In Gold We Trust

The foundation for new all-time-highs is in place. As far as sentiment is concerned, Erste's analysts definitely see no euphoria with respect to gold. Skepticism, fear, and panic are never the final stop of a bull market. In the short run, seasonality seems to argue in favor of a continued sideways movement, but from August onwards gold should enter its seasonally best phase

The foundation for new all-time-highs is in place. As far as sentiment is concerned, Erste's analysts definitely see no euphoria with respect to gold. Skepticism, fear, and panic are never the final stop of a bull market. In the short run, seasonality seems to argue in favor of a continued sideways movement, but from August onwards gold should enter its seasonally best phase. "USD 2,000 is our next 12M price target. We believe that the parabolic trend phase is still ahead of us, and that our long-term price target of USD 2,300/ounce could be on the conservative side," according to the latest Erste Group report "In Gold We Trust".


In an environment of negative real interest rates, the concept of risk has to be redefined, seeing as nominally “safe” assets still incur losses. This doesn’t mean that asset classes with low volatility are free of risk nor relatively safe. The difference between saving and investing is the fact that the saver tries to preserve his purchasing power, while investors try to increase it1. In an environment of negative real interest rates, one has to take risk to preserve one’s capital.

The term “risk-free” is the mother of all oxymorons. There has never been anything like a risk-free investment, nor will there ever be such a thing. Risk can never be eliminated – it can only be transferred. And when it is transferred or disguised, the strong relationship between risk and consequence is disrupted. As soon as risk and capital are misvalued, misallocations will ensue3. This is what is currently happening at a global scale unknown as yet.


Excessive structural debt suggests further increase of the gold price. Even if market participants are currently focused on the debt problem within the Eurozone and its peripheral countries, the situation in the UK and Japan seems to be just as precarious. The Western world and Japan have amassed the highest level of debt ever in times of peace – although the demographic outlook is dire.

Although we are currently faced with the highest level of public debt in times of peace, a far-reaching consolidation of public budgets does not seem to be up for discussion. The required grave cutbacks are being postponed, and the policy of “muddling through” is cheerfully continued. The longer structural and far reaching reforms are postponed, the more substantial will be the need for adjustment and thus greater the burden on future generations. There does not seem to be a painless therapy for these problems. We believe that gold is an effective medicine.

The degree of complexity tends to be greatest at the fringes of the chaos. Societies react to crises by stepping up complexity and thus trying to solve their problems. Every resource investment – be it energy or money – achieves a lower rate of return than the preceding investment, i.e. the marginal utility declines. According to Leonard da Vinci, simplicity is the ultimate sophistication. We believe that gold is a simple, affordable, time-tested, and reliable good for protecting oneself against tail risks.

What does this environment now mean for the gold price? Since Erste's previous “In Gold We Trust” report of early July 2011, gold has set new all time highs in numerous currencies (among others, USD, GBP and EUR). The last year was merely a consolidation pattern, rather than a top-formation. That said, we have to be self-critical here, as the price has clearly fallen short of our target of USD 2,000.


The price of gold is yet to peak, bolstered by low real interest rates and the desire for secure, sustainable forms of savings and investments. As the Federal Reserve will continue its zero interest policy until at least 2014, real interest will continue to be negative, laying the ground for gold price to climb higher. “Since the last Erste Group Gold Report of July 2011, the price of gold in euro has risen by 26%. Over the short term, it would seem that the seasonality implies a continued sideways trend; however, the phase of the best season for gold begins in August. Therefore, our next 12-month target is USD 2,000. As we still have the parabolic trend phase ahead of us, we expect as long-term target at least USD 2,300 at the end of the cycle,” explained Ronald Stoferle, commodity analyst at Erste Group and author of the report.

