In the first part we identified the six major fundamentals that drive gold and silver prices. In this second part we speak about the relationship between gold and silver. We explain which fundamental factors speak for an increase of gold and silver prices and which don’t.
Since fundamentals are very difficult to grasp, many people trade gold and silver based on technical support and resistance levels and is far more subject to speculation.
Many investment advisers were and are moving out of gold. In February the Swiss Pictet decided to reduce its gold share after 10 years of success with their gold investment. The gold price is in a technical bear market.
Central banks do not buy silver, but gold. In response to central banks’ actions, silver prices only rise with the gold correlation. In crisis moments the gold/silver ratio increases, similarly as the gold/oil ratio.
The gold/silver ratio is particularly small when both emerging markets and the United States expand, but the growth of emerging markets is far higher, like between 2009 and April 2011. After that the European debt crisis and a slowing in emerging markets helped to increase the ratio again. Silver prices are more closely related to copper.
The six fundamental factors in a review
The six fundamental factors have for us the following future tendencies.
- Price movements of other commodities in combination with global commodity demand. We think that global growth, in particular in emerging markets, will resume once risk aversion and high inflation in emerging markets have calmed down. A recovery of the European economies, in particular of Germany, will help to improve global growth.
Brent oil prices seem to be currently depressed more because of seasonal Chinese demand weakness than due to the increased U.S. supply and the new fracking techniques.Chinese oil demand alone typically rises by 5-9% per year or an average of 1.0 million barrels per day (Mb/d), while shale oil in the U.S. could reach a maximum production of 2 to 3 Mb/d by 2035 and currently produces 0.9 Mb/d. The weaker Chinese GDP growth of 7.7% is still high enough to support 5-9% oil consumption increase. Hence over the long-term Brent oil prices should rise again. This is positive for gold, silver and other commodities. Non the less, we recommend gold investors to understand oil price cycles, the mechanisms of oil supply and demand.
The U.S. housing market still shows some indications of an oversupply. Chinese authorities are trying to tame excessive demand, the PBoC keeps rates high, the government restricts possibilities of a buying a second home, apart from speculation these are signs of under-supply, while Chinese commercial properties show already an over-supply. This has a negative effect on construction activity and commodities like copper. Falling commodity prices, however will increase margins of home-builders and increase activity over the longer-term. In the U.S., however, the recent increase of home prices is often driven by investors and not families.
- Global money supply and inflation
With continuously rising wages in emerging markets and monetary expansion in many developed nations, we reckon that disinflation, the reduction of inflation, will end soon, even if the mainstream media currently and possibly for years have over-emphasized low inflation and low credit growth. Russian, Turkish, Indian and Brazilian and South African inflation figures are around 6% and more, not much less than during the peak of 2011.
Thanks to the stronger yuan and a high manufacturing share that correlates with commodity prices, Chinese inflation has dropped to 3.1%. While high inflation in developing nations did not matter much until the year 2000, the rising GDP share of these nations have an influence not only via the factor “global inflation” but also by “physical demand” (point 6) as inflation hedge.
Similar as Bill Gross we judge that U.S. inflation might pick up in the coming years because the job market is structurally split in people “in the labor force” and the ones “out of the labor force”. Higher wages for the first group might lead to higher price inflation over the longer term, but the Fed will still be reluctant to hike interest rates because of the second group and high public debt. Core CPI inflation in both Europe and U.S. of nearly 2% despite high unemployment is a symptom of central banks flying blind into unscattered territory.Markets, however, did already anticipate high future U.S. inflation, visible in the increase of gold/US CPI ratio that has recently fallen under 7.
Many gold bears use the high gold/CPI ratio as counter-argument. They ignore that the gold/CPI ratio for many emerging markets did not increase that much. Indian prices are five times higher than in 1993, but the gold price quoted in Indian Rupee has risen by the factor 9.
In summary, we see inflation rising in the U.S. and continuing higher inflation levels in emerging markets over the longer term.
