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Commodities

Global

Precious Metals Outlook

Bound to rebound; raising our price forecasts

10 May 2011

James Steel Analyst HSBC Securities (USA) Inc.

+1 212 525 6515

james.steel@us.hsbc.com

View HSBC Global Research at: http://www.research.hsbc.com

Issuer of report:

HSBC Securities (USA) Inc.

Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

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Global Research

For gold, unease about monetary and fiscal policies should rekindle the rally; supply is likely to rise modestly

For silver, strong industrial demand and a recovery in investor appetite should offset mine and scrap supply growth

Industrial demand is boosting PGM off- take; ETFs hold sizeable metal; eroding Russian stocks may buoy palladium

We are raising our average price forecasts for gold, silver, and the platinum group metals and introducing forecasts for 2013 (see the table below). The bull markets remain essentially intact for gold and the PGMs, and although silver is priced closer to its equilibrium value, its near-term bias is upward, in our view.

Gold: Prices have retreated from record highs. But they should remain buoyed by investor concerns about the global economy, geopolitical risks, high commodity prices, easy monetary policies, and fiscal profligacy. Increased mine output, ample scrap supplies, and moderate jewelry demand are freeing up metal for the investment sector.

Silver: Prices have corrected sharply from 31-year highs near USD50/oz. Higher mine and scrap supplies are being absorbed by robust industrial off-take. Investors have favored silver and coin sales, but prices appear high, especially relative to gold.

PGMs: Moderating growth in auto demand and robust industrial off-take are offsetting slow growth in mine supply. Platinum jewelry demand is moderating. PGM ETFs hold considerable amounts of metal. Widespread belief that Russian stockpiles are near exhaustion supports palladium prices.

HSBC precious metals average price forecasts (USD/oz)

 

2011

2012

2013

_

Long term

Old

New

Old

New

Old

New

Old

New

Gold

1,450

1,525

1,300

1,500

1,450

 

1,050

1,250

Silver

26

34

20

29

24

15

20

Platinum

1,750

1,850

1,650

1,750

1,650

1,600

1,625

Palladium

750

825

650

750

725

600

700

Source: HSBC

Commodities Global 10 May 2011

Contents

Bound to rebound

3

HSBC gold outlook

9

Boosting our gold forecasts

9

An ill wind blows good for gold

9

Gold should rebound

10

Geopolitics and gold

12

Macroeconomic influences

14

Trends in supply and demand

21

Silver

30

Lifting our silver price forecasts

30

Back to earth

30

Recovery phase

31

Supply trends

34

Demand trends

37

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Platinum

40

Raising our platinum price forecasts

40

Heading moderately higher

40

Driving moderately higher

41

Supply trends: Looking flat

42

Demand trends

46

Palladium

52

Increasing our palladium price forecasts

52

Already high but may go higher

52

Start and stop

53

Supply trends

53

Demand trends: Shifting gears

57

Disclosure appendix

62

Disclaimer

63

Commodities Global 10 May 2011

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Bound to rebound

Despite the steep pullback in gold, concerns about the inflationary impact of highly accommodative monetary polices, deficit spending, and high commodity prices should rekindle the rally Silver has retreated; investor sentiment will be crucial to price direction; strong industrial demand is more than offsetting mine supply growth but greater scrap supply may help weigh on prices PGMs are benefiting from growth in global auto production and robust industrial demand; ETFs hold considerable metal

Gold

Increasing our gold price forecasts

Given the prevailing macroeconomic conditions and gold’s proven utility as an inflation hedge, a safe- haven instrument, and a portfolio diversifier, we are raising our forecasts of average gold prices for:

2011 to USD1,525/oz from USD1,450/oz.

2012 to USD1,500/oz from USD1,300/oz.

The long term (five years) to USD1,250/oz from USD1,150/oz.

For 2013, we are introducing an average price forecast of USD1,450/oz.

