World Gold Council - Gold investment statistics commentary

Investment commentary: Q4 and full year 2012

Overview

This commentary summarises gold's price performance and relevant statistics in various currencies and the macroeconomic factors that influenced gold's behaviour during the fourth quarter and 2012 as a whole. It complements the investment statistics analysis updated on a regular basis. It also discusses likely future developments ahead that will underpin the fundamental drivers of gold in 2013, as well as others that may provide challenges.

Q4 and full year 2012 in summary

2012 marked the 12th consecutive year of annual gains. Despite a weak fourth quarter, gold in US dollars ended 2012 up 8.3% at US $1,657.50 /oz on the London PM fix, marking the 12th year of annual gains.
Low volatility despite continued uncertainty. The fall in gold prices in the last quarter came amidst low volatility. Gold in US dollars had an annualised volatility of 11.5%, well below its long-term average of 16% and the third lowest quarterly volatility in the past 10 years, in line with a drop in volatility seen in many other assets classes.
Correlations drop on lack of activity and lower systemic risk. Correlations fell during Q4 2012 as a dearth of macroeconomic events during the quarter left gold's other fundamental drivers and speculative positioning in charge. Gold's correlation to the trade-weighted US dollar, global bonds and equities were all lower than in Q3 2012 and Q4 2011.

Macroeconomic developments likely to influence gold in 2013

Global growth - brighter but fragile. Q4 provided welcome signs of economic recovery in several countries, most notably in the US and China. Yet there are still lingering economic difficulties, which may keep market risks elevated, constrain efforts to reduce sovereign- and private-sector indebtedness, and act as a brake on corporate-sector profit growth. But the role of sentiment should not be underestimated as it could provide an additional boost to economic activity in 2013.
Policy normalisation? Recent releases of positive economic data and some utterances from the Federal Reserve (Fed) have caused some investors to question whether the era of low interest rates and unconventional policy might be drawing to a close. However, while things look less uncertain than during the first half of 2012, the underlying environment suggests a return to normal¹ is some way off in the US, and further still in Europe and Japan.

Macroeconomic events: support and challenges

Chart 1: Gold (US$/oz) performance and key events during Q4 2012

Table 1: List of relevant events during Q4 2012

Table 1: List of relevant events during Q4 2012
Over the fourth quarter, gold prices across multiple currencies edged lower. Macroeconomic events were sparse and mixed in their support for gold (see Chart 1 and Table 1), and with year- end approaching, selling pressure dominated.
The re-election of President Obama provided some support for gold apparently securing the continuation of existing Fed monetary-policy programmes - through an extension of Chairman Bernanke's term.
A softening in Indian demand may have been expected by some - though anecdotal evidence suggests otherwise - as the largest gold consumer saw a resumption of currency depreciation ( 3.7% in the fourth quarter).² India's continuing struggle with a trade deficit in 2012 led to regulatory action intended to curb gold imports.
Continued support from central banks' quantitative-easing programmes came in the form of the 12 December statement from the Fed. With the end of "Operation Twist", the Fed's monetary policy committee (FOMC) announced a transition from its yield-curve-adjustment programme to a new round of monetary expansion. This will take the form of straight purchases and continues the Fed's four-year programme of unconventional easing. However, exercising caution, the Fed also announced thresholds for policy normalisation in addition to the existing date-based thresholds. Although this was not the first time markets had to digest the finite nature of unconventional monetary policy, the additional bitter pills precipitated a sharp reactionary rise in longer-term interest rates. These dynamics elicited a mixed response from gold. On one hand, the continued debasement of the US dollar and the longer-term risks of higher inflation played into the hands of some investors. On the other hand, some market participants were concerned that the Fed's more reticent support for open-ended and unlimited support would signal an approaching end of current monetary accommodation - reducing systemic risk and inflation fears.
National elections were held in the world's third largest economy, Japan. The Liberal Democrat Party, led by Shinzo Abe, returned to power with tough rhetoric on the economy and regional diplomatic crises - two themes that provide support for gold via expansion of unconventional policy and a rise in geopolitical tension.
Central banks continued to add to reserves, as announced by the IMF in December, with a surprise resumption of purchases by Brazil's central bank after more than a decade of inactivity. A compilation of central banks' gold transactions can be found at https://www.gold.org /government_affairs/gold_reserves/.
As 2012 drew to a close, uncertainty surrounding the ability of Congress in the US to avert an immediate automatic spending and taxation hit to the economy, also known as the 'fiscal cliff', influenced gold positioning. However, as confidence of a resolution grew - even one that would not address some of the broader problems in the US - investors' minds were eased and flows into equities increased.

