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Gold For Beginners: EM Conference Call

Edel Tully, Precious Metals Strategy
Edel.Tully +44 207 567 6755

Julien Garran, Metals and Mining Research

Julien.Garran@ubs.com +44-20-7568 3540

June, 2010
Gold’s Bull Run Persists

Source: Bloomberg, UBS

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Assets and loan flow
Capital flows
out of the US to
emerging economies

US authorities
This attracts more Raises central bank
reflate
Capital flows Reserves at commodity
exporters

This bids up Global central banks’

commodity prices reserves rise
Growth picks up,
Asset prices rise

Local banks lend

to local consumers
& businesses

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Clock watching

Absolute trades Relative trades

US$s Out Risk on US$s Out Risk off Very

1 3
positive
emerging
Reflationary boom Inflationary bust markets
Long; Commodities, commodity and
Long; Commodities,
emerging markets currencies, emerging markets resources
Short; dollar, bonds Short; US bonds,
debtor currencies

US$s In Risk off US$s In Risk on

Very
2 4 negative
Deflationary bust Disinflationary boom emerging
Long; US bonds, US dollar markets
Long; US equities, ‘growth’,
Short; Commodities, bonds, and
emerging markets Short; Commodities, resources
emerging markets

So u rce : UBS

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 2010 markets impacted by European Sovereign Risk
Faith in fiat currencies weakens, gold viewed as flight to quality
Eurozone sovereign (10y) spreads over Bunds

Eurozone Sovereign CDS premium (5y senior)

Source: Bloomberg, UBS 5

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 Gold in Multiple Currencies

Gold in alternative currencies remains popular trade

• YTD: XAUEUR +31%; XUAGBP +23%; XAUUSD +11%
Source: Bloomberg, UBS 6
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Gold and the USD – a negative relationship no more

• In May, decoupling of traditional gold and USD relationship

• Previously, a stronger USD had negatively impacted gold’s direction
Source: Bloomberg, UBS 7
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Gold versus the UBS Risk Index

• Risk averse market conditions in Q2 – fuels gold strength

Source: Bloomberg, UBS 8

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The Path to Monetary Policy Normalisation begins…
G10 Policy Interest Rates

RBNZ
9.0

RBA

BOE
Norges
6.0
Riksbank BOC Fed
Per Cent

ECB

SNB
3.0

BOJ

0.0 2009

2009 2007

 RBA and Norges Bank have already raised interest rates

• UBS economists expect a US rate hike from September, ECB much later
• Rising US interest rates (in particular) without an inflation backdrop could be negative for gold

Source: UBS FX Strategy 9

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 Gold and Inflation Expectations

QE actions of 2009 created an inflation potential…

• Prompted gold buying but those expectations now stalled

• Some concerns for anticipated inflation remain, but time horizon extended
Source: Bloomberg, UBS 10
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Emerging Markets are telling an inflation story though…

Era of declining inflation in emerging markets is over

• Inflation is largely concentrated in Asia
• China and India centred – gold positive

Source: Bloomberg, UBS 11

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Fiscal Indicators – Past, Present and Predicted – inflation risk?

Government Debt as % of GDP

Government Balance as % of GDP

Source: UBS

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 Unstable Debt Dynamics - Potential for Inflation
 QE actions of 2009 fuelled significant gold demand
 Risk that persistently high levels of public debt will drive down capital accumulation,
productivity growth and long term potential growth. 

 Long term fiscal imbalances pose significant risk of higher inflation:

— Through Debt Monetisation (quantitative theory of money)
– But increasing interest rates to fight inflation equals larger debt burden
— Potential to inflate away the real value of debt

 BIS Paper: The future of public debt: prospects and implications

— “History shows that countries that ran high public debts eventually ended up with high inflation
because governments were unwilling to pay high interest rates”
— Examples of Belgium, Spain and Italy pegging interest rates and resorting to debt monetisation
post WW1

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Lack of confidence in monetary system, gold’s moment?

