Why gold is still a solid long-term investment

We have been bearish on gold prices since January 2013, when it was trading above $1,650 an ounce. Since then, the price of gold has declined by almost 30%. There are three main reasons for this underperformance over the last two years:

1. Gold GCZ4, +0.70%     as an investment hedge has become less attractive to Europeans as the chance of a break-up of the European Monetary Union declined after Spain, Portugal and Greece were bailed out by the EMU’s richer members, such as Germany.

2. Gold has become less attractive to Americans as the U.S. dollar DXY, +0.45% strengthened and recently hit a four-year high.

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3. India, which accounts for one-quarter of the world’s gold consumption, slapped a 10% import duty on gold during August 2013. Indian gold demand dropped by close to 40% year-over-year in the fourth-quarter of 2013 and did not recover until this summer.

Many analysts are still bearish on gold prices. For example, Goldman Sachs and Credit Suisse have 2014 year-end target prices of $1,050 an ounce and $1,000 an ounce respectively. Some are even expecting gold prices to plunge to below $1,000 an ounce in 2015.

While there are still some short-term headwinds (such as a strengthening U.S. dollar) for gold prices, we believe gold is still a solid long-term investment for the following four reasons:

1. Gold mine production will peak in 2015 at current prices.

For more than a decade, gold miners expanded production by developing lower-grade mines, increasing production costs for the entire industry. This strategy made economic sense as gold prices rose from $300 an ounce in 2002 to nearly $1,900 in 2011. With gold under $1,200 an ounce today, however, this no longer makes sense.

Our analysis of over 80 major gold mines around the world shows that more than half of them have an all-in sustaining cost of over $1,000 an ounce. That is, half of these mines would lose money if gold declines to $1,000 an ounce. More importantly, gold miners have been cutting costs since early 2013, and have little room for more cost-cutting unless they trim production or close their lower-grade mines.

Simply put, the supply of fresh gold from mines will decline if gold prices decline any further, thus putting a floor on gold prices.

2. The European Monetary Union’s viability is questionable.

Before the onset of the global financial crisis in 2008, European retail investors (excluding those from Russia) bought little- to no gold as an investment hedge. Beginning in mid-2008, European investment demand for gold increased steadily as concerns about the viability of the EMU and the euro EURUSD, -0.88%  emerged.

European investment demand for gold peaked at an annual rate of 400 tons in the second quarter of 2009 (11% of world demand), and remained at over 350 tons during the peak of the European sovereign debt crisis in late 2011/early 2012.

Since then, European investment demand has declined to below 250 tons annually as concerns about a break-up of the EMU dissipated. We believe this complacency is misplaced. The “peripheral countries” including Greece, Portugal, Spain, and Italy are still struggling with historically high debt levels, chronically low economic growth, and a wave of retiring baby boomers that will further strain their social welfare systems.

Historically, the only way for economic or monetary unions to stay together is for direct transfers of wealth from richer to poorer areas, with no strings attached. Only the U.S. and U.K. have been able to pull this off. With the Germans opposed to funding any future bailouts, we believe the EMU and the euro will break apart by the end of this decade. European investment demand for gold as a hedge should thus increase, creating future upward pressure on gold prices.

3. The Federal Reserve will remain dovish.

Since the onset of the global financial crisis, the Fed has consistently acted more dovish than the market expected. Both the former chair, Ben Bernanke, and his successor, Janet Yellen, have compared the current economic environment to the 1930s, when (they asserted) the Fed raised policy rates too quickly, consequently choking off any sustained economic recovery.

The Fed has effectively indicated that it would err on the side of too much easing. Today, the size of the Fed’s balance sheet is $4.5 trillion. There is no indication that the Fed will shrink its balance sheet anytime soon; we actually expect it to grow further, especially when the next economic downtown hits.

4. Indian demand for gold is already recovering.

The International Monetary Fund recently raised its 2015 economic growth forecast for India to 6.4% from 6%, while the Organization for Economic Cooperation and Development (OECD) recently noted that India is the “only major economy” to see a pick-up in growth momentum.

The pace of economic reforms in India has also accelerated, with the government recently deregulating diesel prices and creating steps for the privatization of its coal industry. Indian demand for gold is tied to economic growth; the country’s demand for gold during 3Q 2014 is already up by 39% on a year-over-year basis, coming in at 225 tons and surpassing Chinese demand. As Indian economic growth accelerates, we expect consumer demand for gold to pick up, especially for gold jewelry.

Thus, gold is still a solid long-term investment, despite some short-term headwinds. Investors should use any future corrections in gold prices as opportunities to invest in gold for the long run, either through an ETF such as the SPDR Gold TrustGLD, +1.04%   or physical gold.

Source Url:http://www.marketwatch.com/story/why-gold-is-still-a-solid-long-term-investment-2014-11-21