Ronald Stoferle points out that one reason for gold’s excellent performance is the relative scarcity of the precious metal compared to arbitrarily printable bank notes. “Gold is so highly valued because annual production in relation to reserves is so low. Gold reserves are growing at around 1.5% per year. In contrast, the money supply aggregates are growing at multiple times this rate”. Additionally, the appeal of gold as a secure form of saving goes up precisely in economically uncertain times. “The European Central Bank has just lowered interest rates to an all-time low and it looks as if these will stay there for some time to come. Negative real interest is a perfect environment for gold,” explained Erste Group’s gold expert.



The current high purchasing value of gold can be best illustrated by the following example: “If one compares the price of beer to the price of gold, one would be able to buy around 136 Mas (one Mas = one litre) of beer at this year's Munich “Oktoberfest” for one ounce of gold. The mean value is historically at 87 Mas. The peak was reached in 1980 when you could have bought 227 Mas of beer,” Stoferle said.

We are convinced, that the global monetary expansion should continue to ensure a positive environment for gold investments. The reaction to the current crisis is already feeding into the next crisis. The idea of trying to cure a crisis that was created by an expansive monetary policy and chronically excessive debt with the same poison seems naive. The driving forces of economic health are savings and investment, not consumption and debt.



The majority of Western nations are faced with the choice of rigid austerity measures, massive tax hikes, national bankruptcy, or extensive financial repression. By the method of exclusion we can quickly find the supposed magic formula, given that the political implications of rigid austerity measures and drastic tax hikes are largely unpopular and squarely at odds with the goal of getting re-elected. On top of that, drastic austerity measures tend to result in social upheaval. According to Bridgewater the frequency of protests, strikes, and social unrest increases sharply as soon as annual public spending is cut by more than 3% of GDP.

We already discussed financial repression as a perfidious form of redistribution last year. Given that the signals have become more frequent since then, we will now discuss further aspects of this kind of policy. Financial repression always means a combination of incentives and restrictions for banks and insurance companies, which cause the investment universe to be substantially reduced for investors. This means that capital is channelled away from the asset classes that it would flow into in a more liberal environment. This is also supposed to create a home bias. Financial regulation constitutes an important aspect.

The pillars of financial repression:

- Strigent investment citeria (Solvency II, Basel III); for example, under the pretence of more attractive liquidity ratios, European government bonds do not have to be underlaid with equity

- Negative real interest rates

- Interest caps (i.e. randomly imposed, artificial maximum rates), as a result of which long-term interest rates are substantially lower than the fundamental picture would suggest

- Establishment of a more or less direct control of lending policies

- Nationalisation

- Capital transaction controls (e.g. China)

- Ban on the possession of certain assets (gold?)

- Special taxes (financial transaction tax, property tax etc.)

- Manipulation of the CPI

- Rising discrepancy between financing costs for private households and government

Negative real interest rates of course reduce interest rate expense and existing debt. Unpopular measures such as VAT or income tax hikes or cuts in public spending can thus be avoided or postponed. This means that negative real interest rates are a transfer from savers to debtors6. According to a report by the IMF, some countries are in a position to handle inflation rates of up to 6%. The following example illustrates the extent of silent dispossession: at such a rate, assets worth EUR 1,000,000 shrink to EUR 558,000 within ten years.

The financial market regulations Basel III and Solvency II also play an important role given that they contain artificial incentives for holding government bonds. The risk weighting of government bonds issued by EU members is zero. Financial institutions such as insurance companies and banks are coerced by the new Capital Requirements Directive into massively stepping up their holdings of (allegedly) safe government bonds, given that this is the only way to meet the risk criteria. “Risky” investments such as stocks or commodities on the other hand have to be underlaid with equity.

Financial repression was playing an important role as early as after WWII during the phase of debt reduction. The US managed to cut its debt in terms of GDP from 116% to 66% between 1945 and 1955. The average inflation was 4.2%, real interest rates were -0.8%. But one has to bear in mind that the boom that was created by rebuilding after the war was responsible for a large part of the economic upswing. In addition, demographic conditions were much more favourable, and private household debt was comparatively low.

