Precious Metals in 2012

At the start of a new year, it is a tradition to provide an outlook for market developments during the year. Therefore, we will stick to this tradition also in this blog. We participated again at the annual forecast survey of the London Bullion Market Association LBMA, which released its survey for 2012 last Friday.

Reuters reported at the beginning of the New Year that Gold imports by India, which is the world’s biggest consumer of gold, in the fourth quarter of last year plunged by more than 50%. According to the Bombay Bullion Association, India imported last year a total of about 878 tons, down by 8% from 958 tons in the preceding year. Gold is used mostly for jewelry in India. Furthermore, gold is usually in demand during the final quarter of the year due to the festival season. This development indicates that the jewelry industry is probably again not the major driver for the price development for gold. As prices have risen also for platinum and palladium, the attractiveness of the PGMs as a substitute for gold in the jewelry industry has been reduced. Therefore, for all precious metals, we expect that the price trends in 2012 will be mainly depend on the demand of investors or central banks.

Some gold bugs argue that central banks would buy gold to back their currency by gold. We don’t expect a return to the gold standard in the foreseeable future. Another argument for central banks returning as net buyers of gold is that the ratio of gold held by some central banks would be relatively low compared to other major central banks. Thus, especially Asian central banks with high foreign reserves would have to catch up by buying more gold. We are not convinced by this argument as it assumes that central banks would adopt a rather primitive form of portfolio management. Central banks hold most of the reserves in US dollar denominated assets. However, they have to report the balance sheet and profit & loss statement in local currency. Thus, the return on the foreign reserves should compensate for a possible depreciation of the US dollar against the local currency. This implies that beside the return of alternative assets, also the foreign exchange rate movements are a major factor for the portfolio allocation. Yields on US government notes and bonds do not provide a sufficient cushion against a US dollar weakness. Furthermore, the yield on 1yr US T-Bills is currently at 0.1% while the 12 month gold lease rate is above 0.4%. Thus, lending gold already yields a higher return than an investment in US T-Bills. Longer maturities offer a slightly higher return but also the price risk increases with a longer duration of government notes and bonds. For the 10yr US T-Note, a rise of the yield by only a few basis points is sufficient that the coupon income for one year is lost by falling prices. The negative correlation between the US dollar and the gold price is another factor, which has to be taken into account. Normally, the price of gold rises more in percentage terms than the US dollar weakens. Therefore, it is more the risk and return consideration of portfolio management in the current environment instead of some dubious historical or international comparisons, which argue that central banks are likely to increase their gold holdings further.

The correction of precious metals in the final four months of 2011 was driven by fears of a global recession. The major cause for those fears is the debt crisis in the eurozone. In the US, the recession fears were overdone. Not only did the GDP expand further in H2, the economic data also came in stronger than economists predicted. The labor market is also improving. New jobs are created albeit not at the pace of former economic recoveries. Nevertheless, it provides support for the private consumption. The car sales figures also underline this development. In China, the central bank has reduced the reserve requirements after the headline inflation rate came down. Further monetary easing during 2012 is expected, which would prevent a recession. The Chinese economy is likely to grow at a rate of 9.0 – 9.5% this year. This is below the double-digit growth during boom periods, but also clearly above the 8% mark, which is often regarded as a recessionary level. Therefore, the industrial demand for precious metals should remain supported.

The debt crisis in the eurozone is very likely the most important driver for gold once more. The first quarter might be very critical and could lead to increased volatility of precious metals. Even a decline below the lows made during the final four months of 2012 could not be ruled out. The financial markets still fear that some countries might fail to attract enough capital for refinancing maturing bonds. The eurozone has to agree and ratify a treaty on a “fiscal compact” as agreed on the December summit. Greece has to reach a deal on a volunteer debt restructuring with private investors and also has to secure further financial assistance by the troika. The recent remarks by PM Papademos were targeted to Greek lawmakers. While they were intended to push through necessary reforms to avoid disaster, they underline which stakes are at risk.

During the first quarter, three possible scenarios might evolve. The worst case would include a default of Greece, which might lead to collapse of the euro in the current form and/or a shock to the financial system comparable to the bankruptcy of Lehman Brothers in 2008. In this scenario, gold might be in demand as a safe haven again. However, some investors might have to sell gold to cover losses of other assets, which would limit the upside of gold. Other precious metals might fall strongly in this scenario as fears of global recession are likely to intensify.

The second scenario would be that a default of Greece will be avoided but the debt crisis in the eurozone would not be solved. Instead, politicians continue with buying just time. This scenario might be the worst one for gold, but the second best for the other precious metals. Prices might decline below the lows recorded in the first quarter. The euro might weaken further against the US dollar, which would be negative. This would weigh on the prices for precious metals. However, if the debt crisis does not get worse, the precious metals might be more in a sideways market with increased volatility.

The best case for the precious metals would be a solution of the debt crisis. In this case, the euro is likely to recover against the US dollar. Maybe even more important, the fears of a global recession would subside. The stock markets are likely to recover and also crude oil is expected to head higher. In this scenario, all the major fundamental factors in our quantitative fair value models would be positive. Thus, precious metals with the exception of silver might reach new record highs toward the end of the year.