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The Outlook for Gold

As you will be managing a Self Invested Pension Plan you will be deciding for yourself on the suitability of buying gold.

Here is a very brief synopsis of some of the major forces driving the modern gold market.

  1. Gold is in recovery by comparison with other financial assets.  Having peaked in 1980 at $850/oz it subsequently fell to a 2001 low of $260/oz.  During that 21 year period it lost 69% of its value, while shares, bonds and property all rose significantly.  Since then gold has recovered steadily as the following chart shows :-

          
     
  2. The global physical gold market equation of supply and demand is dominated by mining and jewellery manufacture. 
    Supply - annual (approximate) Demand - annual (approximate)
    2600 tonnes - mining 3200 tonnes - jewellery manufacture
    600 tonnes - recycling 400 tonnes - other industry
    800 tonnes - central bank sales 400 tonnes - investment coins and bars
    4000 tonnes - total 4000 tonnes - total

    European central banks have been consistent sellers and have provided a balancing factor in the supply/demand equation.  The US dollar dominates currency reserves in most countries, but because of large US trade and budget deficits the central banks of China, Russia and the oil exporters of the Middle East are now emerging as buyers of gold, to offset the ongoing selling in Europe.
     

  3. Investment gold is a modest 400 tonnes per annum market.  In fact a very much larger sum than this is traded on futures markets around the world - primarily in New York, London, Zurich and Tokyo - and trading on these markets stretches to many times physical supply.

    Trading futures on financial exchanges is arranged so that people who 'own' gold in their portfolios actually own only a gold denominated asset - frequently provided by a major bank in the form of an undertaking to deliver gold if required.

    Few of those undertakings currently get called.  Instead the investment remains a guarantee, and is later sold in the same form, allowing both buyer and seller to avoid the cost of participating on physical bullion markets.

    Trading gold in this derivative, or credit-based, form reduces costs but creates the risk of default during a crisis. It also encourages short term speculators - like hedge funds - and their sentiment and the size of the transactions can make the gold price move significantly - both ways.
     
  4. There is still very little gold in the world.  If the entire world supply were formed into a single cube its edge would be about 20 metres - two metres short of a tennis court.  The cube is growing at about 12 centimetres a year.  The weight of the cube is about 150,000 tonnes. 

    70% of the cube is formed into jewellery.  About 10% is stored as private reserves.  20% is still in central bank vaults, of which one quarter is in the USA's reserve of 8,000 tonnes.  The US gold reserve would fill three car-parking bays.
     
  5. There is widespread international concern about the sustainability of the US economy on its current course.

    The US runs very large trade and budget deficits equivalent to $5,000 a year of unpaid taxes for each of 100 million US families. Many people feel the resulting $8 trillion sovereign debt - now $80,000 per household - is dangerous. 

    Based on history debt on this scale should precipitate serious crisis sooner or later. There is a danger of lenders refusing to finance the US except at much higher interest rates.  The already heavily indebted US consumer will not be able to hold up the world economy once high interest rates filter through to re-mortgage costs and other consumer finance products, so some people fear there could be a high price to pay in terms of stalling consumer demand and its effect on US business profitability.

    The USA's 8000 tonne gold reserve is worth $160 billion.  It is equivalent to about 18 weeks of the USA's current budget deficit, or about 10 weeks of its trade deficit.  China's annual trade surplus with the USA is currently just above $200 billion and it holds $850 billion dollars in its own reserve.
     
  6. There is also concern about mainstream securities markets and demographics.  Earnings yields on equities and bonds are generally at much lower levels than they have been historically, possibly because both equity and bond markets have been powerfully promoted to 'the boomer' generation.  Having been - on balance - big buyers on these markets for two decades this generation must turn into net sellers over the coming years.  Some people think there are not sufficient numbers of younger people looking to own these types of financial assets to sustain prices over the medium term.

    Gold is in the opposite position.  Having previously been a core holding in model portfolios worldwide it has been ignored by the investment community for 20 years.  It suffered a particularly severe loss of market share in the 1990s and is now negligible in the savings of the boomer generation.  In the period 2001-2006 gold more than doubled, out-performing all main securities markets in the process. But it is still below its 1980 price, while shares and many other assets are at 10 times those levels. Twice in the 20th century - in the years of crisis following 1929, and during the 1970s - gold's ability to buy business assets multiplied by about twenty times.