Numerous political protagonists have confirmed the fact that financial repression will represent the strategy of choice in the coming years. Kevin Warsh, former Fed governor, said that the political decision-makers were enticed by the instrument of financial repression. It helped depress the prices of unwanted assets. With the help of various incentives and regulations, investors should be pushed into specific asset classes (government bonds in the first line).

We believe that financial repression will continue to crop up in many shapes and sizes over the coming years. However, the long-term costs of the lack in efforts made towards consolidating national finances are substantial. While low bond yields in the short run suggest that the saving measures are on course, one has to bear in mind that this has mainly been achieved by market interventions. Therefore, we regard the gradual transfer of assets – a rather euphemistic term for gradual dispossession – as a disastrous strategy in the long run. What happens is that none of the previous problems of misallocation are resolved, but instead redistribution takes place (at the beginning mostly invisibly) and problems are dragged out, having to be addressed later.

As the dependence on these measures rises, so does the collateral damage to be expected later, and the seeds for an even bigger crisis have been sown.





The perception of gold has gradually shifted from that of a commodity to that of money of the highest quality. Gold has the international currency code XAU, is traded by banks mostly at their currency desk (and not the commodity desk), and continues to be held as a reserve by global central banks. This confirms the monetary importance of gold. In a US survey, 44% of US citizens declared themselves in favour of returning to the gold standard, with only 28% being strictly opposed to the idea7. Some say that there is not enough existing gold for a gold standard today, but we regard this notion as a distortion of reality. The British Empire flourished under the gold standard, yet operated with only 150-200 tons of gold in the safes of the Bank of England. This means that the quantity is not the problem. We believe that the current return to a traditionally approved monetary status for Gold indicates that the bull market has entered into new phase.

Even in Erste's first Gold Report, the analysts discussed the gradual remonetisation of gold. While it had formerly been up to a handful of critical minds to question our monetary system, high-profile politicians and central bankers have in the meantime also offered their opinion. Last year, Erste's analysts saw numerous signals that indicated the fact that gold was gradually becoming “politically correct”. Ron Paul spearheaded a movement of opinion that was also joined by Newt Gingrich, Steve Forbes, and Robert Zoellick, all of whom spoke in favour of an imminent return to the gold standard.

It seems that market participants have been conditioned to ever-growing monetary stimulus measures like Pavlovian dogs. In the absence of their “treat”, they flee into liquid and seemingly safe US Treasuries or German government bonds, each of which have set new all time highs. This risk on/risk off behaviour reminds us of manic-depressive mood swings.

The analysts illustrate this misallocation by means of an example: in December 2011, the Republic of Germany placed 6M Treasury notes at 0.0005% in the market. The interest expense for this note worth EUR 2.675bn thus amounted to EUR 6,687.508. On the secondary market, the yields of short-term German and Swiss bonds have meanwhile turned negative. In the course of this year, the yields of 6M and 2Y Treasury notes have set new lows and have for the first time dipped into negative territory.


In a study, the IMF forecasts a drastic increase in the demand for safe investments as well as a significant decline in the supply of such investments. The IMF expects the share of safe haven assets to fall by 16% or USD 9,000bn by the year 2016. Due to the turbulences, which are expected to continue, the IMF envisages a continued strong increase in demand for safe investments, but at the same time a drastic decline in their availability. This process has already started. At the end of 2007, 68% of all industrialised nations commanded a AAA rating, whereas nowadays this percentage has fallen to 52%. In accordance with the law of supply and demand, this will trigger an increase in the “insurance premium” of safe investments.

Reliable stores of value that are supposed to preserve the assets are called “safe haven assets”. According to the IMF, they act as a lubricant and sign of trust in financial transactions and strengthen the capital and liquidity base.

Safe assets should fulfil the following criteria:

- Low credit and market risks

- High market liquidity

- Limited risk of inflation

- Low foreign exchange risk

- Low idiosyncratic risk

Gold fulfils these criteria without any problem.