“
The main thing we miss today is universal money. Gold fulfilled this role
from the time of Augustus to 1914. The absence of gold as an intrinsic part
of our monetary system makes our century, the one that has just past, unique
in several thousand years …
I firmly believe gold will be a part of the international monetary system
sometime in the twenty first century. ”
Robert Mundell
Nobel Laureate in Economics
Acceptance Speech—December 1999

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Getting Specific on Gold Fundamentals

 Central Bank Gold Sales: 2009 = Historic Year

• Change in multi-decade official sector approach

• Overall net sellers of 41 tonnes in 2009, but net buyers in Q2, Q3 and Q4
• One of the largest fundamental shifts in this market
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Makeup of Gold Official Sector Reserves
Asia significantly underweight Gold

Source: WGC, UBS 17

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CBGA3 – Limited Sales to Date, IMF dominated

Source: WGC, UBS 18

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Not just the official sector which has altered its gold course

 In 2009, gold investment demand was larger than jewellery demand

— the first occasion since 1980

 Jewellery fabrication represented just 43% of global mine production

 Investment angle takes up the slack
— Gold price heavily dependant on investor sentiment; supply and demand balances of limited
importance

 Main players this year:

— Official Sector: continued IMF selling, but overall buying dominated trend
— Investors: getting longer
— Jewellery holders: priced out of the market
— Potential for scrap supply to dampen rallies
— Fundamentals of limited importance; externalities of economic forces will drive gold

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 Gold Primary Mine Supply

• Mine supply typically follows a downward trend

• Increased 7% in 2009 due to new projects
• But Q1 2010 South African gold production fell 12.4% YoY
• Henry Tax implications - expect lower mine supply
Source: GFMS, UBS 20
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Jewellery Demand – the negative trend extends

Source: GFMS, UBS 21

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 Jewellery Sales in Traditional Hubs Decline

• Current gold price prohibitively expensive

• India reflective of other regional hubs
Source: Bloomberg, UBS 22
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 As jewellery demand diminishes, investors now dominate

• Sharp surge in investment is the primary catalyst for rising gold price
Source: GFMS, UBS 23
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 Producer Hedging – Story Unchanged

• Global Hedge Book at 236 tonnes end 2009

• Anticipate limited demand from this avenue going forward
Source: GFMS, UBS 24
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 Scrap Supply – record high in 2009

• With current gold price, expect scrap supply to resemble 2009

• This will act to curtail rallies
Source: GFMS, UBS 25
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 Gold – Through the Investment Lens
 Macroeconomic forces and sovereign crisis have prompted heightened investor flow –> significant
safe haven demand for gold

 Investment demand is the strongest driver

— Through all investment vehicles: Futures, OTC, ETFs, Bars and Coins.

 The fear trade: coin and small bar demand

— Reflects concern over debt position of many industrialised nations, inside and outside Europe

 The diversification trade

 The Armageddon trade
 Diversification within diversification – increased enquiries about allocated / segregated metal
 Underpinning the market:
— Official Sector see-change: from net sellers to net buyers
— Medium term threat of inflation

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 Intense ETF buying in May – new record high

• After a slow Q1, ETF buyers have returned in force

• May inflows equal 4.8 moz, largest monthly creation since Feb 09
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 ETFs – Drilling down in on a daily basis

• Rolling monthly increase hit 5.34 moz on June 3, levels not seen since March 09
• Closely aligned to demand for physical metal – bars and coins
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Comex Net Longs Get Longer

• Comex speculators /investors near record net long position

• Following March’s liquidation, one way path has been followed
Source: CFTC, Bloomberg, UBS 29
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 US Mint Coin Sales - May volume highest since 1999
Replicated across Mints & UBS sales - reflection of the fear trade

Source: US Mint, Bloomberg, UBS 30

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 Gold Train continues – Short Term Thoughts
 Investment demand persists
— ETF inflows at all time high
— Comex net longs near all time high
— Persistent coin and small bar demand

 Jewellery demand sluggish

 Scrap supply risk
— In May, this helped to stall gold’s rally; similar to Q1 2009
— $1250 appears to be a significant supply point

 So long as fears surrounding the world’s debt baggage remain heightened and sovereign risk concerns
continues, gold should benefit

 Threat of gold caught in cross-fire of another extreme de-risking event

— Buy on dips

 Forecast $1300/oz in one-month; $1200 in three months

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 Looking further out
 Gold to average $1135/oz this year, $1250 in 2011
— Expect new high in H2 2010
— Exchange investment demand to remain firm
— Jewellery demand at current prices to fall, scrap to rise
— Extension of safe haven demand
— Central banks as net buyers

 Anticipate greater diversification flows

 Inflation threat to grow
 So long as fears surrounding the world’s debt baggage remain heightened and sovereign
risk concerns continues, gold should benefit

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