China Holds the Keys to the Gold Market

Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors writes:

Last year China’s private-sector demand for gold reached a record level of 1,132 tonnes, and according to the World Gold Council (WGC), the Asian nation could easily dominate the gold market once again, as they predict demand growing 20 percent by 2017. 

This updated projection from the WGC confirms what I’ve written about previously: China’s love for the precious metal remains robust. We are witnessing this country transform into an economic powerhouse, and now, the world’s largest gold market! I think it’s important for investors to recognize the main drivers behind this tremendous growth.

1. A new middle class has more money to spend.
Despite all the grandiose numbers we see in China’s gold market, the Asian nation hasn’t always been the “golden goose” of the game. The WGC points out in its recent report, China’s Gold Market: Progress and Prospects, that only in the last several years has China seen an emerging middle class supported by higher incomes. Until around 2006 for example, Shenzhen, where 70 percent of the country’s jewelry is fabricated,  only had 330,000 residents. This means that 30 years ago, China’s jewelry market and consumer demand for gold, was minimal at best. 

Over the last 10 years however, a new middle class has emerged and  consumers have been enjoying their new wealth. As GDP began to rise, people started buying more gold jewelry and coins. In addition to increased spending on these items, the investment demand for the yellow metal progressed as the population sought a hedge against inflation.

2. Jewelry is still the top demand driver.
The WGC report also reaffirms the ongoing power of the Love Trade. The Love Trade, one of the two main drivers of gold along with the Fear Trade, relates to the cultural affinity for the precious metal particularly in Asia, India and the Middle East. Consumers continue to purchase gold jewelry and coins year-after-year, and demand rises in synch with gift giving for religious holidays and celebrations.

As you can see in the chart below, since 2004 the volume of gold jewelry consumed in China has tripled. What’s more, China surpassed India as the world’s largest consumer and manufacturer of jewelry in 2013. According to a recent Reuters’ article, gold jewelry sales in India slowed by 10 percent since import restrictions were imposed on the country last year – a likely factor placing China in the top spot.

click to enlarge

3. Industrial demand is increasingly important.
Though not nearly as strong as the gold jewelry demand in China, the country’s rise in GDP has also increased industrial demand for gold. The WGC says that electronics are the dominant source of this industrial demand. Gold is used in cellphones, computers, circuit boards and recently the automobile industry has seen an increased demand for the metal.

Gold may seem like an expensive option to choose from to build cellphone parts or airbag connectors in vehicles, but as the report states, “Although manufacturers are always trying to reduce the cost of components and substitute gold with lower cost alternatives, this cannot be done where optimum performance and, especially, safety concerns are to the fore.” 
In our slideshow, The Many Uses of Gold, we explain other ways gold is used; not only for industrial needs, but for medical and technological advances as well.

4. China is diversifying away from the U.S. dollar. 
When it comes to foreign exchange reserves, China’s totalled $3.8 trillion U.S. dollars in 2013, a sharp increase from the mid-90s as you can see in the chart below. There are several challenges facing the Asian nation’s monetary system too; the multi-currency system which includes the renminbi, yuan and the dollar is no easy task to manage. 

But how are China’s foreign exchange reserves and monetary troubles a driver for gold demand?

click to enlarge

For starters, according to the WGC, the majority of growth in China’s reserves (implied specifically by the country’s current account surplus) has been in U.S. dollars. China used the dollar to buy American debt securities, but upon the global financial crisis and the start of quantitative easing (QE), China has been pulling away from exposure to the dollar.

In a recent article from Casey Research, Chief Economist Bud Conrad even comments on the decline of the dollar’s reserve status in foreign countries such as China. He says, “In 2000, the dollar accounted for 55 percent of all foreign exchange reserves. In 14 short years, that number has dropped to 33 percent. By 2020, I project, it will drop to 20 percent. At that point, other large economies of the world won’t need dollars nearly as much for international trade.” 

I believe that government policy is a precursor to change, so as fiscal and geopolitical challenges rise between the two countries, it’s no wonder China wants to back away from the dollar and thus, diversify to gold. Gold is a hard asset, making it a prime currency choice for China. In regards to gold, the WGC report even states that, “It cannot be created out of thin air at the whim of central banks. Nor can it be manipulated for the benefit of its issuer.” 

