What Happens to Precious Metals?

07/13/2012 8:00 am EST


Don't buy into conventional wisdom when it comes to precious metals, especially in a good economy, advises Julian Phillips in The Gold Report.

A perception has grown that says that, in a recovering global economy—and in particular a growing developed-world economy—the gold and silver prices will fall, because right now their prices reflect economic uncertainty and fear. Any recovery will therefore remove that uncertainty and fear, so gold and silver prices should then fall.

This article looks at that concept and its validity. Gold and silver (because silver's price follows the gold price) are driven by a diverse range of factors from all over the world. The tendency to use simple links like this can prove an expensive mistake.

It's imperative that investors understand not just individual "links," but in what proportion they affect the gold price. It's that overall perspective that affects the price and investors' success.

Monetary Influences
For the last few years, silver has followed the gold price, rising and falling further and faster than gold. In so doing, it has shown that the monetary influences on precious metals are more of an influence than the fundamental demand and supply factors.

The fundamental supply and demand factors show a strong demand, based on electronics and on its various medical applications. In following gold so closely, silver has seen investment demand dominate the price moves.

While silver is not considered a monetary metal by central or commercial bankers, the general investing public sees silver as having the wealth-preserving qualities that a monetary metal needs to have to qualify as such. This explains why silver follows gold so closely.

Gold, on the other hand, is most certainly a monetary metal, and considered as such by bankers in general and in particular central bankers. It comprises 70% of US reserves. For the purposes of this article, we will therefore consider silver moving as a monetary metal. When gold does become visible as a monetary metal in banker's hands (and this may become particularly so at the start of 2013), only then will we see a separation of the two metals' price behavior.

Please note that both gold and silver monetarily-influenced price movements have absolutely no link to economic growth. It has everything to do with the structural condition of the developed and emerging world's monetary system's condition and structure.

Economic Influences
The developed world is currently experiencing flat economic growth or recession. Many feel the US could enter recession next year.

The gold price on the surface appears to be reflecting this, as it sits around $300/ounce (oz) below its peak at present. Some traders see stronger US economic growth as undermining the "safe-haven" value of gold and silver. But do the facts bear that out...and does history do so?

The gold price experienced its greatest rises from 2005 to mid-2007, from $300/oz to $1,200/oz. It then slipped back to $1,000/oz when general "investor stress" forced investors to sell almost everything to lessen their leverage and indebtedness.

Once this was out of the way, gold resumed its rise, reaching $1,900/oz in 2011 before correcting again to current levels. During 2005 to 2007, economic growth was robust in the developed world. The rise from $1,000 to $1,900/oz coincided with a stumbling recovery, whereas the current period of falling gold and silver prices has coincided with flat to falling growth in the developed world.

So, just looking at the developed world during the last seven years shows that gold and silver rise while the developed world is growing economically.

But is this a valid link? As the developed world grows, do people buy gold because they have more disposable income? We think not. The advent of the gold exchange traded funds in the developed world saw gold investors choose that route over investments in gold mining shares, simply because it was the first time they could buy an investment simply and unequivocally linked to the gold price itself and having the ability to influence the gold price directly.

This accounted for not far short of 2,000 tonnes of investments into gold. Again, economic growth was not a factor. It was a structural change in the gold market.

To see a direct link between economic growth and the gold and silver prices, we look across at the emerging world. In Asia—i.e., China, India, the Philippines, and other emerging lands—economic growth has enriched poor people on a broad front.

People emerging from poverty are keenly aware of the need for savings to shield them against returning to poverty. They are not convinced that banks are the place to keep ones cash savings as inflation has whittled away its buying power over time in every country, and intermittently, currencies have been swallowed up in war and runaway inflation.

Therefore gold, the time-trusted investment free of human interference, in itself has been where individuals have placed their savings. In China, this has been with the encouragement of the government. In India, the government is unhappy with so much of GDP being absorbed by gold, but because of distrust in government and its officials, the Indian investor favors gold as protection against Indian institutions and inflation and always buys gold and silver, over time.

The rise in disposable income in Asia has led to a steady and growing investment in gold and silver. So here, economic growth triggers investment in gold. So yes, gold and silver investments can be directly linked to economic growth in Asia and contribute to gold demand and rising gold prices.

Central, Commercial Bank Influences
Will more central bank reserves find their way into gold in times of economic growth? Again, we have to separate developed-world from emerging-world central bank activity.

In the developed world, central bankers stopped selling gold as a component of reserves in 2009. Since then, they have not added gold to their reserves. But the issue is now very firmly on the table amongst the banks.

Both in the US and in Europe, bankers are deciding whether to treat gold as a tier I asset, up from the current tier II level, where banks can only add 50% of its value as an asset on their balance sheets. Under a tier I definition, this will rise to 100%. As we saw in the credit crunch and in the Eurozone debt crisis, banks will unload asset from the tier II category in favor of tier I assets—such as US Treasuries—to boost their creditworthiness.

If (in the US and through the Basel discussions in Europe) gold is redefined as a tier I asset, then it will serve the commercial banks to switch into gold from other tier II assets in times of credit stress. With a prudent diversification in mind, it will also serve to place some of the emphasis they now place on US Treasuries onto gold. After all, even a central bank as august as the Bundesbank has the opinion that "gold is a counter to the swings in the dollar."

The impetus this will give to gold demand will be significant to the gold price, and by extension to the silver price.

In the emerging world, the rise of both central and commercial bank reserves has, for the first time, given the central banks levels of reserves that need to be diversified. It's clear that the emerging world is unhappy with its concentration in the US dollar, and needs to have a wider spread of investments to counter not just the uncertainties facing their own countries, but the countries of the reserves they hold.

Over the last couple of years, we have seen emerging world central banks buying significant amounts of gold both from local production and in the open market to raise the percentage of gold they hold in reserves. At the moment, the percentage of gold in their reserves is nowhere near the levels seen in the developed world's central banks. It's this shortfall that's prompting their interest in gold now.

In total, central bank demand is a very significant contributor to gold demand and will continue to be so for the foreseeable future. In this case then, economic growth has a direct link to the gold price. With the emerging world's demand for gold accounting for around 60% of total gold demand, on this demand alone we have to say that, yes, gold and silver prices will continue to rise in a growing global economy.

Subscribe to The Gold Report here...

Related Reading:

The Election Won't Change the Markets

Is This All the Recovery We Get?

A New Bull Phase for Gold?

Related Articles on COMMODITIES