Price performance: Gold ends the year on a bittersweet note, but annual performance is reflective of underlying drivers

In US dollar terms, prices fell during the fourth quarter from US $1,776 /oz to US $1,657/oz, a 6.7% drop, reminiscent of Q4 2011. Weakness was seen with regard to other currencies too, from the euro ( -9.1%) and pound sterling ( - 6.7%) to Indian rupee ( -3.2%) and Chinese yuan ( -7.4%) (Table 2). Gold in Korean won posted a double-digit fall, as the currency - worryingly for exporters - saw a rapid appreciation in the latter half of 2012.³ At the top end of returns, Japan was the sole gainer, with a sharp currency depreciation courtesy of the new government's initiative, leading to a 3.1% local gold price gain over the period. On average across multiple currencies, gold prices fell 6.2% in the fourth quarter.
Despite price drops in the last quarter, gold prices etched out an 8.3% gain for the year (+6% in euro, +3.2% in pound sterling). This was the 12th consecutive annual gain for gold priced in US dollars - a feat mirrored in Turkish lira, Indonesia rupiah, Thai baht, Vietnamese dong and Egyptian pounds across the currencies that the World Gold Council monitors. Average cross- currency returns posted their 15th consecutive annual gain.
This performance, demonstrating gold's resilience and appeal as a unique asset class, came amidst a range of gains among other assets (Chart 2). For the year, both developed and emerging market equities saw impressive gains (MSCI World: +16.4% and MSCI EM: +17.4%) with better economic data from the US and China and lower financial-sector stress globally.⁴ Among alternative assets, commodities as a group performed poorly, with the S&P GSCI total return index gaining just 0.1%, largely as a result of weak demand from China and other emerging consumers for crude products and industrial metals. Hedge funds managed a 6.2% gain - lagging behind broader markets for the fourth year in a row,⁵ while global REITs posted a strong 23% return year-on-year supported by continued accommodative policy and tentative strength in US housing. In fixed income, aggregate global bonds etched out a 5.7% gain with unconventional policy and slow growth not only promoting safe government paper, but also riskier high-yield bonds, which enhanced performance. The US dollar, on a broad index basis, remained flat for the year (+0.1%).

Price performance of various asset classes in 2012*

Chart 2: Price performance of various asset classes in 2012

Table 2: Performance of gold with respect to various currencies*

Table 2: Performance of gold with respect to various currencies

Volatility: low levels belie nervous markets

Gold volatility recorded one of its lowest quarterly levels over the last 10 years though this feat was not confined to gold alone. The fourth quarter was a quiet period for most markets. Historical volatility across various assets reached decade lows, with implied volatility not far behind (Chart 3). This finding is somewhat surprising given that uncertainty still appeared to preoccupy investors.⁶
Low market transaction volumes were certainly a contributor, having shifted down year-on-year in 2012 as a whole and in Q4 relative to the rest of the year.⁷ Low volumes could have been indicative of investors sidelining decisions until the 'fiscal cliff' deadline had passed. In addition, the combined efforts of the Fed, European Central Bank (ECB) and Bank of Japan (BOJ) to underwrite markets with promises of unlimited monetary support served to quell nervousness, as did the results of the US elections. A record net shorting of volatility futures and options (VIX derivatives) may have reflected this sentiment - that market volatility was now too high given the implicit 'put' provided by central bankers.
Whether this relative market calm persists rests on the outcome of a number of events in 2013.

Correlations fall in Q4 on lower systemic risk

Gold's correlation to other assets fell in Q4 (Chart 4). The low number of macroeconomic developments, the fall in peripheral euro-area yields and the status quo in US politics with the re-election of the Obama administration, likely affected correlation as it had seemingly affected volatility. A lack of market-moving events and new fundamental developments - with the exception of central bank purchases - may have led to investors being more influenced by positioning ahead of the 'fiscal cliff' outcome. Certainly, the correlation between gold and the futures market non-commercial positioning, often representing the more speculative end of investment reached a multi-year high in Q4 (Chart 5). It must be noted, however, that higher correlation between these two series only implies a closer association, not causality.

