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Goldman Sachs expects gold bull run to continue into 2012

Last updated: 01:50 24 Dec 2011 AEDT, First published: 02:50 24 Dec 2011 AEDT

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Wall Street investment bank Goldman Sachs (NYSE:GS) predicts that gold's bull run will continue into 2012 with a low interest rate environment and continued Europe debt worries, but gold stocks will likely continue to fail to match the yellow metal's rise.

As of earlier this week, gold was up 10.8 percent in 2011 and 43 percent since January 2010, driven by a continued decline in US real interest rates as growth has slowed, governments cutting interest rates in an attempt to kick-start growth, and inflation kicking in owing to energy and food costs.

The investment bank expects the gold price to remain at recent high levels, peaking at over $1,900 per ounce in 2012 and averaging $1,810 per ounce.

Looking ahead, Goldman Sachs said the price of gold will remain strong due to US real rates remaining low; continued monetary demand for physical gold from central banks and institutional investors on continued concerns over paper currencies; and muted risk appetite due to events in Europe and a general sluggish recovery - keeping gold's demand as a lower-risk asset class.

"Our economists’ central thesis is that US real rates will remain low given limited appetite to slow the fragile US recovery or hurt the all-important job growth in an election year. Inflation from non-domestic sources (e.g. imported oil) will also lower US real rates," the report said.

The biggest risk to Goldman Sachs' view, however, is the potential for the US dollar to strengthen on an extreme risk-off mindset from investors.

Gold could also potentially be lumped in with other, high-risk assets as investors opt for cash. The default currency for that type of move is the US dollar, which would naturally strengthen against other currencies and gold. The consequence would be a lower US dollar gold price, "which to some extent we have seen recently, with spot gold down to around $1,660/oz", the investment bank said.

But looking at the short- and medium-term economic outlook and the still unresolved European debt crisis, the investment bank views the risks to its gold price forecast as skewed to the upside in 2012.

Goldman Sachs cited the the easy access to physical gold, as well as the under-delivery by miners on volume and costs, as the reasons why gold equities have lagged the gold price – a trend it expects to continue.

In a research note, the banks said: "Single-stock opportunities exist through growth, low costs and resource growth, but we do not expect the sector to trade back in line with the gold price again."

Gold equities - such as stock in gold-focused miners - have lagged the strong rise in the gold price in 2010 through to 2011. This correlation is at odds with copper equities, for example, and certainly one of the most frustrating aspects for gold investors.

The Wall Street bank noted that the decoupling of gold equities and gold began as far back as 2005. Equities have lagged the gold price for two predominant reasons.

Firstly, Goldman Sachs cited the increased ability to access physical gold through the introduction of exchange traded funds (ETFs), growth in the transport, storage and insurance industries to support secure warehousing, and development of a reliable options market meant that investors who previously had to buy equities to gain access to the underlying commodity could now just buy gold directly.

Indeed, the largest precious metals ETF is SDPR Gold Shares (GLD), which currently has a $66 billion market capitalization. The fund is physically-backed, meaning it holds gold bullion in storage in custodian vaults.

ETFs as a whole now hold around 70 million ounces of gold valued at over $115 billion. ETFs have added around 230 tonnes of gold during 2011, and the bank expects ETFs to remain a popular way of accessing gold.

Up to 2003/04, gold equities traded at a premium multiple, reflecting the relatively higher demand from mining and gold investors who wanted to access the gold price but had limited other means to do so. Even as the amount of capital invested in gold has increased, it is being fractured into multiple channels for investment (such as ETFs).

Secondly, the investment bank said that under-delivery by the miners on volume and costs have led to lower returns. This resulted in a de-rating versus historical levels and under-performance versus the gold price.

Just like any other sub-sector in mining coverage, when miners systematically under-deliver, costs over-run or the quality of projects deteriorates, and the sector tends to de-rate.

The bank said grades are as much as 50 percent lower across its coverage universe than 20 years ago, the royalty and tax take is substantially higher, and country risks are challenging. This is a sector that has justifiably de-rated.

Looking at the reasons for gold equities lagging the gold price – the rise of ETFs/physical investing options and declining returns – Goldman Sachs said that it is hard to imagine a time in the future when these two issues will reverse and investors flock back to gold equities.

In the investment bank's view, it is more likely that returns continue to decline as capital intensity increases, cost inflation comes through and tax/royalty structures enacted by governments around the world extract more from the mining industry.

The investment bank also said the world's central banks are currently net buyers of gold, reversing a decade-old trend of selling gold reserves.

In 2011, the World Gold Council estimated that around 350 tonnes - or 11.3 million ounces - of gold has been acquired by entities such as central banks, the ECB and the IMF in order to diversify reserve holdings. Goldman Sachs reckons that the 2011 total could exceed 400 tonnes.

In order to avoid unfavourable price movements, central banks often buy on dips in the price of gold.

Goldman Sachs also expects net demand from the investment sector at 1,600 to 1,800 tonnes in 2012, with the US dollar strength remaining the biggest risk to this view. A flight to cash could strengthen the US dollar, which could reduce demand.

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