Gold outlook 2011: Irreversible upward pressures and the China effect

I know this may appear to
some to be an enviable job—getting to speak about the one asset class
that seems to continually out-perform all others year after year—but it
is a double edged sword.

I’ve struggled to find an appropriate simile. The best I can come up
with is that speaking about gold is like one of those good news bad news
jokes, you know the ones—your doctor phoned with some good news and
some bad news. The good news is they will be naming a new incurable
disease after you.

The good news is that gold is rising in value; the bad news is—well nearly everything else about the economy.

This year we travelled to the Middle East, the Far East and South and
Central America to discuss gold. The different mindsets about gold we
encountered there surprised all of us. Most people in these countries
see gold as the protector of wealth. In the West, we view gold as a
commodity for speculation.

Western economists treat the act of buying gold as an admission of
defeat and their attempts at disparaging gold’s steady rise became even
more tenuous than ever this past year. Some of these disparaging
opinions include:
“Financial tightening will cause commodity prices to fall.”
“Gold is in a bubble.”
“The gold stocks haven’t confirmed the gold bull.”

Perhaps most desperate of all—“The economy is on the road to recovery.”
Despite these protests, gold had another remarkable year. It was up 25
percent in 2010, which marked its tenth straight annual gain.

Although we are speaking about gold today, I would be remiss in ignoring
silver’s performance. Silver is up 78 percent in 2010 as it is, like
gold, beginning to assume its role as a monetary metal. Platinum was
also up 17 percent.

When we look at a ten year chart of the US and Canadian dollars, the
Euro, the British Pound and the Yuan, we see that these five major
currencies have lost between 70 to 80 percent of their purchasing power
against gold over this 10 year period. In truth, gold is not rising,
currencies are falling in value and gold can therefore rise as far as
currencies can fall.

Three Short to Mid-Term Trends

I’d like to pick up where we left off last year with a review of three
dominant medium term trends that put upward pressure on the price of
gold in 2010 and will likely continue to in 2011. Then I’d like to look
briefly at three longer term, irreversible trends that will to put
downward pressure on currencies resulting in upward pressure on gold for
decades.
First, the three dominant mid-term trends we discussed last year. These are:
1. Central Banking Buying
2. Movement away from the US Dollar
3. China

Central Bank Buying

In 2009, for the first time in 20 years, monetary gold, or central bank
and investment buying, outpaced gold buying for industrial or jewellery
purposes. In 2010 China, Iran, Russia and India’s central banks were all
significant buyers as they moved cash reserves to gold.
In Q3 of 2010, Russian central bank gold holdings rose seven per cent to
756 tonnes. In 2010, the Russian Central Bank bought 2/3 of its own
gold production.

In December we learned that China had imported 209.7 metric tonnes of
gold in the first 10 months of the year. This was a 500 percent increase
over the same period of 2009 and on top of their world leading domestic
gold production.

By the third quarter, India’s gold imports, both commercial and private,
for the year were 624 tonnes, putting them 100 tonnes above the
previous year’s total of 595 tonnes. Fourth quarter purchases could put
India’s annual total over 750 tonnes.

China and Russia need to acquire gold to bring their gold reserve ratio
to outstanding currency closer to Western central banks. Russia needs to
acquire at least 1000 tonnes and China at least 3000 tonnes to remain
on parity with the US. Chinese officials have stated publicly that China
would like to acquire at least 6000 tonnes. Unofficially they have
stated targets as high as 10,000 tonnes.

Movement Away from US Dollar

Last year we quoted a November 2009 story written by veteran journalist
Robert Fisk claiming Russia and China along with France, were working on
an agreement to trade oil with Arab states using currencies other than
the US dollar. As expected, central bankers fervently denied these
rumours. The US dollar has since 1973 been the only currency that oil
could be traded in. This is the only reason the US has been able to
amass nearly $14 trillion in debt. Loss of the petrodollar`s hegemony
would have a devastating effect on the US as this is essentially the
only reason foreign countries in the past needed to hold US dollars.

On November 24, 2010, China and Russia officially ``quit the dollar``
and agreed to use each other’s currencies for bilateral trade—including
oil. Official trading on Moscow’s MICEX Index began December 15th, 2010.

In 2009, Robert B. Zoellick, made his well-publicized comment that, the
US would be ". . . mistaken to take for granted the dollar's place as
the world's predominant reserve currency.” And that, “. . . looking
forward, there will increasingly be other options to the dollar." In
2010 he continued hinting at a new reserve currency made up of five
currencies with gold as the “reference point.” He also called for a new
Bretton Woods agreement this year. Mr. Zoellick is no lunatic goldbug.
He’s the President of the World Bank.

China

Last month, I was a speaker and panellist at the China Gold and Precious
Metals Summit in Shanghai. I can confirm that Chinese buying, both
official and public, is a major trend that is not only well in place,
but may be the single most important influence on the price of gold in
2011. As I said, the Chinese see gold quite differently from the way we
see it. If we are to understand gold’s price direction in 2011 and
beyond I believe it is essential to understand the “mindset” the Chinese
have built around gold.

Economic Mindsets and Gold

Although the forming of economic mindsets is a complex topic, I’d like
to simplify how major financial mindsets are created in one sentence.
What our government, our banks and financial media tell us about money
is what most of us will accept as our financial mindset or financial
reality. If anyone doubts the power of government economic policy to
shape mass economic reality, just look at how we have changed our
attitudes towards debt, saving and economic value over the past 40
years. Our current debt based mindset began to form the day the US
dollar, the worlds reserve currency, was removed from its final
international peg with gold in 1971.

Different Attitudes about Gold

Although the West shares many common economic principles with the East,
as the capitalist banking systems are similar, there is one area where
there is a clear distinction—this is how Easterners view the role of
gold as money.