Chart 3: Market volatilities at multi-year lows

Chart 3: Market volatilities at multi-year lows - click to enlarge

Chart 4: Gold’s correlation to global assets

Chart 4: Gold’s correlation to global assets - click to enlarge

Chart 5: Correlation between net long futures positions and the gold price

Chart 5: Correlation between net long futures positions and the gold price - click to enlarge
The interaction of all assets on average - referred to as cross- correlations - dropped sharply in Q4. Elevated asset cross- correlations are sometimes coincident with markets reacting in concert to a small number of factors, perhaps even a single factor - such as a data release or a central-bank announcement. When correlations fall, one would expect asset prices and, by extension, returns, to be influenced more idiosyncratically by their individual fundamentals. As Chart 6 shows, gold's correlation to other assets was negative during the recession of 2002⁸ and the global financial crisis of 2008-2009, while cross- correlations between other assets increased during sell-offs. The period between 2010 and 2013 has witnessed a closer relationship between gold's correlation to assets and their cross- correlations - but this has been a relatively strong period for most asset classes. This highlights gold's unique ability to act as a hedge when higher correlations are caused by market stress rather than generally positive sentiment.
Q2. Whatever agreements are put in place, the government's fiscal position will remain far from balanced; with an 8.5% deficit and a 4% target, the drop in public sector spending will undoubtedly have an impact on aggregate demand. Deleveraging and deficit reduction will create a negative feedback loop for growth.
Europe's resilience in 2012 surprised many commentators. A steep fall in peripheral European bond yields in the latter half of 2012 was largely a result of the European Central Bank's promise of 'unlimited' purchases of bonds to secure the euro's future. While the fall in yields has reduced exit and or default fears, it is likely that markets will test whether the ECB is willing to follow up its words with action in the coming year as further peripheral European funding requirements fall due. In addition, fiscal austerity appears to have had a much

Developments likely to influence gold in 2013

Global growth looks brighter but abundant risks warrant only cautious optimism

The biggest threat to global growth appears to have dissipated with the preliminary agreement by US Republicans and Democrats in early January to avert an immediate US $ 600bn in spending cuts and tax increases – which would have shaved almost 5% off GDP in 2013 and pushed the economy back into recession. A combination of a pickup in spending by consumers, investment by firms, and the aversion to public spending cuts, may position the US as one of the brighter economies in 2013. Positive growth, lower consumer uncertainty and greater business visibility all lend themselves to increasing the propensity for discretionary spending – a driver of gold demand in the jewellery and technology sectors, which together account for over 50% of annual gold demand.

A preliminary agreement on the 'fiscal cliff' may have been reached, but the Houses of Congress still have to agree on details. This includes a likely raising of the federal debt ceiling, a discussion which will now take centre stage in the middle of Q2. Whatever agreements are put in place, the government's fiscal position will remain far from balanced; with an 8.5% deficit and a 4% target, the drop in public sector spending will undoubtedly have an impact on aggregate demand. Deleveraging and deficit reduction will create a negative feedback loop for growth.
Europe's resilience in 2012 surprised many commentators. A steep fall in peripheral European bond yields in the latter half of 2012 was largely a result of the European Central Bank's promise of 'unlimited' purchases of bonds to secure the euro's future. While the fall in yields has reduced exit and or default fears, it is likely that markets will test whether the ECB is willing to follow up its words with action in the coming year as further peripheral-European funding requirements fall due. In addition, fiscal austerity appears to have had a much had a much greater negative impact on growth that originally expected.⁹ Contraction in non-bank credit (decreasing in 8 out of the last 10 months), rising unemployment, falling German production, and poor retail sales continue to point to a regional economy heading the wrong way. While the lit fuse fizzled out in the last quarter of 2012, euro area problems may be set to reignite during 2013. Spain's €100bn funding requirement was argued by some market participants to be too large for the investor base to absorb, in which case funding via Outright Monetary Transactions (OMT)10 would be necessitated.
Following the election of a new government, Japan's announcement of a higher inflation target weakened the yen and rallied equities, but had a marginal impact on yields, suggesting some bond-market scepticism. Unlimited quantitative easing with an inflation target of 2% is a bold step for a country battling with deflation, a gross debt ratio more than twice its GDP, a 10% budget deficit, a rising exchange rate and a falling current account balance. An emerging trend of gold investment by a number of pension funds may still be a trickle, but should the country's fiscal credentials deteriorate further and central bank credibility come into question, this could underpin investment demand in 2013 and beyond.
Despite numerous headwinds, emerging markets, responsible for the majority of physical gold demand are showing signs of improvement. The MSCI Emerging Market Index has continued to perform well through the latter half of 2012. Strong equity market performance indicates investor expectations about prospects but also feeds through to domestic sentiment – creating a positive feedback loop in these economies. The largest of these, China, has seen improvements in a number of areas. Equities, exports and imports, as well as manufacturing and services indices, have been doing well. Resumption of growth appears to be on the cards for China, where the corrosive effects of inflation indicate strong supportive factors for higher gold demand – both for wealth creation and wealth protection.

