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Beware of the Downside Risks For Gold!
May 20, 2010

Gold spot price hit a record high of US$ 1235 per ounce on 12 May 2010 as the sovereign debts woes in Europe spurs risk aversion. However, we believe the current downside risk for gold price is similar to the crude oil price in July 2008. The upside potential for gold price is limited after the rally.


Author : iFAST Research Team



Untitled Document
Chart 1: Gold Price Vaulted In Flight-To-Safety
Chart 2: The Comparison of Gold Rally
Chart 3: Breakdown Of Gold Demand
Chart 4: Gold Equities Are Still Trading At Discount

Key Points

  • In the recent rally, gold price has been moving in tandem with the US dollar, indicating the overwhelming demand for the safe haven assets is the primarily factor that drives the gold price upwards this time.
  • The return during end-March to 12 May 2010 is lower than the previous rally, even though gold price hit a new all-time high.
  • Currently, the downside risk for gold price is similar to the crude oil price in July 2008.
  • The expected return of gold is lower than the expected returns of our favourite markets
  • We continue to recommend investors to avoid funds with exposure to the gold futures.
  • We stay neutral in the gold equity.

Gold spot price hit a record high of US$ 1235 per ounce on 12 May 2010 as the sovereign debts woes in Europe spurs risk aversion. Investors remain concerned about the details of the 750 billion euro rescue plan and the externalities of the liquidity injection to the European economy. Gold, as a safe haven and a good hedge against inflation, climbs sharply in a flight to safety.

Traditionally, the gold spot price is inversely correlated with the US dollar. In the recent rally, however, gold price has been moving in tandem with the US dollar. It indicates the overwhelming demand for the safe haven assets is the primarily factor that drives the gold price upwards this time.

Gold Price Vaulted In Flight-To-Safety

Chart 1 shows the performance of gold price since 2010. In the first quarter of 2010, gold spot price increased by only 1.4%, lower than the MSCI Emerging Market and MSCI World Index. It was also underperformed by the average returns of the markets under our coverage in the same period. Gold price was mainly traded in the range of US$1085 to US$1140 in the first quarter. This supported our view that the gold price will remain vulnerable as indicated by the sluggish 1-year forward price.

Table 1: Timeline of the Europe’s Debt Crisis (Reference of Chart 1)
Date Event

1. 24 March 2010

Fitch Ratings lowers Portugal’s sovereign credit rating by one notch to AA- and warns of further cuts

2. 6 April 2010

10-year Greek government bond yields jump to 7.1%

3. 9 April 2010

Fitch cuts Greece’s sovereign credit rating by two notches to the lowest investment grade rating BBB-

4. 22 April 2010

Moody’s lowers Greece’s government bond rating to A3 from A2

5. 5 May 2010

The euro tumbles to a 14-month low against the dollar

6. 10 May 2010

EU officials agree to 750 billion euro rescue plan to support the debt-laden euro zone countries
Source: Wall Street Journal and iFAST compilations

From end-March 2009 till 12 May 2010, as Europe’s debt crisis worsened ominously following a series of bad news (see chart 1 and table 1), gold spot price surged 9.8%. For example, after the 750 billion euro rescue package was announced, the gold price surged 2.5% in the following trading day (11 May) as investors worried about the inflation risk in euro zone economies and the devaluation risk of euro.

Notably, the recent gold rally is comparable with the spike in November 2009 (see chart 2). From 1 November to 2 December 2009, gold price jumped 14.8%, breaking away from their sluggish performance in the past 6 months. A double-digit increase in gold price for a single month is quite unusual. We believe speculation was the dominant force that spurred gold price (see Gold Bubble Set To Burst In 2010). On the other hand, the return during end-March to 12 May 2010 is lower than the previous rally, even though gold price hit a new all-time high. It implies that investors are more cautious about the high gold price in spite of spiralling contagion fears on Europe’s debt crisis.