Cocktail of factors ushers gold to new highs

The 10-year gold rally remains intact, despite the recent steep pullback in prices. Prices had reached a new high of USD1,575/oz as investors continued to seek out bullion for its inflation hedge and safe-haven qualities. The most virulent phase of the gold rally can be traced to the global

economic and financial crisis, which began in mid-2007, and the subsequent unprecedented monetary and fiscal responses. Investors’ appetite for gold was increased by inflationary concerns that were prompted by highly accommodative monetary policies, including quantitative easing and huge fiscal spending increases throughout member states of the Organization for Economic Cooperation and Development (OECD), and a flight to safe-haven investments.

Easy accommodative monetary policies by the US Federal Reserve stimulated already high demand for commodities, notably – but not exclusively – in the emerging world. In addition to higher oil prices, agricultural prices surged, which prompted the UN’s Food and Agricultural Organization to declare a global food crisis earlier this year. Commodity price rises fanned inflation fears and stimulated demand for hard assets, including gold. The eruption of popular discontent in the Middle East, in particular the civil war in Libya, with implications for oil supply disruptions, raised the global geopolitical risk thermometer, which

Commodities Global 10 May 2011

further buoyed gold. A report by the World Economic Forum this year warned of rising global geopolitical risks, growing income disparity, increasing food prices, and the inability of the world’s governments and institutions to fend off another economic crisis with depleted resources. All of these factors supported gold.

US fiscal profligacy also supported gold prices. Continued heavy US government deficit spending and warnings by the credit rating agency Standard & Poor’s that the US must restrain its fiscal spending have further galvanized investor demand for hard assets, including gold.

Gold prices moved in an almost unbroken upward trajectory for much of this year. A pullback in early May was triggered by a correction in commodity prices, notably oil, which, along with a bounce in the USD and heavy liquidation by investors, clipped cUSD110/oz off record-high gold prices by the end of the first week of May.

Though steep, the pullback in prices dented rather than reversed the gold rally, in our view. Longer- term, we expect an eventual return to some type of economic normalcy, and the consequent winding down of heavy deficit spending and easy monetary policies could signal an end to the gold rally. Nonetheless, we believe that gold will remain at elevated levels for several years, as investors are likely to keep a portion of gold in their portfolios for its diversification properties.

Investor demand now is the main driver for gold pricing, while traditionally important physical supply and demand components, such as jewelry demand and mine supply, have recently exerted little influence on day-to-day moves in the gold price. The bulk of current investor demand for gold has been channeled into gold exchange- traded funds (ETFs). Despite modest liquidation this year, the ETFs still hold considerable amounts of bullion. The major gold ETFs contain

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about 2,040.4t of gold, or c80% of the world’s annual production. This is down c28t from the all- time high of 2,068.4t in ETF holdings reached near the end of 2010. Should investors choose to liquidate even a fraction more of these holdings, a substantial amount of bullion could appear in the markets in a short period, with a commensurate impact on price.

The growth in investor demand also is evident from the rapid rise in net long speculative positions on the Comex. Although Comex longs are down from the high for the year to date of 26.7moz reached in mid-April, they still exceed 24moz. Heavy long positions also hold the potential for further investor liquidation, with a threat to the near-term gold price. Demand for coins and small bars have been very strong for many quarters. Even accounting for the recent pullback in prices, we question whether retail investors will continue to purchase coins and bars in such heavy volume. High prices appear likely limit the retail demand for gold in this segment.

After many years as a contributor to supply, central banks have swung to being net buyers. We believe this is an important development that will support prices going forward. The signatories of the third Central Bank Gold Agreement (CBGA) sold little gold in the compact’s first year, through end-September 2010. Central bank sales have been similarly low so far this year. Most of the major holders of gold in the CBGA, such as Germany’s Bundesbank and Swiss National Bank, have signaled a reluctance to sell. Meanwhile, some emerging-market central banks have shown an increased appetite for gold. The International Monetary Fund announced an end to their sales program at the end of 2010.

