at how worried markets are about it and its consequences.

Gold equity

While it is true that production costs have gone up, that has not prevented margins from expanding; under this consideration, one would expect companies to keep their valuations, not lose them.

Gold producers have never been better off, as it can be seen above. Indeed, their cash margins are at their highest levels ever which will bring higher dividends and also some M&A activity. Additionally, current macro-economic worries could lead to lower oil and steel prices, meaning lower input costs for gold miners, and then even better margins/cash fl ow generation.

EdR Goldsphere

As can be seen in the graph below, EdR Goldsphere (in blue) held up very well compared to equity markets in general (MSCI World AC in grey) during this summer crash. Indeed, since July 1st, the fund is up 12.3%, while equity markets are down by 12.3% (in USD as of 2 September).

Since its launch late September 2008, EdR Goldsphere’s outperformance is even more compelling: +88.2% for EdR Goldsphere compared to 11.3% for the broader equity markets.

Gold equities are nonetheless still lagging behind the change in the gold price itself (+116.2% since EdR Goldsphere’s launch and +24.2% since July 1st). Based on the regular leverages that gold equities exhibit on gold itself (operating leverage, volume leverage, exploration leverage and M&A), we don’t think this performance gap makes any sense and we expect gold equities to catch up.

EdR Goldsphere is well positioned for that with a selected list of promising juniors (13% of the fund) with strong projects (M&A targets), and a tilt towards producing companies able to exhibit growth.

Emmanuel Painchault , Raphaël Dubois September 2011

Article also available in : English EN | français FR

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