UniCredit has upgraded their target price for gold from $1,250 to $1,600 by the end of 2012. The reason for the upgrade is based on three powerful trends: the fear over “money printing” at the Fed (QE), the idea that the Euro sovereign debt crisis represents a condemnation of fiat money and increasing demand for gold from China.
UniCredit invokes the always frightening sounding “debt monetization” term in their latest report. Of course, the Fed has not monetized anything (as it is operationally impossible) and they certainly aren’t causing inflation, however, I am certainly in the minority in believing this reality. Quantitative easing has already proven to be a monetary non-event yet market participants continue to believe this will somehow magically cause severe inflation. There is no doubt, however, that inflation fears are rampant due to the Fed’s actions and in the market expectations can be just as important as reality:
“The Fed’s decision to reinvest the proceeds from maturing and prepaid agency debt and MBS in longer-term Treasuries and to continue rolling over its holdings of Treasury securities as they mature has eliminated the slight tightening bias of US monetary policy. Thus far, it is not yet clear whether this will now also result in a lengthening of the Fed balance sheet. In the past, however, the gold market reacted extremely positively to a monetization of government debt.”
The second major trend is the Euro sovereign debt crisis. Gold demand has surged as fears in Europe have continued to roil the markets. I’ve previously explained why I think the market has this incorrect (the Euro is in fact a single currency system much like the gold standard), however, my opinion matters little in the grand scheme of things. What matters is how people perceive the current environment and right now they see the European sovereign debt crisis as another flaw in fiat money. Demand for gold is subsequently surging as Euro fears continue:
“In the second quarter of 2010, demand for gold measured in tons increased by 34% yoy. On a USD basis, a new record was even posted for the quarter. The reason for this is the surge in investor demand triggered by the Fed decision and the renewed widening of CDS spreads in Europe.”
I think the previous two trends are largely unfounded (though that doesn’t mean they won’t persist), however, the third trend is very real. UniCredit cites China’s surging demand for gold:
“The Chinese government has encouraged consumers to invest in gold, and with great success. In the last 12 months, demand for gold totaled 532 tons. While jewelry demand is merely stagnating, investors are increasingly discovering the gold market. While as recently as 2008 only 17 tons of gold were purchased, in 2009 the figure was already 73 tons. In the last 12 months, demand was even 143 tons! Although China has evolved into the world’s largest gold producer in recent years, the annual production of most recently 330 tons is by no means sufficient to satisfy this demand.
China announced important gold market reforms at the beginning of August. Foreign companies are now permitted to offer their gold coins at the Shanghai Exchange, more banks are permitted to import gold from abroad, and more domestic, gold-based investment products are to be developed. As a result, demand of Chinese investors will increasingly be felt on the global market. But the Chinese government also has an ever greater interest in gold imports. In April 2009, China had reported an increase in its gold reserves from 19.29mn to 33.89mn troy ounces. Nevertheless, they are still at a very low 1.7% of the entire foreign exchange reserves. If China is targeting a gold reserve of, for example, 10%, it would have to purchase 6,130 tons of gold or 2.4 times global annual production. If China were to meet the demand only from domestic producers, it would take 19 years to achieve this objective. Since the gold market is per se only a very small market, further increases in the price of gold are pre-programmed.”
These are indeed powerful trends even if I believe some of them are unfounded. I think one thing that can be concluded from all of this is that demand for gold is likely to remain strong so long as the Euro crisis continues, the balance sheet recession in the USA continues and China remains the primary driver of the global economy. These look like pretty good bets to me.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.