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Tuesday, June 21, 2011

Will gold continue to perform as well as it has in the past?

Gold has given a return of about 160% in the past five years. That is, if you had invested Rs 100 in gold back then, it would be worth around Rs 260 today. Now, compare that to the investment made in the stock market during the same period. The 50-share NSE Nifty Index, which is a broad representation of the Indian stock market, has grown by around 83%, which means that Rs 100 invested in the stock market five years ago would have grown to Rs 183 by now.
The point is: return from gold has been almost double than from stocks. But that, as they say, is the past. What about the future? Will gold continue to perform as well as it has in the past? The answer is most likely yes. Gold prices will continue to rise even further in the days to come. Here are some reasons why.
For many years, central banks around the world have been net sellers of gold. But in 2010, after a very long period, they became buyers again. Central banks have been net buyers of gold in 2010 for the first time in the past 21 years. In 2010, central banks bought nearly 76 tons of gold.
This trend further accentuated in the first quarter of 2011, when central banks were net buyers of gold to the extent of 129 tons. Central banks were selling gold for a while, reaching a peak sale of 674 tons in 2005.  The current purchases are a reversal of that trend - a case of sell low, buys high remarks
Over the years, the central banks have had a major portion of their reserves in US dollar, with a minor portion in other currencies like euro and yen. This trend is now changing. The rise in gold prices has caught the eye of various central banks who believe it is a welcome addition to their reserves given its status as 'store of wealth' even during periods of crisis. Thus, the central banks have indicated their preference to hold gold over a depreciating asset.
Most of the bigger economies around the world have been printing currency big time to revive their declining economies and also to pay off the loads of debt they have accumulated. This has led to a threat of paper currencies collapsing and, hence, the flight to the "safety" of gold. There is concern over the major reserve currencies like the dollar, euro and yen.
The only way for the over-indebted western economies to get out of the mess is to print more money, since gold cannot be printed or mined that fast; the value of currencies is sinking against gold." This means the price of gold is rising.
Over the past 20-odd years, the supply of gold has been growing at the rate of 0.7%. The main reason for this has been the decline of South Africa as a major supplier. As the Standard Chartered report says: A very important driver of the slow production growth was the dramatic decline of South Africa (as a producer), which produced about 1,000 tons in 1970, but below 200 tons last year (i.e., 2010).
The supply is likely to remain tight as very few large gold mines are expected to come up. Over the next five years, only seven gold mines that are capable of producing more than 500koz (1 oz =31.1 grams) are expected. Also, gold mines have a high lead time and take time to set up.
As the report points out: "According to a study conducted by MinEx, the average lead time for the 214 greenfield projects in 1970-2003 was about 5.4 years in Australia, Canada, and the US, and 8.3 years for other countries."
Also, as explained above, central banks, which were major suppliers of gold, have now turned buyers. This means a lot of supply of gold will come from scrap sales. Supply mainly comes from mines and recycled scrap; there is no central bank sale happening now. The scrap supply though tends to be more prices sensitive. Since the demand-supply situation remains tight, any incremental new demand for investments or from China would take the prices higher.
Finale: Due to these reasons, the supply of gold will be lower than the demand over the next five years. Even if the demand remains flat for the next five years, there is likely to be a supply deficit of 665 tons, the Standard Chartered report says. This clearly will lead to a higher price.

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