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IN FOCUS
February 21, 2013

Economics

Why Gold’s Lustre Will Fade by Avery Shenfeld and Emanuella Enenajor

Avery Shenfeld

It’s been a glorious run. The gold price climbed by nearly 500% from 2002 to

Chart 1
Global Inflation Fears Overrated

(416) 594-7356 avery.shenfeld@cibc.ca present, making it one of the best performing asset classes. But already, many of the forces

8%

Inflation Rate*

Benjamin Tal
(416) 956-3698 benjamin.tal@cibc.ca Peter Buchanan
(416) 594-7354 peter.buchanan@cibc.ca Warren Lovely

that made the yellow metal so attractive look to be turning over, and expectations for other supportive factors are overdone.
Gold will have its day in the sun at other points down the road, but the clouds on the horizon could portend still lower gold prices over the next couple of years.

6%

4%

2%

0%

BRIC

G7 + Eurozone

(416) 594-8041 warren.lovely@cibc.ca Emanuella Enenajor
(416) 956-6527 emanuella.enenajor@cibc.ca Andrew Grantham
(416) 956-3219 andrew.grantham@cibc.ca “text text text”

The Money Myth

Gold’s allure has typically rested on two concerns about the alternative asset: money.
Either inflation alone, or in concert with a steep currency depreciation, is seen as a reason for holding gold rather than the most prominent alternative, the US dollar.

In terms of current inflation, it’s hard to see what anyone would be worried about. CPI inflation has all but melted away, not only in the US, but across the developed world
(Chart 1). True, there’s been a bit more heat in the developing world, but for the four large players that make up the so-called
BRIC group, inflation is still well below where it stood in 2011. Those in India might be somewhat more concerned, but it’s not clear that they would be better off piling into gold than simply holding assets in an alternative currency, like the dollar. Or that gold couldn’t rise in rupee terms, while still stalling in US dollar terms.

*Country group inflation rates are weighed by GDP shares
Source: Bloomberg

Of course, those buying gold could fear what comes next. Neither measures of economic slack, which is still in abundance in the US,
Europe and Japan, nor wage pressures, give any hint of inflation. So why would anyone be worried about it?

In no small measure, the fear is rooted in a fundamental misread of monetary policy, particularly that of the US Federal Reserve.
Investors have piled into gold in fear of the consequences of an unprecedented build in the balance sheets of the three largest developed economy central banks
(Chart 2).

The myth is that these central banks, particularly the Fed, have been printing money with wild abandon, making inflation

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CIBC WORLD MARKETS INC. In Focus—February 21, 2013

Chart 2
Gold Prices Chase Central Bank Balance Sheets

Chart 3
US Broad Money Measures Still Lagging

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US Divisia M4 Index (1967=100)

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Balance Sheet of ECB,
Fed, BoJ in US$ tns (L)

US$/oz Gold

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price (R)

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Source: ECB, US Federal Reserve, BoJ, Bloomberg, CIBC Source:Centre for Financial Stability

an inevitable final chapter to the story, and favouring gold as a hedge against that loss of purchasing power.
A myth because, in reality, money growth has not been particularly brisk.

Note that when the Fed buys bonds, it does so not by printing money, but by taking bonds in exchange for crediting the selling bank’s reserve deposit at the Fed.
These reserves, some $1.5 trillion of them, are not money, and do not count in the money supply. Reserves are a necessary condition for bank lending, which does spark money supply growth, but they are not the only condition.
Capital requirements, risk tolerance and loan demand are also critical, and for the time being, these are preventing the sort of breakout in lending, and therefore in broad money supply measures.

Indeed, cause and effect runs the other way. It’s because credit collapsed in the recession, and has a lot of ground to make up, that central banks like the Fed, the BoJ and

to let prices surge as a means of inflating away its accumulated debt. A country can lower its debt/GDP ratio by being tough on deficits and lowering debt growth, or by letting nominal GDP, the denominator, climb with higher inflation.

If history is a guide, that doesn’t seem to be the most likely outcome in the US. While the Weimar republic let a hyperinflation build, that hasn’t been America’s approach to debt/GDP reductions. The two major periods of deleveraging, from 1945 to 1970, and again from 1995 to 2000, both featured historically low average rates of
GDP inflation, and instead relied on taming debt itself. In the wake of recent budget deals, current fiscal plans are already on course for a substantial paring in both annual deficits and the debt/GDP ratio (Chart 4).

Chart 4
US to See Fiscal Improvements Ahead

the BoE leapt into quantitative easing. The broadest money measure most appropriate for this purpose, a
Divisia M4 Index, shows that although money growth has picked up in the US, there’s a mile to go to catch up to its pre-crisis trend (Chart 3). In sum, there is ample time for monetary authorities to rein in their balance sheets, or take other steps to lean against lending growth, when growth does pick up and inflation threatens.

4%
2%
0%
-2%
-4%
-6%

US Deficit-to-GDP fcst 100%

80%

60%

40%

US Debt-to-GDP

fcst

Debt and the Inflation Temptation

A more credible argument recognizes that QE has not made inflation inevitable, but that the US will choose

-8%
-10%
-12%

20%

0%

Source: US Congressional Budget Office

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CIBC WORLD MARKETS INC. In Focus—February 21, 2013

Dollar Devaluation a Done Deal?

Investors might not fear inflation, but might instead be holding gold as an alternative to the dollar for fear that the greenback is due to weaken sharply against other currencies. That wasn’t just fear, but of course was reality for the US dollar from 2002 to 2008, a period in which the greenback experienced a steady slide against most other majors (the euro, yen, Canadian dollar, Aussie dollar, sterling, Swiss franc among them).

