Waiting for the Real Gold Bull Market

At Seabridge, it is our contention that the real bull market in gold may not have begun yet. There is a bull market in commodities in which gold has participated somewhat fitfully but this bull market is based upon a perceived shortage of commodities in response to rapid economic growth. Commodity production has been constrained by a lack of investment due to low prices in the 1980s and 1990s while demand has risen in the third world, especially China. This imbalance has been made much worse by an unprecedented flow of speculative capital from commodity and hedge funds chasing momentum and driving prices to record highs in nominal terms.

Gold is not in short supply. There are about 4.5 billion ounces of gold above ground - nearly all the gold ever mined. That’s about 60 years worth of current production. Why? Because unlike a commodity, gold is not consumed. Its highest and best use is as a store of wealth, its role as real money. The propensity to save gold far exceeds the propensity to consume it. Gold as jewellery is nothing other than a traditional form of savings readily mobilized when needed. If gold had significant other uses, there would be far less of it and it would be much cheaper. Conversely, the highest and the best use of oil, copper or silver is not in a vault.

Over the past 200 years or so, the real price of every single commodity has declined, typically by 2-3% per annum, as primary supplies have grown more rapidly than global income (Veneroso’s View, April 19, 2006, pp 4). Commodity prices are determined by the interplay of current supply and current demand among users and producers, with inventories usually measured in terms of months.

Over the same 200 year period, primary gold mined supply has grown less rapidly than global income and its real price has slowly appreciated (Veneroso). The price of gold in the long run is determined by the relative value of 4.5 billion ounces of gold against the global pool of financial assets - now about $150 trillion in fiat currencies, stocks, bonds and other instruments, not to mention some $270 trillion in derivatives contracts. If confidence in financial assets is high, the relative value of gold as stored wealth tends to be low. If confidence in financial assets wavers, the gold price measured in fiat currencies rises as gold develops a monetary premium.

As Steve Saville notes in the April 19, 2006 edition of The Speculative Investor, “if gold were attracting the sort of monetary premium it attracted at the end of 1979 (a period of high inflation) then a copper price of $2.95/lb (the current price) would be associated with a gold price of well over $1,500/ounce.”

The gold price is higher against all the world’s major currencies and has recently set new historic heights against the South African Rand, Indian Rupee, Chinese Yuan and Japanese Yen. But the ratio of the gold price to a basket of industrial metals is at a five year low. The reason is that confidence in the world economy remains high and inflation expectations remain low.

How do we know that inflation expectations are low? Because the additional yield on an inflation-indexed 10 year U.S. Treasury Note is less than 2.6%, about the same as a year ago. Because the yield curve is nearly flat, providing very little premium for holding longer maturities. And because price/earnings ratios are at high levels globally when they would normally be lower if investors were concerned about inflation.

It is our view at Seabridge that the real bull market in gold, during which gold will outperform commodities, is likely to begin in earnest when inflation expectations rise. A steeper yield curve will probably be the signal. A recent trend to higher yields in the longer maturities of the bond market may be an early indicator. In the past, gold and gold equities have tended to correlate well with rising yield spreads (when interest rates on longer maturities are rising faster than interest rates on shorter maturities). A move by major central banks to counter slower economic growth by lowering short term interest rates would likely be a catalyst.

The key issue is the public’s understanding of what constitutes inflation. If inflation is defined as an upward movement in the consumer price index, as is generally the case now, inflation expectations would probably remain low. If inflation is correctly understood to be a rise in money supply in excess of real growth, gold’s performance would be enhanced. In the larger western economies, the supply of fiat currency is typically growing at the rate of 7% or so annually. In Asian economies, the growth rates are much higher, some exceeding 20%. Fiat currencies can be looked at as a commodity with a zero production cost. In comparison, gold is difficult and expensive to produce and the world’s supply of gold is rising at less than 2% per year, about the average of the last two centuries (Veneroso). How long will it take for investors to recognize this fact?

We believe that gold as an investment will be increasingly volatile as we go forward and significant corrections are possible. If speculative capital leaves the commodity sector, gold will also be hit, at least in the short term. Investors need to be prudent and patient. But in our view, the performance of gold against other asset classes is still far from its peak.