Due to its high liquidity and unique characteristics, gold is becoming ever more prominent as collateral. Along with LCH.Clearnet, IntercontinentalExchange, JP Morgan, and the CME Group, Eurex, too, now accepts gold as collateral. This step definitely makes sense for clearing houses. On the one hand these institutions can diversify their assets (due to the low or in some cases even negative correlation), on the other hand they honour the wish of many market participants, who want to lodge gold as collateral. This initiative is currently also supported by the World Gold Council, which in addition wants to have gold acknowledged as “tier 1” asset within the framework of Basel III. This clearly highlights the renaissance of gold in international finance. We expect the debt and system crisis to cause a thorough review of the international monetary system. The downgrading of the ratings of numerous countries and companies will likely continue and come with a clearly positive effect for gold as safe haven.




From our point of view, the gold sector is riddled with an elementary misunderstanding. Many gold investors and analysts operate on an erroneous assumption: they attach too much importance to annual production and annual demand. We often read that the gold price cannot drop below production costs.

Every gramme of gold that is held for a variety of reasons is for sale at a certain price. Many owners would sell at a price slightly above spot, others would only sell at a substantially higher price. If, due to favourable prices, a private individual wants to sell his gold holdings that he acquired decades ago, it will not reduce the overall supply of gold. All that happens is the transfer from one private portfolio to another private portfolio. To the buyer, it makes no difference whether the gold was produced three weeks or three millennia ago.

This means the annual gold production of close to 2,600 tonnes is of relatively little significance to the pricing process. Rather, the supply side consists of all the gold that has ever been produced. The recycling of existing gold accounts for a much larger share of supply than is the case for other commodities. Paradoxically, gold is not in short supply– the opposite is the case: it is one of the most widely dispersed goods in the world. Given that its industrial use is limited, the majority of all gold ever produced is still available.

Much like an increase in the money supply dilutes the purchasing power of existing money, and the issue of new stock dilutes the existing share holders’ equity per share, an increase in the supply of gold should be understood as a dilution of the existing supply. A one-percent increase in supply can be absorbed by the market via a 1% price drop, with total demand remaining the same in nominal terms.

In contrast to other commodities, the discrepancy between annual production and total available supply (i.e. the stock) for gold and silver is enormous. This is called a high stock-to-flow ratio. As already discussed in 2011, we believe that this is the single most important distinctive feature of gold (and silver). The aggregate volume of all the gold ever produced comes to about 170,000 tonnes. This is the stock. Annual production was close to 2,600 tonnes in 2011. That is the flow. Dividing the former by the latter, we receive the stock-to-flow ratio of 65 years.

Gold reserves grow by about 1.5% every year, and thus at a much slower rate than any of the money supply aggregates around the world. The growth rate is vaguely in line with population growth. Trust in the current and future purchasing power of money or any means of payment not only depends on how much is available now, but also on how the quantity is expected to change over time.

What does that mean in numbers? If annual mine production were to double (which is highly unlikely), this would translate into an annual increase of only 3% in the supply of gold. This is still a very minor inflation of total gold reserves, especially compared to current rates of dilution of paper currencies. This fact creates a sense of security as far as availability is concerned and prevents natural inflation. If production were down for a year, this would also have little effect on the total stock and on pricing. On the other hand, if a significant part of oil production were to be disrupted for an extended period of time, stocks would be exhausted after only a few weeks. This means it is much easier for gold to absorb any form of significant production expansions or shortages.

Many gold market analysts attach great importance to the rate of change of mine production (increasing mine production being bearish; decreasing: bullish). The change in production from one year to the next is an increment on top of an increment and is really of miniscule importance to the supply situation.

We therefore believe that gold is not precious because it is scarce, but because the opposite is true: gold is precious because the annual production is so low relative to the stock. Gold has acquired this feature over centuries, and cannot lose it anymore. This stability and safety is a crucial prerequisite for the creation of trust. And it is what clearly differentiates gold and silver as monetary metals from commodities and the other precious metals. Commodities are consumed, whereas gold is hoarded. This also explains why traditional supply/demand models are only of limited use for the gold market.

