In December, the monthly average price of gold exceeded $400 per ounce, its highest level since 1996. Investment demand, driven by increasing global geopolitical risk and dollar weakness, helped propel the price of gold higher by over $70 per ounce in 2003. In addition, hedge unwinding by gold producers and limited gold production also underpinned gold prices.
In 2004, the price of gold is expected to continue rising, reaching levels comparable to those seen in the early 1980s during the last oil price shock. Factors that pushed gold prices higher in 2003 will again drive gold prices higher in 2004.
Most important for gold prices will be the strength of investor demand. Increasing global geopolitical instability, further dollar depreciation and growing risk of dollar devaluation will all strengthen investor demand for gold.
Demand from producer de-hedging will continue at last year's pace. Gold supply is expected to remain nearly stable. Gold production will increase slightly while central bank sales of gold are expected to decline. With investor demand expected to increase and supply to hold roughly stable, the price of gold should approach $500 per ounce by the end of 2004.
The key factors in creating investment demand for gold in 2003 were increasing global geopolitical instability and dollar depreciation. Last year global geopolitical risk was pushed to its highest level since the Korean War.
The increasingly unilateralist foreign policy of the Bush administration was the primary factor driving global geopolitical risk higher. Unilateralism has defined U.S. positions on issues ranging from trade to the global environment.
However, the most profound and damaging expression of unilateralism has been through the pursuit of the war on terrorism. The invasion and occupation of Iraq explicitly contravened the United Nations and abrogated international law.
This severely damaged U.S. foreign relations with many countries, most notably France, Germany and Russia. In addition, the war on terrorism has also inflamed tensions between Israelis and Palestinians, and increased instability on the Korean peninsula.
Lastly, the war on terrorism has not subdued global terrorism. Terrorist strikes have become more frequent. The U.S. presidential election will be fundamental to pushing global geopolitical instability higher in 2004. Continued hardening of unilateralism, driven by electoral politics, will further strain US foreign relations and intensify instability in the Middle East and the Korean peninsula.
Most importantly, the probability of a major terrorist strike in the US and against US interests abroad is increasing. As in 2003, the US-centric nature of global geopolitical instability argues for further dollar depreciation this year.
Last year the strong dollar policy advocated by the US Treasury since the mid-1990s was subtlely abandoned. It is generally assumed that dollar policy was changed in order to improve the competitiveness of US exports, spurring growth of manufacturing jobs.
It is more probable that dollar policy was changed, with heavy influence from the Federal Reserve, in order to counter building deflationary pressure in the US economy. According to the advance estimate of gross domestic product released by the US Bureau of Economic Analysis on January 30, deflation of durable goods prices accelerated to -3.7 percent in 2003 from -2.9 percent in 2002.
Durable goods purchases accounted for 20 percent of total US gross domestic product in 2003. In addition, deflation remained stubborn in non-residential fixed investment prices. This investment accounted for a further nine percent of US gross domestic product last year.
To counter deflationary pressure, the US Treasury, at the behest of the Federal Reserve, will continue earnestly exporting US deflation, via dollar depreciation, to the rest of the world in 2004.
In addition to abandonment of the strong dollar policy, the economic threat posed by the staggering twin US deficits are likely to push the value of the dollar lower in 2004. Last year, the US current account deficit was estimated to have reached a record 5.1 percent of GDP while the US general government deficit, which includes both the federal and state governments, was likely to have approached six percent of GDP.
This year, weaker US economic growth will ease the current account deficit toward four percent of GDP. However, very loose fiscal policy will push the general government deficit toward seven percent of GDP. The era of massive twin deficits in the US has returned.
The last such episode, which occurred in the mid-1980s, heralded a 30 percent decline in the real effective exchange rate of the dollar. By comparison, the real effective exchange rate of the dollar has depreciated by less than 10 percent over the past 18 months.