High prices are also having an effect on more- traditional participants in the gold market, encouraging an increase in recycled gold supplies and creating significant financial incentives for

Commodities Global 10 May 2011

producers to increase output wherever possible. High prices may also curb jewelry demand, which is still recovering from a near-collapse of demand in 2009. Moderate jewelry demand and increases in scrap and mine supplies will free up considerable amounts of bullion for the investment markets, we believe. This should also eventually help cap any further rallies.

Silver

Increasing our silver price forecasts

We are raising our forecasts of average silver prices for:

2011 to USD34/oz from USD26/oz.

2112 to USD29/oz from USD20/oz.

The long term (five years) to USD20/oz from USD15/oz.

For 2013, we are introducing an average price forecast of 24/oz.

Silver roller coaster

Before retracing heavily at the beginning of May, silver had rallied from USD18/oz in September 2010 to 31-year highs near USD50/oz by late April 2011. Just as the case for gold, silver prices have benefited from demand for hard assets stemming from the 2007-09 financial crises and the monetary and fiscal responses. The most recent phase of the silver rally coincided with the Fed’s signal in August 2010 that it would reintroduce quantitative easing, in which lending programs are financed by the Fed’s balance sheet, essentially creating and using cash to finance lending facilities.

For investors interested in hard assets, such as gold, silver has a similar attraction based on growing inflation concerns, higher commodity prices, and elevated geopolitical and sovereign risks have spurred demand.

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Silver prices gained noticeably on gold for much of the past year. The silver/gold ratio moved from 68:1 at end-April 2010 to 30:1 one year later, marking the lowest point since the early 1980s. The recent correction in silver which drove prices back down to USD34/oz, also buoyed the ratio back to 42:1. Although this indicated a growing preference among some investors for silver over gold, we believe that the ratio is likely to increase as investors recognize that silver has become too expensive relative to gold and reverse their positions. Indeed, the silver/gold ratio increased at the beginning of May to 42:1. Meanwhile, in early May, silver prices pulled back to USD34/oz in the days after the CME Group, the Comex operation, announced margin increases, which triggered heavy long liquidation, and a wider retreat in commodity prices.

The earlier surge in silver prices came in tandem with a modest increase in holdings by silver exchange-traded funds (ETF). The combined holdings of all three ETFs – the Barclays iShares and the smaller ETF Securities and the Zurich Kantonalbank Bank (ZKB) – increased by c9.0moz to 467moz on 30 April 2011 from 457.9.6moz on 1 January 2011. Since then, investors liquidated a substantial 16moz, taking ETF holdings down to 451moz. Sales of coins and small bars remain vigorous, following on from robust levels in 2010.

We forecast that the silver market will be in surplus this year due in large part to increases in scrap and mine supplies. Substantial investments in silver mine projects earlier in the mining cycle are bearing fruit. Also, a greater supply of base metals will increase the silver byproduct supply, we believe. In addition to growing mine output, increased scrap recycling will contribute to silver supply. As long as prices remain above USD30/oz, we expect both individuals and manufacturers to supply considerably more scrap metal for recycling than in recent years.

Commodities Global 10 May 2011

Increases in mine and scrap supplies will be offset by robust industrial demand, we believe. More than half of the annual silver supply is regularly consumed by industrial sectors. High prices have not yet deterred industrial demand for silver. Based on HSBC’s macroeconomic forecasts for global industrial production, we forecast substantial increases in silver purchases by industries this year.

Photographic demand for silver, meanwhile, appears likely to extend its decline, as traditional photography continues lose market share to less silver-intensive digital cameras. The decline in silver for photography has led to a corresponding decline in recycled silver nitrates.

The recent pullback by silver prices is a closer reflection of the underlying fundamentals, in our opinion. Conditions in the global economy may keep silver prices elevated and well above historical averages this year and next year, in our view.