The demand side is made up of investors, the jewellery industry, central banks, and the industrial sector. But this is still only a fraction of total demand. Reservation demand accounts for the largest part of demand. This term describes gold owners who do not want to sell gold at the current price level. By refusing to sell, they are responsible for the price remaining at the same level.

This means that the decision not to sell at current prices is as important as the decision to buy gold. In net terms, the effect on the price is the same. The gold supply is therefore always high. At a price of USD 5,000, the supply of recycled gold would exceed annual production several times. This also explains why the often-quoted gold deficit is a fairy tale. Of course the supply of recycled gold has increased significantly throughout the bull market. But it strikes us as interesting that the supply has only increased marginally since 2009, in spite of a drastic increase in the price. This could mean that the market has gotten used to a higher price, to the extent that new sellers will only come forward at substantially higher prices. This distribution indicates that gold holdings are gradually moving from weak to strong hands.

But what is the implication of that? Whenever a seller sells, that means that gold has hit their reservation price, so they sell to a buyer - who inherently has a higher reservation price demonstrated by his willingness to buy at that price. This means that large sales improve the market structure.

The gold market should therefore be seen as an integrated market. We believe that the segregation into annual production and total reserves is incorrect and leads many analysts to the wrong conclusion. All sources of supply are equivalent, given that every available ounce of gold is in direct competition with other ounces, regardless of whether this specific ounce was produced 3,000 years ago or three months ago or consists of recycled dental gold. The annual gold production of close to 2,600 tonnes is therefore of no significant relevance to the pricing.




Gold has always abandoned regions of stagnating wealth, heading instead for prospering economies and rising savings volumes. The hunger for gold in emerging markets is also responsible for the rising price. While in 1980 Europe and the US still accounted for 70% of global gold demand, now it is barely 20%. Within the past five years, the share of emerging markets in the overall global demand for gold rose to 70%. More than half of it was in China and India. Apart from the strong traditional affinity to gold (especially in India), growing demand and the increasing savings ratio in emerging markets are attributable to greater prosperity. However, local investors’ options are very limited in terms of how they use their savings. In this respect, gold has over centuries been proven the best asset to preserve value. “Assuming that incomes in China and India continue to rise and real interest stays negative or low, gold will automatically benefit from this development,” said Stoferle.

Moreover, criticism of the hegemony of the USD as a currency is growing: many nations apparently want to liberate themselves from the slavish link to the US currency. China, Russia and India but also Japan are increasingly showing a desire to settle bilateral trades in their own currencies or in commodities to avoid the US dollar. This is a clear indication of a shift in paradigm especially as more than 2/3 of all US dollars are held abroad.

The increasing welfare and the gradually rising propensity to save, i.e. the savings ratio, in the emerging countries are the crucial factors for this paradigm shift. In China, said ratio increased from 40% in the 1990s to 49% in 2010. In India, it rose from 22.4% to 30% over the same period of time. According to GMO, total savings increased during that time from USD 557bn to USD 3,400bn in 201011. Therefore, it comes as no surprise that China and India have meanwhile turned into by far the most important gold consumers. The clearly growing gap between demand in “Chindia” and that in the US and Europe is also highlighted by the following chart.

In India, there are 21 different terms for gold. No other country in the world has a similar soft spot for the metal. Estimates put the private Indian gold reserves at more than 20,000 tonnes, or USD 1,000bn in value terms. Last year India accounted for almost 27% of global demand, with jewellery making up 61% thereof, and coins, bullions, and other investments accounting for the rest. Turkey, too, is one of the biggest gold consumers. According to the World Gold Council, Turkey accounts for the fifth-largest jewellery demand and has the eighth-largest retail market. The Turkish population holds more than 5,000 tonnes of gold, i.e. USD 250bn. The majority thereof is held as jewellery outside of the banking system.