But that slide was as much about where the dollar started from, an egregiously overvalued level relative to trade fundamentals, one that generated an unsustainable trade and current account deficit. While the dollar might still be overvalued against some trade counterparties, including the Chinese yuan, the devaluation now behind us looks to have addressed much of the imbalance with other majors. True, the US still sports an annual current account deficit of some $480 bn or 3% of GDP. But the bulk of that is now the trade deficit in petroleum products (Chart 5, left). The petroleum balance is now making progress as
US crude production and dampened gasoline demand growth cut into import requirements (Chart 5, right). Add it all up, and trade fundamentals suggest that most of the broad dollar decline is behind us.

In the past year, the dollar has softened, against the euro at least, by the Fed reaching for QE while the ECB stood aside. That in part reflects the same mistaken fears of a

Chart 5
Petroleum Trade Deficit Drives Funadamental US$
Weakness (L), But Improvements Seen Recently (R)

deluge of money printing noted above. But even so, if the
Fed had a hidden (or not so hidden) objective to boost trade through a weaker dollar, it worked.

Looking ahead, however, QE looks poised to end before
2013’s calendar runs out, as the Fed only needs to see a significant improvement in “the outlook” for labour markets to pull back, not the completion of that labour market recovery. With Europe in recession again, odds are that US monetary policy will tighten before that of the
ECB, and that if anything, the dollar will recoup more of its earlier weakness against the euro.

The ETF Shadow

One plus for gold, and a new one at that, has been the return of central banks as net buyers of gold. That’s part of an overall trend towards diversification, one that has also seen an increased appetite for alternative currencies like the Australian and Canadian dollars.

These reserve fund managers have not, however, been decisive in driving gold prices for the past decade. As central banks ran to the hills, as steady net sellers from
2002 to 2009, gold climbed 250% (Chart 6). In contrast, gold seems to be hitting a plateau just as some central bankers are adding weight.

Instead, the elephant in the room has been the private investor, operating through the surge in gold ETFs.
They currently hold more than 2,500 metric tonnes, approaching the holdings of the IMF (Chart 7).

Chart 6
Central Banks Missed the Initial Gold Rally

US Current Account
Deficit
(last 4 quarters)

Other

Petroleum

0
-10
-20
-30
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-50
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US$ bns
Current account balance: other

Petroleum trade balance

800
600
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Central Bank net purchases/sales of gold (tonnes)

250% increase in gold price trade deficit -800

Source: US Commerce Department, BEA, CIBC

Source: World Gold Council

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CIBC WORLD MARKETS INC. In Focus—February 21, 2013

Chart 7
ETFs: The Elephant in the Room

why gold seems to have plateaued since mid-2011 is that some investors are looking with envy at improving returns

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Holdings of gold, metric tonnes*

in the stock market. If the fear of equities helped build the
ETF mountain, a few years of better performance could

2500
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IMF ETFs Chinese Russian
Government Government
*China has not released official gold holdings since 2009. The US is the largest holder at 8,100 tonnes, with Germany at 3,400.

Source: World Gold Council

ETF gold purchases, as well as non-commercial long positions on the Comex, both peaked in 2009. At that time, the rush to gold was less about inflation, than it was about seeking an alternative to equities, after investors were bloodied in the recession’s crash. Note that since then, while ETFs have still been strong net buyers, the volumes haven’t been sufficient to sustain the upward price momentum.

The ETF stockpile, and to a lesser extent, long positions in futures markets represent a significant risk of a pullback in gold, should investors decide that their money would do better elsewhere. And there are two potential reasons why such a portfolio rethinking should be on tap in the next two years.

First, the Fed will confound the inflationistas by pulling back from QE late this year, and beginning to talk more

similarly take that mountain down to size.

We’re not expecting a huge torrent of selling over our two-year forecast horizon. The gold bugs will need more convincing that the Fed and other central banks will keep inflation under wraps as the economy recovers, and we will be a long way from full capacity in the US or elsewhere as 2014 comes to a close. But a continued slide to $1,500 an ounce would still mean that gold will underperform equities as an asset class over that two-year period. What does that mean for a related asset, equities in gold-producing companies? Not much, at least when judged by the past two years. While some heavy-hitters in the sector aren’t pure gold plays given appreciable copper production, the precious metal and stock prices parted company in the past few years. Namely, the TSX gold index suffered a near-30% slide, far worse than the corresponding move in bullion (Chart 8). Operating performance and the inability to deliver new projects on time and budget, have been key to that result, with earnings growth on TSX gold companies falling short of analysts’ expectations and underperforming gains in the shiny metal recently. If gold slips further to $1,500, it will be a turnaround in operating performance, rather than dynamics in the gold price, that will be critical to a recovery in the market’s taste for gold producers.

Chart 8
Gold Equities' Underperformance
4000

seriously about upcoming 2015 rate hikes in the latter half of 2014. If, as we expect, that actual and verbal tightening takes place long before CPI has heated up, it will cast serious doubts in the minds of those expecting the Fed to take a cavalier attitude towards inflation risks.
Note that expectations for rate hikes in 2015 will also push up bond yields, so the opportunity cost of holding a gold bar with a zero yield will also be increasing over the forecast horizon.

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TSX Gold Equities (L)

Gold Price
US$/oz (R)

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Second, improving global growth prospects for 2014, as the US moves past the steepest stage of fiscal tightening and China’s earlier stimulus kicks in more vigorously, should prompt a renewed leg-up for equities. One reason

Source: CIBC Equity Research, Bloomberg

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CIBC WORLD MARKETS INC. In Focus—February 21, 2013

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