Similar To Downside Risk For Oil Price In July 2008

Currently, the downside risk for gold price is similar to the crude oil price in July 2008. From February to July 2008, oil price rose from US$ 88 per barrel to a peak level of US$ 145 per barrel, delivering a 63% gain. At that point in time, some “peak oil” experts predicted that oil price will hit US$ 500 per barrel because of the robust demand from emerging markets. Since then, oil price plunged significantly and fell below US$ 33 per barrel in December 2008. The Commodity Futures Trading Commission put the blame on the speculators for their significant role in driving wild swings in oil prices.

Similarly, the upside momentum of gold price has no support from the fundamentals. The gold rally has been strong and comparable with the crude oil price. Since May 2010, the gold price hit a fresh record high and the momentum is also as strong as the rally of oil price. Investors should be more cautious about the potential downside risk of gold price.

Demand in jewellery, which consistently accounts for over 60% of the total gold demand, is still very sluggish as shown in chart 3. Jewellery consumption plunged 20% year-on-year in 2009 and 8% year-on-year in the fourth quarter of 2009 (measured by tonnes). On a quarter-on-quarter basis, a strongest growth should be recorded in the fourth quarter traditionally due to Diwali, Christmas and other year-end festivals, but in the fourth quarter of 2009, demand has only picked up by a mere 2.4%.

On the other hand, ETF demand rose 85% year-on-year in 2009 to 594.7 tonnes. The strong demand in 2009 was largely driven by an exceptional result in first quarter which soared to 465.1 tonnes. Demand in the fourth quarter of 2009 was significantly lower than the demand in both year-on-year or quarter-on-quarter bases, as well as the average quarterly demand over the past 5 years.

In the article Gold Bubble Set To Burst In 2010, we have mentioned that economic growth is a leading indicator of jewellery demand and will head the demand for the next 2 to 3 quarters. As the global economy has just started to recover, it may take more time to see demand for real physical gold to pick up.

Ultra Low Interest Rate Drives Up the Gold Price

Investors fret that the aggressive fiscal austerity measures in the euro zone countries will slowdown the region economic growth. Uncertainty in Europe will postpone the major central banks’ rate hike timetable. As a result, a massive amount of speculative capital has entered into the markets. The gold holdings of the world’s largest gold-backed ETF, the SPDR Gold Trust, remained flattish in the first four months this year. the holdings was increased significantly by 50 tonnes or 4%, to a record high of 1209 tonnes from 1 to 12 May 2010.

Investors should note that gold investment does not generate interest. If the Federal Reserve starts to raise interest rates, investors will re-embrace the US dollar and there will be a re-pricing on gold. The gold price would then experience a nasty correction.

More importantly, the upside potential for gold price is limited after the rally. The expected return of gold is just 13% (as at 14 May 2010) given that it can hit the target price of US$ 1400/ounce which is the most bullish call in the Bloomberg survey (the mean estimate is US$1180). This is lower than the expected returns of our favourite markets like Russia, Korea, China and Hong Kong.

Table 2: The Expected Returns of Our Favourite Markets In 2010 (As At 14 May 2010)
Market/Sector Fair Value In 2010 Potential Upside

Hong Kong (Hang Seng Index)

28700 42%

Russia (RTSI Index)

1800 25%

Korea (KOSPI)

2100 24%

Gold

1400 (Target Price)* 13%
Source: Bloomberg and iFAST Compilations
*Most Bullish Forecast in Bloomberg Survey. The Market Consensus is US$1180 in 4Q 10.

We stay neutral in the gold equity. On the one hand, we expect the analysts to revise the estimated earnings of gold mining companies downward once the gold price drops. On the other hand, the gold mining companies continue to benefit from the rise in the gold price. Also, as shown in chart 4, gold equities are still trading at a discount to its long-term trend (gold equities still fall beneath the linear trend in recent months). Thus, we remain neutral for the gold equity fund.


Related Information

Gold Bubble Set To Burst In 2010

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iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

© 2010 iFAST Financial India Private Limited All Rights Reserved.


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