Nearly $1 trillion of foreign capital is funding the US public sector and current account deficits. About $800 billion of this foreign money is invested in US government, agency and corporate bonds. The size of these deficits and the nature of their funding make the dollar very vulnerable to depreciation, and long-term interest rates exposed to upward pressure.
Higher long-term interest rates will strongly undermine the growth of credit that has been crucial to US personal consumption expenditure and overall economic growth in the past two years. Assuming that dollar depreciation remains controlled, the dollar/euro exchange rate should exceed 1.40 by the end of 2004.
The yen/dollar exchange rate should reach about 98 by the end of 2004. The weight of foreign investment in the US financing the large twin deficits indicates that the risk of much greater dollar weakness is substantial. Expected dollar depreciation, the large current account and fiscal deficits and increasing geopolitical instability, driven by US electoral politics, make the dollar a very unlikely safe haven for global investors. Foreign capital flight from the US could easily trigger a large dollar devaluation.
Increasing global geopolitical instability, weak US economic fundamentals and the preponderance of foreign investment in US fixed-income securities imply dollar depreciation will continue in 2004 and suggest the possibility of a large dollar devaluation. These factors are expected to increase the demand for gold among investors.
In the past two years, producer de-hedging has also contributed to improved demand for gold. De-hedging, or reversal of forward gold sales by mining companies, has gained momentum with industry consolidation, pressure to improve accounting transparency and rising gold prices. Producer de-hedging created demand for 423 tons of gold in 2002 and an estimated 400 tons in 2003. In 2004, de-hedging is expected to induce demand for another 400 tons of gold.
Fabrication demand for gold is expected to increase by around one percent this year after growing by an estimated three percent in 2003. Against the background of increasing investor demand for gold, continued producer de-hedging and steady fabrication demand, the supply of gold is expected to be steady.
Gold production from mining has been nearly stable over the past two years. Consolidation among mining companies and mines has led to consolidation of gold production.
Gold production should increase by only around one percent in 2004 to 2,625 tons. Apart from mining production, the other significant component of gold supply has been central bank sales of gold reserves. In 1999, 15 European central banks agreed to limit their sale of gold reserves to a total of 400 tons annually for five years.
This agreement expires in September but will very likley be extended for another five years. Speculation surrounds the scope of the next central bank agreement. Expectations for the amount of gold these central banks will agree to sell annually range from 400 tons to 650 tons. While at least two more European central banks are expected to join the next gold sales agreement, the aggragate amount of gold that these banks will sell is very unlikely to increase sharply due to the impact that such a change would have on prices.
In 2002, total central bank sales of gold amounted to 559 tons. Central bank gold sales are estimated to have increased slightly to about 575 tons in 2003. This year, renegotiation of the central bank gold sales agreement is expected to slow central bank gold sales to about 500 tons.
The final element of supply is scrap. Supply from scrap was 835 tons in 2002 and an estimated 865 tons in 2003. Rising gold prices have encouraged an increase in scrap supply. This year, scrap supply, pushed higher by rising gold prices, will probably climb toward 900 tons. The rise in scrap supply will moderate the decline in supply from lower central bank gold sales.
Overall, the total supply of gold should be relatively unchanged this year. With gold supply steady, demand - specifically investment demand - will determine gold prices this year. As in 2003, investment demand will benefit from global geopolitical instability and dollar weakness.
However, this year, geopolitical instability and dollar weakness are very likely to intensify, pushing the price of gold toward $500 per ounce. Gold and gold mining stocks will remain an attractive investment and hedging vehicle in 2004. Over the next few months, the price of gold is expected to be volatile. This volitility will come as a result of speculation ahead of the next central bank gold sales agreement. However, once this agreement is finalized, probably in the second quarter, the price of gold will move higher.
The price of gold will continue to rise as the US presidential elections approach in November.
Jephraim Gundzik is President of Condor Advisors. Condor Advisers provides independent, emerging markets investment risk analysis to individuals and institutions globally.