So what is China up to now?
So perhaps the People’s Bank of China is amping up its gold reserves to diversify away from the U.S., but one question remains. Exactly how much gold does China have?

As Mineweb reported this week, China deemed Beijing as an additional import city for gold, a clear indicator even more of the precious metal will find its way into the country. China does not release any official numbers about its gold imports, so Beijing will be another source of unpublished data. Rather than reporting its own gold traffic, other countries report their gold export data to China. Hong Kong provides insight into China’s gold holdings and in February  I wrote how Switzerland released its gold trade data this year for the first time since 1980. Only through these alternate reports can we infer the amount of gold China truly holds.

No matter the exact amount of gold that China has, this country is a good example that the demand drivers for gold remained the same. People around the world react with concern over government policies that can devalue currencies, thus making gold attractive. Similarly, as economies flourish and people have money, they will spend it on gold. The Love Trade will also continue; consumers will purchase gold as gifts as long as cultural celebrations and religious traditions carry on.

It’s important to follow the money, or in this case the gold, to see how people around the world react to this rare commodity. Looking forward, stay curious as an investor and you’ll see if China can keep the key to the gold market.

p.s. Have you ever wanted to be a global portfolio manager? Here’s your chance to give it try. There’s still time to travel to Turkey with me and shadow Emerging Europe Fund portfolio manager Tim Steinle. You’ll meet CEOs of leading Turkish companies and ask them questions directly. You’ll also have the opportunity to visit two companies we think are worth taking a look at investing in.  Come investigate one of Europe’s fastest growing economies on this investment adventure, begininning May 4. Here’s your last chance to check out the amazing agenda and reserve your spot. With Tim as one of your guides, you’ll learn from an expert.  Tim completed his undergraduate studies in electrical engineering at the Azeri Petroleum Institute in Baku, Azerbaijan and earned an MBA in computational finance at the Unversity of Texas at Austin. He is a native Russian speaker and his Turkish will come in handy at the world famous Grand Bazaar.

Gold Market

For the week, spot gold closed at $1,302.54, up $7.01 per ounce, or 0.54 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 3.26 percent. The U.S. Trade-Weighted Dollar Index fell 0.08 percent for the week.

Strengths

• Gold rebounded towards the end of the week to $1,302.54 per ounce, as conflicts in Ukraine continue and traders bet that prices will rise amid quickening inflation. Gold sales in Japan more than doubled in the first quarter, ahead of the consumption tax hike that is expected to fuel inflation. Platinum also posted strong performance this week as companies and labor unions in South Africa failed to reach a deal that would end a 13-week-long strike.
• Signs that inflation has likely bottomed are now showing up everywhere and should stoke inflation expectations in support of gold. The Federal Reserve’s M2 money supply growth is running at an annualized rate of 8 percent, a multiple of gold’s long-term supply growth of around 2 percent, annually. Similarly, U.S. bank loans have accelerated to levels not seen since 2007, with commercial and industrial loans rising at a 16.1 percent rate over the past 18 weeks. Similarly, average hourly earnings for American workers now run consistently above a 2 percent annual growth rate.

click to enlarge

• Canaccord Genuity reports an insider trading trend that is predominantly positive for junior gold mining stocks this year. This type of trading underpins confidence that the companies are undervalued. Two noteworthy companies with insider buying are Pilot Gold and Klondex Mines. This week, Pilot Gold reported additional high-grade mineralization intercepts at its Kinsley Mountain project. Klondex announced its entry into a toll milling agreement with a California-based producer, expecting to bring in additional cash flow as well as optimization to its Midas mill utilization. Klondex is also expected to release its Fire Creek Preliminary Economic Assessment shortly, which M-Partners’ analysts expect will show very robust economics and begin to close the company’s valuation gap to its peers.

