Gold and Silver Prices Versus a Growing Global Economy

While some may say that a growing global economy spells doom and gloom for gold, silver and other precious metals, rational thought would seem to think otherwise...

Buckle your seatbelts and keep your coffee nearby folks. We're gonna get pretty deep into the cogs and wheels of the gears that drive both gold and silver...

There seems to be a growing misconception that believes something like the following: "In a recovering global economy and in particular a growing developed world economy, the gold and silver prices will fall because their current prices reflect economic uncertainty and fear. Any recovery will therefore remove that uncertainty and fear, so that gold and silver prices should then fall." I beg to differ on this rather misguided and unfounded assumption.

The truth is that gold and silver prices are driven by a diverse range of factors from all over the world. The tendency to use the aforementioned overly simplified correlation can be a pretty costly mistake. It’s vital that investors understand not just individual "links" (i.e. a growing global economy lowering gold and silver prices), but in what proportion they affect the gold price. It’s that overall perspective that affects the price and investors’ success.

Influence #1 - Monetary

For the last few years, silver has been following gold price - rising and falling, further and faster than gold. This type of behavior shows that the monetary influences on precious metals are more of an influence than the fundamental demand and supply factors. The fundamental supply and demand factors show a strong demand, based on electronics and on its various medical applications. By following gold so closely, silver has seen investment demand dominate the price moves. While silver is not considered a monetary metal by central or commercial bankers, the general investing public seems to think that silver has the wealth-preserving qualities that a monetary metal needs to have in order to qualify as such. This explains why silver follows gold so closely.

On the other hand, gold is most definitely a monetary metal and considered to be so by bankers in general (and by central bankers in particular). It even comprises 70% of the U.S. reserves. When gold eventually becomes visible as a monetary metal in banker’s hands (and some say this may occur in 2013), only then will we start to see less correlation between the two metals' price behavior.

Influence #2 - Economic

As you have most unavoidably noticed, the developed world is currently experiencing a flat economic growth or recession. Some believe that the U.S. could enter recession next year and gold price appears to be reflecting this as it trades around $300 below its peak. Many traders feel that stronger U.S. economic growth actually undermines the "safe-haven" value of gold and silver. But is this really so and does history reflect it as well?

Gold experienced its greatest rises from 2005 to mid-2007, from $300 to $1,200. It then slipped back to $1,000 when general "investor stress" forced investors to sell almost everything to lessen their leverage and indebtedness. Once this was out of the way, gold resumed its rise, reaching past $1,900 in 2011 before correcting again to current levels. From 2005 to 2007, economic growth was robust in the developed world. The rise from $1,000 to $1,900 coincided with a stumbling recovery, whereas the current period of falling gold and silver prices has coincided with flat to falling growth in the developed world. Thus, so far just looking at the developed world during the last 7 years shows that gold and silver prices rise when the developed world is growing economically.

But is this a valid correlation? As the developed world grows, do people buy gold because they have more disposable income? Probably not. The advent of the gold Exchange Traded funds in the developed world saw gold investors choose that route over investments in gold mining shares, mainly because it was the first time they could buy an investment that was linked to gold price itself and had the ability to influence gold prices directly. This accounted for just under 2,000 tons of investments into gold. So economic growth was probably not a factor. I say the one with their hand in the cookie jar was actually the structural change in the gold market.

But then where is the link, if any at all, between economic growth and the gold and silver prices? For this, I suggest we look across at the emerging world - namely Asia (i.e. China, India the Philippines and other emerging lands), where economic growth has enriched poor people on a broad front. People emerging from poverty are well-aware of the need for savings to shield them against returning to poverty. They still aren't totally convinced that banks are safe places to keep cash savings as inflation has slowly eroded away its buying power over time in every country.

Therefore, gold has been the time-trusted investment where individuals have placed their savings. In China this has been supported with strong encouragement from the government. In India, the government is unhappy with so much of the GDP being absorbed by gold, but because of distrust in government and its officials, the average Indian investor still favors gold as protection against Indian institutions and inflation and thus continues to buy gold and silver. The rise in disposable income in Asia has led to a steady and growing investment in gold and silver. So here, economic growth triggers investment in gold.

In this manner, one may conclude that, yes, gold and silver investments can be directly linked to economic growth IN ASIA and contribute to gold demand and rising gold prices.

Influence #3 - Central, Commercial Bank

Will more central bank reserves find their way into gold in times of economic growth? To answer this question, it becomes necessary to separate developed world from emerging world central bank activity.

In the developed world, central bankers ceased selling gold as a component of reserves in 2009. Since then they have not added gold to their reserves. But NOW the issue is very firmly on the table amongst the banks. In both the U.S. and Europe, bankers are deciding whether to treat gold as a Tier I asset up from the current Tier II level, where banks can only add 50% of its value as an asset on their balance sheets. Under a Tier I definition this will rise to 100%. As we saw in the credit crunch and in the Eurozone debt crisis, banks will unload assets from the Tier II category in favor of Tier I assets - like U.S. Treasuries - in order to boost their creditworthiness.

If (in the U.S. and through the Basel discussions in Europe) gold is re-defined as a Tier I asset, then it would behoove the commercial banks to switch into gold from other Tier II assets in times of credit stress. And sense they would have to keep diversification in mind, it will also serve to place some of the emphasis they now place on U.S. Treasuries onto gold. The drive this will give to gold demand will significantly affect gold prices, and by extension, silver as well.

In the emerging world, the rise of both central and commercial bank reserves has, for the first time, given the central banks levels of reserves that need to be diversified. It’s clear that the emerging world is unhappy with its concentration in the U.S. dollar and needs to have a wider spread of investments to counter not just the uncertainties facing their own countries, but the countries of the reserves they hold.

Over the last couple of years we have seen emerging world central banks buying significant amounts of gold both from local production and in the open market to raise the percentage of gold they hold in reserves. Currently, the percentage of gold in their reserves is nowhere near the levels seen in the developed world’s central banks. However, it’s this shortfall that’s prompting their interest in gold now.

In sum, central bank demand is a very significant contributor to gold demand and will continue to be so for the foreseeable future. In this case then, economic growth has a direct correlation to gold prices. With the emerging world’s demand for gold accounting for about 60% of total gold demand, on this demand alone I could say that gold and silver prices WILL continue to rise in a growing global economy - and not the inverse, as touted by many doom and gloom anti-metals analysts.

Be safe, be wealthy and above all else, be happy.

- Mitch

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