China's boom appears to coincide with India's gloom. The latter's government still faces hurdles as it attempts to return the economy to stable and manageable growth. Sticky inflation continues to concern the Reserve Bank of India (RBI). Although 'core' inflation, as measured by the non-food manufacturing WPI, has receded from 7% at the beginning of the year, both headline WPI and CPI remain well above the RBI's comfort level. As the government and central bank battle with uncomfortable inflation and lower levels of economic activity, it is likely that investors will remain cautious until signs of uncertainty dissipate. However, currency volatility has been falling since October. Notwithstanding weak growth, a more stable foreign exchange rate should provide some comfort to gold investors who typically shy away from purchases during periods of elevated rupee volatility.
Strong global equity market performance, which typically leads and sometimes ignores the state of the underlying economy, may well continue into 2013. An allocation shift by investors from bonds to equities may, at first, appear to disadvantage gold as risk aversion declines. However, general risk aversion does not preclude prudent risk management and portfolio diversification. If investors reduce safe-haven bond exposure, gold may play a larger role in value preservation within portfolios. Recent data shows that margin deb (Chart 7) and hedge fund leverage have hit multi-year highs in the US, suggesting that market risk measures may not yet reflect these exposures.¹¹

Chart 6: Average asset cross-correlation and gold's average correlation to assets

Chart 6: Average asset cross-correlation and gold's average correlation to assets - click to enlarge

Policy normalisation?

Demand for gold is diverse, both geographically and across sectors. While gold demand in the US is small relative to China and India, US central bank policies exert an important inﬂuence on gold investment. As the world's largest economy, the issuer of global benchmark bonds, and the backer of the world's reserve currency, developments in the US have clear global implications. An understanding of US policy is critical, therefore, as it affects many aspects of the global economy.
Investors appears to have grown accustomed to unconventional policy in recent years - as can be seen in negative market reactions to the FOMC meeting announcement on 12 December 2012 and the recent Fed minutes on 3 January 2013. Both emphasised that unconventional policy must have an end, and that end may be desirable sooner than previously anticipated.¹² With growth indicators in reasonable health, in the US at least, investors may be concerned about the prospects of an early end to the low interest-rate environment in the US and the likely impact it will have on gold.
Although recent data may point to a pickup in activity and an improvement in economic health, there are a number of remaining structural issues that are likely to reveal policy normalisation optimism to be just that - optimistic. An end to unconventional policy and a rise in interest rates will need to be very carefully orchestrated and are unlikely to occur for some time.

Chart 7: Securities margin balance among NYSE member firms

Chart 7: Securities margin balance among NYSE member firms - click to enlarge

Chart 8: Post WWII US recession job losses (% from peak) and recovery

Chart 8: Post WWII US recession job losses (% from peak) and recovery - click to enlarge

What does this mean for gold?