Weaknesses

• Gold ETF investors have been sellers in April, as monthly outflows reach 516,000 ounces. Outflow days have outnumbered inflow days by a 2:1 ratio. According to UBS, this trading action contrasts with buying during February and March of 261,000 and 463,000 ounces, respectively. On the positive side, April selling is just shy of the inflows recorded in the prior two months, leading UBS analysts to believe the bulk of the selling is now done.
• Bloomberg reports that at least 40 unlawful prospectors have died in South Africa this year due to mines collapsing, workers dealing with poisonous gases, and gangs waging turf wars underground. The South African government estimates 14,000 people are now involved in illegal mining, which has aided the creation of a complex criminal industry. Legal operators are also falling victim to these illegal operators who steal equipment and mine on their prospective land.
• Turkey and Russia both cut gold holdings in March after increases during the previous month, according to data from the International Monetary Fund (IMF). Bullion holdings by central banks are closely watched since the group became net buyers in 2010, after two decades as net sellers. This selling highlights gold’s role as a backstop in times of crisis, with Russia likely swapping gold for foreign currency amid the threat of western sanctions.

Opportunities

• Newmont Mining and Barrick Gold reportedly held advanced-stage merger talks to bring together the world’s two largest gold miners. The negotiations called for a newly-merged company chaired by Thornton of Barrick Gold to hold the combined Nevada assets, along with other American assets. Additionally the negotiations called for a spin-off company (Spinco) to hold African and Pacific assets and chaired by Newmont’s Calarco. Interestingly, the proposed Spinco would hold nearly one third of the combined company’s production, making it the fifth-largest gold producer. Although negotiations have reportedly been halted, the transaction could add much needed dynamism to the gold sector by helping boost the merger and acquisition (M&A) space, along with refocusing the strategies of the global producers. On that note, Goldcorp has rescinded its Osisko offer in favor of the combined Agnico-Yamana bid, leaving it in a healthy position to pursue other M&A transactions this year. Potential acquisition candidates include Pretium Resources and Detour Gold.
• A study of gold forward rates and the investment cycle, signals that gold is at a major multi-year low, according to Ian Williams, CEO of Charteris Treasury Portfolio Managers. Williams asserts that inventories are falling rapidly at a time when replacement cost is $1,500 an ounce. In such an environment, it is clearly not possible for gold to trade below replacement cost for very long. Not surprisingly, the U.K.’s Financial Conduct Authority is considering adding bullion to its list of eligible investments for investors saving up for retirement. This move could give a boost to institutional and retail gold demand.
• RBC analysts upgraded Agnico Eagle to “outperform” following the pullback from the combined bid offer for Osisko. The analysts argue that in addition to the overall transaction being accretive to Agnico, the company deserves a premium over its peers. They note its strong 13-percent annual growth profile, its highly diversified and high-quality asset portfolio, along with its ability to generate substantial free cash flow at current prices. On a related note, Solitario Exploration and Royalty engaged SRK to complete a Technical Resource Report on its Bongara Zinc project in Peru. The Bongara deposit is undergoing an advanced technical evaluation by Votorantim, the Brazilian conglomerate, which will carry Solitario to production upon a positive Feasibility Study.

Threats

• China added Beijing as its third mainland gold import point, in a move that would help keep purchases secret if China (the world’s top buyer) opted to boost its official reserves. China does not release its gold trade data, leaving Hong Kong’s net export data to Shenzhen as the only reliable indicator of Chinese gold imports. The new import channel will aid China in increasing its gold purchases in a discreet manner, but may also relieve some of the pressure seen in Hong Kong as it funneled gold to satisfy China’s strong consumer demand.
• Gold fell to a 10-week low before recovering mid-week, as markets were concerned that a weaker Chinese yuan may force supply out of China. The weakness in the Asian currency mounted concerns that investors would be forced to unwind the 1,000 tonnes of the metal allegedly pledged as collateral for loans. However, the assumption that 1,000 tonnes are at risk of liquidation is likely overstated. A large portion likely ended up in the vaults of the central bank, with many more tonnes locked in commercial bank’s balance sheets under consumer gold-accumulation plans.
• The Chilean mining sector has raised concerns over the government’s proposed abolition of the DL600 tax provision that allowed firms with projects over $50 million to receive a negotiated, 10-year fixed corporate tax rate. According to Sonami, the private sector mining society, foreign miners have invested over $50 billion into the country over the past 30 years, largely incentivized by the DL600 provision. The abolition will make it increasingly difficult for miners to justify investments in the country at a time when production costs are challenging, and the permitting landscape is not clear.

April 25, 2014 (Source: U. S. Global Investors)

http://archives.subscribermail.com/msg/18f5939f1f0040829151eb6f30de375e.htm