7 Reasons why we should invest in gold

1. Investment demand continues to be extraordinarily strong (and we see no reason for this to change) given the loss of confidence in both the financial system and policy makers and as investors prioritize capital preservation over capital appreciation, increasing portfolio allocation to more creditworthy or “safe haven” investments, i.e., precious metals. Regaining this loss of confidence in the financial system and policy makers, in our view, will take a considerable amount of time, earning precious metals a permanent place in any prudent portfolio and underpinning prices over the longer term.

2. Declining supply – central banks have moved from net sellers to net buyers. This is a significant structural change in the gold market as central banks have been net sellers for two decades. Central banks looking to diversify their reserves in light of the rampant currency debasement have very few options available, and we would argue gold is the most attractive. It is also important to note new mine supply has essentially just been replacing aging mines. Given the long lead time between finding a deposit and actually moving it through to production is on average around 10 years, new mine supply remains largely inelastic. Adding further pressure on the supply side of the equation is the dearth of new discoveries and the increasingly challenging mine development environment.

3. All-in costs remain high – aging mines are experiencing declining grades, and new projects tend to be of lower quality, requiring higher and higher metal prices in economic studies, which are still returning IRRs in the mid to high teens.

4. Very low/negative real rates – lowers the opportunity cost of holding hard assets. Most major countries (including the U.S.) continue to support a low interest rate environment; we suspect this will be the case for some time to come as increasing rates may derail recoveries.

5. Central banks are buying Gold. – The Central Bank Gold Argreement, originally signed in 2001 and recently renewed for another five years, limits the amount of gold European central banks – including the International Monetary Fund – can sell to 400 tons per year. This means that even if governments want to sell off their gold reserves, they can’t – further straining the supply of gold on the market. The U.S., the world’s largest holder of gold, is holding on to their stash as well. Some governments are going even further: Venezuela’s Finance Ministry now requires 70 % of gold produrced in the country to be sold domestically. At the same time Russia, Ecuador, Mexico and the Phillippines are all buying gold. And China has increased its reserves by a staggering 76 % and will continue to do so until its Central Bank will have a 20 % gold reserve.

6. Push for Gold-backed Currencies. As investors the world over lose faith in their governments ability to contain the financial and economic crises, many are calling for gold backed currencies – much like the U.S. dollar was until the early 1970’s. Even Zimbabwe, which a year ago had hyperinflation running at 231 million percent annually, is now considering reintroducing its Zimbabwe dollar, but this time fully backed by assets, including gold. In order for this to happen, countries would have to purchase enough gold to back all their currency – putting extreme pressure on the gold supply.

7. Asian Demand for Gold is Exploding. Asia, with more than two and a half billion people, has a major impact on investment demand. Asians have a long-standing cultural affinity for gold as a store of wealth. India is the world’s largest gold consumer. For the las 50 years, the Chines government has forbidden its citizens from owning gold. Today, Chinese investors even have access to gold linked checking accounts. As a result, demand for gold in mainland China is expected to triple in the next few years.

…what is ahead of us? The SGP is an indicator.

The Shadow Gold Price (SGP):

To identify the intrinsic value of the dollar today, we examine the corollary – the intrinsic value of gold in dollar terms, which we dub “The Shadow Gold Price” (SGP). To do so we assume that Federal Reserve Bank liabilities are again exchangeable into gold (recall, FRB reserves are bank assets – the stuff that used to have to be gold). As we discussed in “A Not-So Modest Proposal”, one would simply divide the dollar amount of current Fed liabilities by official gold holdings. This calculation, while simple, is intellectually honest and produces a breathtakingly large “equilibrium” gold price of approximately $9500 per ounce today ($2.5 trillion divided by US official gold holdings of 8100+ metric tons).