- Trade and growth imbalances, the U.S. twin deficits and the “fear factor”
Global imbalances are partially reduced, thanks to high wage increases in emerging markets and slower demand in developed nations. Recession fears have greatly diminished and have been replaced by a “fear of dropping gold prices.”The US current account deficit has halved since 2007. Between December 2011 and December 2012 WTI oil prices fell from levels around 100$ to 88$. WTI oil is mostly an appropriate benchmark for imported US oil due a higher share of cheaper Canadian and Mexican oil. This depreciation had as effect that energy made up only 33% of the U.S. deficit instead of 42%.Due to high import costs of oil, the surplus countries are less and less Asian economies, like China, South Korea or Japan, but increasingly European economies like Germany, Switzerland or Sweden. This is partially bad news for gold and silver, because those countries will not spur so many commodity-intensive investments like China did.
The Chinese and Japanese, however, are the ones that will profit most on the decrease of Brent prices from 120$ to 100$ since last year. We judge that in some months China will see a trade surplus again and possibly even Japan. This will support gold and silver prices.
The increasing public debt, however, is another reason to buy the yellow metal.
- Central bank’s activities like money printing or gold purchases and sales
Smaller current account surpluses of emerging markets due to weaker commodity prices and higher wages will lead to smaller gold purchases by central banks. Thanks to smaller differences between emerging markets and US growth, Fed non-conventional easing measures might diminish over time. Both points are bad news for gold and silver prices.
- Real interest rates, in particular in the United States and “financial repression”
Seven years after the start of financial crisis, the typical length of a weakness period in a credit cycle, a U.S. recovery seems to be possible, especially because emerging markets had high inflation and lost some competitiveness. We think that oil prices will rebound with stronger global growth, which is negative for the U.S. On the other side, a main argument for U.S. blue chips was and is their sales to emerging markets. U.S. firms cannot lead the global economy any more as they did until the 1960s and during the 1990s until the dot com bubble; the U.S. are similar to many German firms a slave of the global expansion.
We reckon that the U.S. housing market might have recovered thanks to implicit purchases by the Fed and other state organizations. An exit from QE3 and a rate hike would be detrimental for US home owners. Therefore we do not believe in US rate hikes in 2015, like many members of the FOMC do. As long as the Fed does not hike rates, gold and silver prices will remain strong.
- Physical demand and supply
We think that growth of emerging markets will be slower, but still high enough to support continuing purchases of physical gold and silver. More and more people will be able to purchase precious metals, last but not least as protection again inflation (factor 2). This is long-term positive for prices.
For the supply side see the comments in the first parts or the comment below.
Summary and Outlook
For us, most fundamental factors (items 1, 2, 5 and 6) speak for an appreciation of gold and silver prices, while factor 4, smaller future central bank interventions, favor a further weakening. Point 3 is rather neutral. We give factor 5, the “financial repression” the highest importance: Despite improvements in the US economy, we do not see a rate hike coming in the next 5 years, but countries like China are still competitive enough to replace American manufacturing with cheap imports. In factor 2 we disagree with mainstream media: we see global inflation rising again.
Many factors like weaker growth of emerging markets might not have been priced in correctly in commodity prices and – as the gold-silver correlation shows – even less in the price of gold. One example, Chinese growth rates between 12% and 18% in 2007/2008 combined with low U.S. rates drove the oil price up to 150$, while growth of 2-4% let it fall to 30$ a barrel in 2009. The current price of 100$ for Brent oil does it point to a future Chinese growth rate of rather 6% (rather oil and gold-bearish) or better 8% (oil and gold-bullish)?
We think that Chinese authorities will offer more easing measures if Chinese GDP growth is really in danger to fall under the the promised 7.5%. This will sustain gold prices.
Technical movements might further depress gold and silver similarly as many investors might follow the bearish technical trend in gold and sell the metal. Gold and silver prices currently show similar high volatility like stocks in bearish markets like in 2008/2009 and August/September 2011. Prices are mostly driven by short futures, put options, margin calls and day traders, that sooner or later will exit the market again (see details). Volatile times, however, are the best periods for long-term investors to buy.
On several occasions in October 2012 we recommended to sell gold and metals – here or here. In the current bear market gold and silver are getting interesting again; long-term fundamentals are mostly positive.
Our strategy would be to echelon gold and silver purchases at different entry levels, like a gold price level in the lower 1300s and at 1200. Due to the high gold-silver ratio and supply issues (see comment) we prefer to invest in silver instead of gold. In a US recovery helped by cheaper oil and gas prices, silver will advance first. If, however, stock markets follow the gold price plunge, then silver prices might fall with stocks, while gold will remain rather stable.
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