A premature end to quantitative easing in the US and other developed economies may concern gold investors who invested solely on the notion that such policies are eventually inflationary and low rates are gold-supportive from an opportunity cost perspective. While gold prices are linked to inflation and, by extension, real rates (through the compensation for inflation), the relationship is neither linear nor symmetrical. Furthermore, even though policy-rate normalisation will eventually come to pass, this path must go hand in hand with substantial structural reform and careful withdrawal of monetary stimulus.
Gold will continue to serve as a capital preserver during times of market stress as it tends to perform well when other assets are languishing or when investors are anxious. Its role in this regard will transcend the economic fortune of any one country or region. In the long-term, demand for gold is determined by a globally diverse set of drivers not least of which is economic expansion, as evidenced by the massive demand for gold in emerging-market economies.
¹Normal policy is commonly identified as the interest rate determined by a variation of the Taylor rule. However, the Fed regularly refers to its current policy as extraordinary - referring to both the level of policy rates and the use of unconventional quantitative easing.
²Please see Gold Demand Trends released in February 2013 for an update on supply and demand trend developments.
³Korea has been one of the prominent buyers of gold for reserves during the last couple of years as its central bank seeks to diversify foreign security holdings.
⁴The Markit Global Banks 5Y CDS Index fell almost 50% in 2012.
⁵Hedge Fund Research.
⁶BIS Annual Report 2011/2012, Neely, Christopher J. The large-scale asset purchases had large international effects, 2012.
⁷BIS Annual Report 2011/2012, White, 2012. The unintended consequences of loose monetary policy. Economist, QE, or not QE?, July 2012.
⁸The 2001-2002 recession was shallow, slowing global growth to around 2.5% (affected primarily US, Japan and Germany). However slower growth would have been exacerbated by the 9 /11 terrorist attacks - likely raising overall market anxiety.
⁹http://www.imf.org /external /pubs/ft/wp /2013 /wp1301.pdf
¹⁰http://www.bloomberg.com /news/2012- 06 - 09 /spain-seeks-125 -billion-bailout-as-bank-crisis-worsens.html.
¹¹Hedge-fund leverage rises to most since 2004 as margin grows, Bloomberg News, 14 January 2013.
¹²It has been noted by some that the more hawkish views from the Fed minutes released 3 January were from outgoing members. Therefore, the late January meeting may better represent the incumbent board's views.
¹³http://www.federalreserve.gov/newsevents/press/monetary/20121212a.htm
¹⁴Excluding Switzerland, South Korea and Hong Kong which have also employed unconventional measures to deal with appreciating currencies.
¹⁵http://www.bloomberg.com /news/2012-12-17/fed-s-lacker-says-reaching- 6 -5 -unemployment-may-take-3-years.html

Investment statistics commentary archive

The quarterly Investment Statistics Commentary succeeded the Gold Investment Digest (GID), which was published between Q3 2006 and Q2 2011 and examined trends in price, investment markets and the macro-economy relating to gold and other assets typically found in an investor portfolio.
The Commentary complements the investment statistics analysis updated on a regular basis.
Investment statistics commentary Q3 2012
Investment statistics commentary Q2 2012
Investment statistics commentary Q1 2012
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Explanatory text... [+]

The statement on 12 December did not deviate from previous iterations that "a highly accommodative stance of monetary policy (will) remain appropriate for a considerable time after the asset purchase programme ends and the economic recovery strengthens."¹³
While the US may, at the margin, be closer to unwinding unconventional policy, this appear to be far from the case for the other three major economies to have embarked on a similar path: Europe, UK and Japan. Given that unconventional policy appears to have been conducted in concert to achieve a unified and more global impact, it would seem odd for the US to unilaterally reverse this policy.

Policy normalisation may be indicative of improving economic health, but is also a double-edged sword as higher interest rates can lead to higher debt-service costs for governments, corporations as well as households - shifting the burden from lender to borrower. It is therefore a transition that will have to be managed with extreme caution - particularly as there is no useful precedent for such a process.
As detailed in the FOMC meeting in December, the end of quantitative easing - a first step towards normalisation - is conditional upon unemployment and inflation. The threshold for unemployment was set at 6.5% and tolerated inflation at 2.5%. It is uncertain when these targets might be reached.
Richmond Federal Reserve President Jeffrey Lacker, recently put the timeframe for reaching this target at “up to three years”.15 Employment data (payrolls) surprised to the upside in the US for the better part of H2 2012, yet the recovery in employment remains in its infancy (Chart 8) and even more so on the broader measure that includes temporary, discouraged and marginally attached workers (U6 ). Small businesses (500 or fewer employees) are the
lifeblood of employment in the US. The NFIB optimism index, which captures this sector’s view about the current and expected environment, remains immutably weak.

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