Gold is often called the investment of doomsayers and chronic pessimists. This component is currently presented as the only reason for the gold bull market. However, this point of view fails to acknowledge the fact that China and India are the driving factors on the demand side. Real interest rates remain negative in both countries. On top of this the market is clearly underdeveloped with respect to its investment universe. Basically local investors are very limited when it comes to the use of their savings. Gold has been a time-tested store of value for centuries. The traditionally high affinity for gold and the rising net worth will support demand in the long run. Whoever expects incomes in China and India to continue rising and real interest rates to remain negative or low, will by default recognise gold as the beneficiary of these developments.



The last time that central banks bought as much gold as they did last year was in 1964. From our point of view, this constitutes a clear paradigm shift in the official sector. Total purchases amounted to 455 tonnes, according to the IMF (as compared to 77 tonnes in 2010). Mexico (99 tonnes), Russia (65 tonnes), Turkey (65 tonnes), Thailand (53 tonnes), and South Korea (40 tonnes) were among the biggest buyers. And the momentum does not seem to wane in 2012 either. Purchases in the first quarter amounted to 81 tonnes. The trend seems to be continuing in Q2 as well; in April and May alone the Philippines (32 tonnes), Turkey (36 tonnes), Russia (15t) and Mexico (3 tonnes) were buying according to the IMF.

We believe that the central bank purchases signal a new phase of the bull market. Since the buyers are mostly emerging countries, we regard these efforts as a logical catching up. Compared with the industrialised nations, the majority of the central banks in emerging nations remain clearly underweighted in gold. Thus the hedging of their enormous US dollar holdings is inadequate.

In times of turbulences on the global financial markets, gold has regained its attractiveness as “ultimate hedge”, as numerous studies confirm12. According to the study “Central Banks and Gold Puzzles“ the holding and /or buying of gold signals “global power” and tends to go hand in hand with strengthening national self-confidence and national pride. This theory is confirmed by reality. China, Russia, India, Thailand, Mexico etc. have stepped up their gold reserves in line with their growing economic importance. China currently (officially) holds the sixth-largest volume of gold reserves, with Russia following in eighth rank and India ranked eleventh. We expect the countries to continue diversifying their reserves towards gold in order to signal their growing economic power13.

According to the IMF, the US dollar still accounts for the lion’s share of 61.7% of all global currency reserves, followed by the euro (27.5%) and gold and other currencies (12.6%). These shares should go through major shifts in the future. According to a survey of 54 central banks, that hold total assets of USD 6,000bn, 71% said that gold has clearly gained in terms of attractiveness due to the euro crisis14.

If the 18 central banks (outside the EU and the USA and excluding China) with the largest US dollar reserves were to increase their gold reserves to 10% of total reserves, aggregate demand would amount to 3,400 tonnes15. If China wanted to increase its share of gold reserves to 10%, it would have to buy more than 5,300 tonnes. We think it is an unlikely scenario for China to step up its share quickly and publicly to 10% or more. On the one hand, it would signal a lack of confidence in the development of the purchasing power of the US dollar reserves worth USD 3,300bn; on the other hand, such amounts could hardly be placed on the market. If China wanted to maintain its share of gold at 1.8% in terms of total currency reserves it would have to buy close to 170 tonnes of gold per year (provided that US dollar reserves were to keep rising at the current rate).



In the previous reports we have discussed the alleged “gold bubble” at length, and our conclusions have always been that the gold price is still far from being in “bubble territory”. Many market participants and commentators find it difficult to differentiate between a bull market and a bubble. On top of this we wonder why none of the bubble augurs proclaimed the trend reversal towards a bull market at the end of the bear market. Also – why do those people refuse to open short positions if they are so convinced that gold is in a bubble?



Looking at the numbers, there is a lot that defies the notion of a gold bubble. According to the World Gold Council in Germany 159 tonnes of gold were bought last year, i.e. a total worth of about EUR 6.3bn, or EUR 79 per capita. The sum spent on life insurance policies, by comparison, amounted to EUR 76bn or EUR 1,000 per capita – an amount that substantially dwarf