The Most Important Trend in the Gold Market Today
There is a common misconception that the price of gold is primarily determined by Western institutional investors. From time to time, and in the short-term, this may be true given the size of individual trades on an institutional level. In the medium to long term, it is still only one of many equally important drivers. Equally the investment component of demand often steals headlines in the press, overlooking the fact that gold jewelry still constitutes the dominant source of demand for gold.
Furthermore, while gold market fundamentals have traditionally reflected events and activity in North America and Europe – whether from jewelry purchases, central bank activity or investment demand, a strong shift away from these two centers has taken place in the last 40 years. The rise of the BRIC countries and other high growth economies is diluting the influence of the West. This shift is undeniably conspicuous in the gold market.
– World Gold Council, Gold Demand Trends, Third Quarter 2011
We recommend you allocate 20% of your total assets to gold. So it’s important we keep a close eye on the gold market. And that we always challenge our assumptions and our investment case.
Most analysis is focused on short-term moves and the drivers of these moves – forced selling by leveraged hedge funds, margin hikes in the gold futures markets and so on. Because of this fixation on the short term (a disease that infects most investing), most investors completely miss the biggest driver of the gold market over the long term: the shift in wealth and power to the emerging markets.
In 1970 the US and Europe accounted for 47% of world gold demand. This increased to 68% by 1980 – the blow-off top of the last bull market in gold. In the final stage of that bull run a huge amount of investment demand came from the developed markets.
But by 1990 the US and Europe accounted for only 37% of global demand for gold. And this has continued to trend downwards, reaching just 27% by 2010. The US makes up for the same percentage of global demand as it did in 1970 – about 12%. But demand from Europe has fallen from 25% to just 15% over the same period.
About 83% of gold demand today is from emerging markets. In fact, the figure is probably higher than 83%. That’s because these figures exclude demand from central banks. And the big central bank buyers are concentrated in the emerging markets. Places such as China, India, Russia and so on. Central banks in Thailand and Bolivia have also been big buyers recently.
Conclusion: A long-term investment in gold is also a long-term investment in one of our big “beta” themes at Bonner & Partners: the shift in wealth and power away from the US, Europe and Japan towards high growth overseas economies.
India and China: Gold Giants
This doesn’t mean there won’t be large short-term price swings driven by the speculative activities of large institutional investors in developed markets. It just means that the longer term trend is about emerging markets.
India and China…the two emerging market giants…dominate the gold market. India has been a big player for many years. But China has been catching up recently. We can see this in consumer demand figures – which made up 74% of total gold demand in the recent quarter. Consumer demand includes jewelry, bars and coins. It excludes ETFs and central bank buying and technology (mostly electronics).
In the 12 months to the end September Indian consumer demand increased 15% (or 31% of the global total). In China it was up 35% (or 24% of the global total). Indian and Chinese demand has grown fast. Although Chinese demand is growing at a faster pace.
Combined, these two countries accounted for 55% of global consumer demand over the same period. And other emerging markets made up a further 28.4% (spread across countries such as Turkey, Indonesia, Saudi Arabia, the UAE, Russia, Vietnam, Thailand and so on).
You could imagine that jewelry demand is a bigger deal in India and China than the buying of bars and coins. To an extent this is right. But the difference is less than you might think. In the same 12- month period India and China made up for 59% of the world’s gold jewelry demand and for 48% of demand for new bars and coins.
In fact, if we look at gold jewelry demand over the decades, it gives us a useful snapshot of global prosperity (or the lack of it, depending on where you are). In 1970, Europe and North America made up 44% of global jewelry demand. By 2000, this had fallen below 30%. And by 2010, it had collapsed to just 14%. Emerging markets account for nearly all the remaining demand for jewelry.
China alone accounted for 28% of global jewelry demand in the most recent quarter, having grown 13% year on year. Put another way, Chinese bought four times as much jewelry as Americans during that three-month period.
This is just one sign of a booming consumer economy in China. The World Gold Council says this growth was largely generated in China’s smaller “third and fourth tier” cities, where infrastructure improvements have allowed retail chains to expand their store networks and tap into new consumer markets.
And all this in the context of record high gold prices and a slowdown in China. I can’t think of a better example of pent-up emerging market consumer demand.
Looking at investment demand – which includes ETFs as well as bars and coins but excludes central bank buying – the older data is patchier. But recent data is better quality. Europe and North America made up 45% of the global total in 2010. Another 43% came from Asia, of which over half came from India. The rest came mainly from the Middle East.
