Expanding Gold Holdings May Add Huge Demand, Mine Production Stagnant

World Gold Council’s head of Investment Research speaks to the potential growth in gold holdings as investors increase their allocations.

Juan Carlos Artigas leads investment research in the U.S. for the World Gold Council. His responsibilities include managing the global Investment Research team, and providing oversight of the World Gold Council’s research initiatives related to investor portfolios. HAI’s Sumit Roy caught up with Artigas to discuss the World Gold Council’s new research paper, “Gold holdings: ample room for growth in a broad and liquid market.

HardAssetsInvestor: Can you tell us about gold holdings in relation to financial assets as a whole? Are they growing? And how do they compare to other historical periods?

Juan Artigas: Gold holdings as a percentage of financial assets have increased, but they’ve increased at a slow pace. If you look back over the past 10 years, financial assets such as bonds and other types of fixed-income assets have grown exponentially; they’ve actually tripled in that period. Equity markets have also grown, though not as much as bond markets. Similarly, derivatives markets have increased substantially.

Against that backdrop, we have seen more purchases from investors into gold. They’ve acquired more gold over the past decade, but not nearly at the same pace. At the beginning of the decade, gold holdings as a percentage of assets were well below 1 percent of all financial assets. Now they account for a little bit more than 1 percent of financial assets. Obviously, they have not kept pace with the growth in these other “paper assets” in the financial system.

Now, if you go back to the beginning of the decade, gold holdings were less than they are now. But if you go back in the 1990s - or even to the 1980s - gold holdings as a percentage of total financial assets was much higher. In the 1980s, it reached a peak of about 14 percent of all assets.

Relative to where they have been in previous decades, gold holdings are fairly low. That’s of course in part because of the significant growth in financial assets.

HAI: Given all of these factors you discussed, you believe gold is still under-owned. How much upside do you see in terms of gold demand, if gold allocations increased as you think they should?

Artigas: That’s one of the particularly important questions. We estimate that if investors were to increase their allocations from 1 to 2 percent, it would translate into a very robust demand flow into gold markets.

If you assume something like that, gold holdings would increase from 34,000 to about 55,000 metric tons of gold. Thus, they would increase by roughly two-thirds, or 66 percent. If we assume that total financial assets continue to increase further, that would add another 5,000 metric tons of gold, for a total of 60,000 metric tons of gold in investment holdings.

It will happen over many, many years going forward. It can come from new mine production, as well as from recycled gold that may be sitting in other forms currently in the market.

HAI: Gold is often used to hedge against financial calamities. In your report, you say the frequency of tail risks have increased in recent years. Would you discuss that a little bit?

Artigas: One of the things we’ve noted - and not only us through our research, but obviously what investors around the world have been seeing - is that the frequency and the magnitude of negative events has increased. For example, the number in which we have seen a two-sigma move in the equities market, has been consistently increasing, from just a few in the 1990s to around 20 or so since 2000.

Not only that, but negative returns have increased in magnitude. When prices fall, they tend to fall by more than they used to. For example, negative returns on equity markets back in the 1990s were on average about 30 percent. And now you have returns of minus 40 percent or so. You have not only a larger number of these tail events, but the overall magnitude of negative returns has also increased.

HAI: With the recent correction in gold prices, a lot of people are saying the bubble has popped. The World Gold Council has strongly refuted the idea that gold is or was a bubble. Can you tell us what separates gold price increase over the past decade from bubbles in other assets in the past?

Artigas: I think that the main point to consider here is that gold is a diverse market that’s accessed around the world. What we have seen are structural shifts in the markets that have created organic sources of demand, which are supporting the market. This has not been a purely investment-led demand for gold.

A large portion of demand for gold has come from Asian markets. And it has been in physical form, partly in jewelry and partly in bars and coins. Moreover, the families and individuals in these countries have increased their average income; thus, they can actually save more, and gold becomes a natural mechanism for saving.

The gold market has also seen a shift in terms of central bank activities. Central banks have turned from net sellers into net buyers as a whole, led by emerging markets. And that has been another important structural shift. These structural shifts matter, because it means that it’s not a temporary, transient shock in the gold supply and demand dynamics, but it’s something that’s more permanent and that will have a lasting effect.

Also, the advent of new investment vehicles has facilitated access for a set of new investors that would like to use gold to hedge against systemic risk, currency risk, inflation and so on. The combination of these factors has been particularly important.

Now, if you look back at markets that have experienced bubbles, and that have been well-documented to be in bubble territory—like the housing market in the U.S., or Nasdaq back when we had the dot-com bubble, or the Nikkei in Japan a couple of decades ago—when you look at what the performance of those asset classes were, you had an exponential rise in price in a very short period of time.

Artigas : With gold, the growth has not really been exponential, but rather linear in some sense. It has been increasing at an average rate of about 15 percent annually. It’s not doubling every year or something like that. It’s growing little by little and increasing, but it’s driven by organic sets of demand.

And the other really important part is that supply - particularly mine production - hasn’t flooded the market. In fact, mine production has remained close to flat for the past decade.

When it comes to gold, mine production hasn’t increased that much. Gold is a scarce asset; it’s not something that suddenly is available everywhere. And that scarcity creates value for investors.

HAI: Just to reiterate, these high prices have not led to an increase in mine production from what you’ve seen?

Artigas: It has led to an increase in mine production, but it hasn’t been very profound. For example, last year, mine production was about 10 percent higher, at most, than the mine production level we saw in 2000 or 2001. In 10 years, mine production has only increased by 10 percent or so.
In fact, mine production declined for most of the decade.

It declined slightly for most of the decade until 2008, when it started to increase on the back of higher gold prices. But one of the reasons gold prices are at the level where they are is because costs of production have increased. The reason mining companies are not able to extract much more than they were 10 or 12 years ago is in part because the cost of extracting gold has increased substantially, and new exploration has not yielded too many large discoveries.

HAI: How does gold’s liquidity compare with other assets?

Artigas: It is very, very liquid. It’s a market that trades primarily over the counter, like bonds or currencies. But the London Bullion Market Association, which conducted a survey back in 2011, estimated that volumes in gold on a daily basis were on the order of $240 billion.

The majority of those transactions, as the survey finds, are spot transactions. They are not derivative in nature. About 90 percent of them are actually physical transactions of spot gold. And only about 10 percent of them - back when the survey was conducted - were based on forwards or other types of derivatives. That gives gold a very unique type of dynamics in terms of the liquidity. That’s one of the reasons central banks around the world have gold in their reserves: It’s such a liquid market that they can access the market without creating distortions.

When you compare it to other assets or to other markets, obviously Treasurys are the most liquid. But after Treasurys, gold really stands high in the ranks. The volumes are higher than those in U.K. Gilts, those in agency bonds, those in German bunds, actually rival some of the volumes that you can see on major currency transactions.

For example, if you look at the dollar/sterling exchange rate market, or the U.S. dollar/Aussie dollar exchange rate, and some of the other major trading currencies, they would be similar to the volume levels that you see in the gold market.