Is Gold Still A Solid Long-Term Investment?

Many have been bearish on gold prices since January 2013, when it was trading above $1,650 an ounce. Since then, the price of gold has declined by nearly 30 percent. There are three main reasons for this underperformance over the last two years:

1)      Gold as an investment hedge has become less attractive to Europeans as the chance of a break-up of the European Monetary Union (EMU) declined after Spain, Portugal and Greece were bailed out by the EMU’s richer members, such as Germany;

2)      Gold has become less attractive to Americans as the U.S. dollar strengthened and recently hit a four-year high; and

3)      India, which accounts for one-quarter of the world’s gold consumption, slapped a 10 percent import duty on gold during August 2013. Indian gold demand dropped by nearly 40 percent year-over-year in 4Q 2013 and did not recover until this summer.

Many analysts are still bearish on gold prices. For example, Goldman Sachs and Credit Suisse have 2014 year-end target prices of $1,050 an ounce and $1,000 an ounce respectively. Some are even expecting gold prices to plunge to below $1,000 an ounce in 2015.

While there are still some short-term headwinds (such as a strengthening U.S. dollar) for gold prices, we believe gold is still a solid long-term investment for the following four reasons:

1.  Gold mine production will peak in 2015 at current prices

For over a decade, gold miners expanded production by developing lower-grade mines, increasing production costs for the entire industry. This strategy made economic sense as gold prices rose from $300 an ounce in 2002 to nearly $1,900 in 2011. With gold under $1,200 an ounce today, however, this no longer makes sense.

Our analysis of over 80 major gold mines around the world shows that over half of them have an all-in sustaining cost of over $1,000 an ounce. That is, half of these mines would lose money if gold declines to $1,000 an ounce.  More importantly, gold miners have been cutting costs since early 2013, and have little room for more cost-cutting unless they cut production or close their lower-grade mines.

Simply put, the supply of fresh gold from mines will decline if gold prices decline any further, thus putting a floor on gold prices.

2.  The European Monetary Union’s Viability Is Questionable

Before the onset of the global financial crisis in 2008, European retail investors (excluding those from Russia) bought little to no gold as an investment hedge. Beginning in mid-2008, European investment demand for gold increased steadily as concerns about the viability of the EMU and the euro emerged.

European investment demand for gold peaked at an annual rate of 400 tonnes in 2Q 2009 (11 percent of world demand), and remained at over 350 tonnes during the peak of the European sovereign debt crisis in late 2011/early 2012.

Since then, European investment demand has declined to below 250 tonnes annually as concerns about a break-up of the EMU dissipated. We believe this complacency is misplaced. The “peripheral countries” such as Greece, Portugal, Spain, and Italy are still struggling with historically high debt levels, chronically low economic growth, and a wave of retiring baby boomers that will further strain their social welfare systems.

Historically, the only way for economic or monetary unions to stay together is for direct transfers of wealth from richer to poorer areas, with no strings attached. Only the U.S. and UK have been able to pull this off. With the Germans opposed to funding any future bailouts, it's possible the EMU and the Euro will break apart by the end of this decade. European investment demand for gold as a hedge should thus increase, creating future upward pressure on gold prices.

3.  The U.S. Federal Reserve will remain dovish

Since the onset of the global financial crisis, the Fed has consistently acted more dovish than the market expected. Both the former Chair, Ben Bernanke, and his successor, Janet Yellen, have compared the current economic environment to the 1930s, when (they asserted) the Fed raised policy rates too quickly, consequently choking off any sustained economic recovery.

The Fed has effectively indicated that it would err on the side of too much easing. Today, the size of the Fed’s balance sheet is $4.5 trillion. There is no indication that the Fed will shrink its balance sheet anytime soon; it's possible it could actually grow further, especially when the next economic downturn hits.

4.  Indian demand for gold is already recovering

The International Monetary Fund (IMF) recently raised its 2015 economic growth forecast for India from 6 percent to 6.4 percent, while the Organization for Economic Cooperation and Development (OECD) recently noted that India is the “only major economy” to see a pick-up in growth momentum. The pace of economic reforms in India has also accelerated, with the government recently deregulating diesel prices and creating steps for the privatization of its coal industry. Indian demand for gold is tied to economic growth; the country’s demand for gold during 3Q 2014 is already up by 3 percent% on a year-over-year basis, coming in at 225 tonnes and surpassing Chinese demand. As Indian economic growth accelerates, it's expected that consumer demand for gold will pick up, especially for gold jewelry.

Thus there's a scenario where gold is still a solid long-term investment, despite some short-term headwinds.

Disclosure: Neither I nor my firm, CB Capital Partners, holds any shares in GLD.

Bio:

Henry To, CFA, CAIA, FRM is Partner & Chief Investment Officer at CB Capital Partners. Established in 2001, CB Capital Partners is a global financial advisory and investment firm headquartered in Newport Beach, California, with an office in Shanghai, China and an affiliate office in Mumbai, India. Visit http://www.cbcapital.comand http://www.cbcapitalresearch.comfor more information.