So although Europe and North America are more significant in the investment market than the jewelry market, over half of investment demand still comes from emerging markets.
Gold: Not a “Useless Metal”
Another significant demand category is technology. Despite what most people will tell you, gold is not a “useless metal.” Technology use has stayed steady at about 10% of global gold demand for many decades.
The largest drivers of demand are electronics and dentistry. Over the years the use of gold in dentistry has fallen. And use in electronics has risen. Electronics uses make up for about 70% of the total technology demand for gold these days.
It’s no big surprise that the leading countries buying gold for technology are manufacturing centers such as Japan, South Korea and China.
Central Banks Are Buyers
Central bank buying was about 10.7% of total demand in the first three quarters of 2011 – at 348.7 tons. This was up sharply from full year 2010, when central bank buying made up for 1.8% of total demand – or 77 tons. As recently as 2009 central banks, in aggregate, were still net sellers of gold.
Information on exactly who is doing the buying is murky. Some countries delay the disclosure of their purchases. But the World Gold Council reckons total buying by central banks over the past year was 384.4 tons and that sales were 53.3 tons (of which 52.2 tons were sold by the IMF). That means net buying by central banks was 331.1 tons.
The average price of gold was about $1,500/oz over that time. There are 32,150.7 troy ounces per ton of gold. So each ton cost $48.2 million on average. This means net central bank purchases were around $16 billion when measured in dollars…give or take about $5 billion.
When you consider that China alone added over $700 billion to its foreign exchange reserves (now at $3.2 trillion), you realize that gold buying by central banks has plenty of room to increase. In fact, gold buying by emerging market central banks is still tiny in relation to their foreign exchange reserves. In other words, the apparently big increase from 2010 to 2011 is small relative to the buying power of the world’s emerging market governments.
So overall we can see a demand picture for gold that is split between jewelry and investment, plus some uses in electronics. Jewelry demand is dominated by emerging markets. Investment demand is more balanced.
But emerging markets are still over half of the picture. And central bank buying has increased substantially, is concentrated in emerging markets and has plenty more upside. Especially if central bankers continue to lose faith in the euro and the US dollar.
Are We Heading for a Supply Shortfall?
What about the supply side of the gold markets?
In the first three quarters of 2011, 63.8% of supply came from mines and 36.2% came from gold recycling. Gold recycling is mainly the sale of old and unwanted jewelry by its owners, which is then melted down for its gold content. This business is global. But it is most developed in traditional gold markets such as India and the Middle East.
Gold recycling is trending downwards slightly. Since 2009 it has fallen about 3.5% a year. But production from gold mining has been growing at a steady 3.7% in each of the last two years. Combined, the supply has grown around 0.5% a year since 2009. (Notably this is less than global population growth, which is about 1.1% a year.)
Conclusion: We could be approaching a supply shortfall in the gold market. This means there is the potential for an accelerated rise in the gold price.
If mined-gold production keeps rising at 3.7% a year, it should reach 2,882 tons in 2012. If recycling doesn’t fall any further, it should reach 1,580 tons in 2012. This gives total supply of 4,462 tons in 2012.
At that level there is no room for demand to grow in 2012, when measured in tons. In fact, it must shrink by around 1% just for the market to balance.
This is how much demand grew in 2011 (comparing annualized figures for the first three quarters of 2011 to figures for full year 2010):
- Jewelry – +0.5%
- Technology – +0.5%
- Private investment (retail bars and coins, plus ETFs) – +1.6%
- Private investment plus central bank buying – +25.8%
In other words, something’s gotta give in 2012. Gold demand can’t keep increasing. In fact, it probably needs to fall. If recycling continues to fall, or new mine supply doesn’t accelerate, then the supply shortfall will be even worse.
People will have to buy less jewelry despite massive pent-up emerging market demand (combined Indian and Chinese jewelry demand was up 11.7% in the past 12 months). Or investors will have to buy less (despite rising awareness of the bull market in gold and ongoing and severe financial distress in Europe and the US).
That or central banks have to buy less (with the euro on the brink of meltdown and the US on the brink of printing even more dollars through QE). Or a suitable replacement for gold will have to be found for use in electronics. (I’m not a scientist. But I suspect this is unlikely.)
What’s going to make one or more of these groups stop buying more gold? A higher gold price (for jewelry buyers) or a miracle solution to the world’s debt problems (for investors seeking insurance).
I don’t expect the miracle solution to the debt overload. Therefore I expect the gold bull market to continue…and maybe even accelerate.
Next year…and beyond…is shaping up to be a great time to own the yellow metal.
Until next week,