Western governments fear gold. It restricts their ability to create currency

In the West, governments borrow and encourage their constituents to
follow their example. Banks encourage us to borrow for everything from
vacations to widescreen televisions made in China. They tell us we are
“stimulating” the economy through consumption. Generally speaking, the
investing public in the West sees gold as a wealth gaining asset to be
traded like stocks and bonds. This is why Westerners are constantly
fretting about the price of gold in currency terms.

The Chinese government, on the other hand, respects gold. This is
evident by the laws they have passed to facilitate mining and private
gold ownership. China currently leads the world in gold production.
The government encourages the public to put 5 percent of their
savings—yes they encourage savings—into gold. This is significant
because the Chinese can save up to 40 percent of their annual salary. In
the West, most middle class families are lucky to break even. The
Chinese see gold as a wealth preserving asset that will weather all
seasons. This is the difference that I believe anyone who wishes to
fully understand gold’s rising price must comprehend. Inhabitants of
older countries, who have lived through the destruction of an inflation
fuelled currency crisis, do not need to be reminded that gold is the
most effective hedge against inflation and a currency crisis.

Former CEO of Newmont Mining, Pierre Lassonde also feels that it will be
buying by the Chinese public that will eventually propel gold prices
into the stratosphere.

Three Irreversible Trends

Clearly, the three medium term trends we noted last year are still
firmly in place. Now I’d like to look at three longer irreversible
trends that I believe will affect the price of gold and currencies for
decades. These are:
1. The aging population.
2. Outsourcing
3. Peak oil

The Aging Population

The aging population is a combination of a population that is living
longer and the “pig in the python” effect of a huge tidal wave of “baby
boomers” born between 1946 and 1963 who are just starting to enter
retirement age. As people age, they spend less and downsize. GDP and tax
revenues are reduced and a much smaller workforce follows the baby
boomers so this is a triple whammy. This problem is universal. In China,
it is further exacerbated by their one child per couple policy.
Governments will have no choice but to create more currency and further
debase it.

Outsourcing

Outsourcing has almost entirely destroyed the manufacturing sectors of
many first world countries like the US and Canada and much of Europe.
The Chinese worker who built your IPhone made $287 a month; this was
after a well-publicized raise. The West simply can no longer compete
with these labour costs. The United States was the world’s largest
manufacturer after WWII and has driven the world’s economy ever since.
However, the US consumer can no longer buy things as they lose their
jobs. As factories move off shore the high unemployment becomes
systemic. Without jobs, the GDP and the tax revenues of the US fall. The
mountain of federal, state and municipal debt will become even harder
to service and the government will be forced to go even deeper in debt
and to further debase its currency.

Peak Oil

Peak oil is the point at which the maximum rate of global petroleum
extraction is reached, after which the rate of production enters
terminal decline. This has already happened in the US, Alaska and the
North Sea. In the next few years Mexico will become an importer of oil
and the US will lose its third largest supplier. Our fragile, highly
indebted economy relies on this land based cheap oil to continue and it
cannot withstand the shock of transitioning to more expensive
alternatives. In September of 2010 a German military think tank reported
that the German government is taking the threat of peak oil seriously
and preparing accordingly. Numerous studies around the world have
concluded that we are very close to peak oil production, which will be
accelerated due to gulf drilling bans.

This will lead to higher price inflation for most goods. This will be
another blow to the fragile US economy, which currently pays less for
oil and gas than any of the first world countries. When added to the
effects of the waning strength of the petrodollar the results will be
devastating.

May I remind you that if China, which currently has one tenth the number
of cars per capita as Americans, was to reach par with the US, we would
need, by one estimate, seven more Saudi Arabia’s to meet their needs.

These three mega trends will continue to lower the GDP, lower the tax
revenue, create higher trade deficits, create higher unemployment,
resulting in the need for further currency creation. This will cause
inflation to rise as currencies depreciate in value and create higher
universal debt. All of this means the gold price will continue to rise.

Competition for the World’s Gold

Finally, as a direct result of world-wide debt and currency debasement,
more people will be competing for the world’s available gold. We
discussed peak oil, but gold is also reaching a peak as fewer and fewer
new deposits are being found. Smaller, lower grade deposits with none of
the “economy of scale” benefits of larger deposits are being put into
production out of desperation. Mine supply has been in a decline since
2000.

As safe haven demand accelerates, there will be a transition from the
$200 trillion of financial assets to about the $3 trillion of above
ground gold bullion. Of the $3 trillion of above ground gold bullion
about half is owned by central banks and half is privately held. The
privately held gold is largely held by the world’s richest families and
is not for sale at any price. The central banks are now net buyers. If
the world’s pension funds and hedge funds moved only five percent of
their assets into gold, which these days seems quite conservative, gold
would trade above $5,000.

So in conclusion, I will say that without any new financial crisis, both
mid-term and long term trends are in place to ensure gold and silver
will continue rising through 2011 and well beyond. For those of you who
are looking for a prediction...last year at the Empire Club, I forecast
that the price of gold to be between $1300 and $1500 at the end of 2010.
We ended up right in the middle at $1405. For 2011, I recently forecast
it may climb to $1,700 to $2000 per ounce based on the last five years
performance and the factors I have presented today.

I encourage you to follow the example of those who know how devastating a
currency crisis can be and buy gold to protect wealth and not treat it
as speculation. I’d like to close with a quotation that seems to put all
of this into perspective. It comes from Norm Franz’s appropriately
titled book, Money and Wealth in the New Millennium. He said,
"Gold is the money of kings; silver is the money of gentlemen; barter is
the money of peasants; but debt is the money of slaves."

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