Tuesday, January 21, 2014

Random thoughts on the barbarous relic

Okay, so Keynes was referring to the gold standard rather than gold itself, which is something I have been thinking about. While I am a long way from being a gold bug, the sell-off in the price of gold combined with gold getting an increased amount of press coverage for various reasons got me wondering whether it might be time to allocate more than a token amount of capital to this asset.

A collection of observations:

Potentially bullish factors:

1. the ability of banks to import directly into the PRC has the potential to enable more PRC investors to buy gold - in simple terms, more people in China will have access to gold distribution channels. As a matter of policy, I can see the PRC government encouraging this as a means of diverting money from both an over heated property market and away from shadow lending activities. Increased gold imports also have the effect of lowering China's trade surplus (gold is an imported commodity for these purposes) and effectively substitutes onshore gold for offshore USD securities (which is where the bulk of China's trade surplus ends up);

2. global demand has been partly suppressed by India imposing import restrictions (now joined by Pakistan) which may or may not have reduced Indian imports by eighty(?) percent (less however much is being smuggled in through one means or another). At some point, there will be an element of catch up;

3. the pick up in demand for physical bars and coins when gold dropped below USD1,200 per oz was huge;

4. COMEX inventories continue to fall - this is not something that can continue for ever;

5. ETF holdings continue to fall - this cannot continue for ever;

6. unexplained delays in returning Germany's gold are a cause for concern;

7. current gold prices may be low enough to render some current and future production uneconomic.

Potentially bearish factors:

8. gold has no fundamentals which can be analysed;

9. gold has few uses other than as a store of value and therefore no more than a very limited intrinsic value (silver is better in this respect);

10. historically it can be argued that gold has more or less provided no substantial real return and, if that is correct, the current price is (depending on where you start the analysis) above its long term trend;

11. the rise in nominal yields on debt securities increases the opportunity cost of holding gold;

12. the ready availability of unbacked paper gold products and the absence of restrictions on the creation and issuance of such products divert some buying interest away from physical gold;

13. the buy-sell spreads on physical are very large;

14. there is a non-negligible risk of fake gold;

15. there is a risk of government confiscation which I view as being extremely low in Hong Kong (but devastating if it happens);

16. banks in Europe and the US are reducing their involvement in non-trade commodities businesses . While this is largely due to regulatory pressures making it more difficult and expensive for banks to take on the risks involved (i.e. it is not part of some conspiracy to manipulate the price of gold), the practical effect is to reduce the accessibility of gold and gold related products by clients of these banks. Put differently, banks will be selling different products to their clients.

Issues which may be relevant, but on which I have no views:

17. storage risk - there is storage risk or equivalent with all asset classes;

18. Deutsche Bank withdrawing from the London fixing mechanism - which is a redundant throwback to the days when the price of gold was fixed and should have been done away with in the 1970s;

19. the emotional appeal of gold - undoubtedly one of the reasons why gold continues to be a popular investment but emotions are very fickle things;

20. digital currencies like Bitcoin diverting some money away from gold.

Issues which could be either bullish or bearish:

21. inflation;

22 deflation,

as much would depend on other circumstances at the relevant time (e.g. an inflationary environment which saw high interest rates could be either bullish or bearish for gold).

The real difficulty is that it is difficult to quantify most of these items (not all, obviously). FWIW, I am more bullish than bearish at this time (which means nothing because my track record is not so good either).

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