Platinum

Raising our platinum price forecasts

We are increasing our forecasts of average platinum prices for:

2011 to USD1,850/oz from USD1,750/oz.

2012 to USD1,750/oz from USD1,650/oz.

The long term (five years) to USD1,625/oz from USD1,600/oz.

For 2013, we are introducing an average forecast of USD1,650/oz.

Driving higher

Platinum prices rallied from a year-to-date low of USD1,654/oz on 17 March 2011 to a high of USD1,884/oz on 2 May. The price decline earlier in the year was prompted by the earthquake and tsunami in Japan and anxiety that global auto production would be significantly disrupted, limiting the need for platinum. After recovering

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from this decline, prices weakened again in early May in tandem with a broad-based pullback by commodities. We believe this latest platinum price decline was triggered more by weakness in other precious metals, notably gold and silver, rather than a change in platinum’s underlying fundamentals.

Based on our supply/demand model, we expect the platinum market to remain in deficit this year. A production/consumption deficit seems to be the normal state of affairs for the platinum market. According to our supply/demand model, the market has been in deficit every year in this decade except for 2006 and 2009, when auto and industrial demand almost collapsed due to the global economic crisis. As deficits continue, we expect the platinum price to be increasingly well-bid.

The listing of a US platinum group metals (PGM) exchange-traded fund (ETF) has been a notable success, absorbing a significant amount of platinum since its launch at the beginning of the 2010. Last year, the combined holdings of the four major platinum ETFs jumped by 555,000oz to 1.126moz. This year so far, combined platinum ETF demand is up by 145,000oz to 1.271moz. The demand has been driven by the same factors that propelled investor interest in hard assets in general, namely, concerns about potential inflation, the direction of the USD, heavy deficit spending by governments, loose monetary policies, and geopolitical tensions. Despite the recent pullback in the platinum price, these factors appear likely to support platinum ETF demand for the rest of this year. If appetite for the ETFs should dim and investors choose to liquidate even a fraction of their holdings, the market could move into surplus, according to our supply/demand model, with a commensurate impact on prices.

Commodities Global 10 May 2011

The automotive industry is the single largest demand source for platinum, where the metal is a necessary input in construction of autocatalysts and particulate filters. The industry’s demand for platinum soared in 2010 in line with the global recovery in auto production following a near- collapse in 2009. Based on HSBC equity research by the automotive team, we expect platinum demand from the auto industry to increase at a more modest pace this year as growth in auto production decelerates. HSBC equity analysts forecast that growth in global auto output will slow in 2011 but remain positive.

Other forms of industrial demand for platinum, including electronics, glass, chemicals, and petroleum refining, are growing at a brisk pace. Based on HSBC macroeconomics forecasts of a continued recovery in global industrial demand in 2011, we expect industrial demand for platinum to remain robust but to grow at slightly lower percentage rates, compared with 2010 levels.

We believe that demand for platinum jewelry in 2011 will decline modestly, based on high prices. China accounts for the bulk of demand for platinum jewelry, which remains very popular. Chinese consumer income is rising rapidly, and we believe that some demand response to high prices is likely. In addition, we expect that high prices will encourage jewelry recycling.

Meanwhile, producers in South Africa face obstacles and challenges in raising platinum mine output. These include power constraints, availability of fresh water, labor costs, a strong ZAR currency, and a variety of geological and technical problems. High prices above marginal costs and investment earlier in the cycle will support a modest increase in production. Similarly, we expect Russian platinum output to increase modestly. A recovery in North American output following poor production levels in 2010 will help boost mine supply.

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Palladium

Raising our palladium price forecasts

Following many years of heavy supply/demand surpluses, the palladium market has moved into deficit, where we believe it is likely to remain. This will have a pronounced psychological impact on the market, in our view, and will sustain higher prices. Based on this, we are raising our forecasts of average palladium prices for:

2011 to USD825/oz from USD750/oz.

2012 to USD750/oz from USD650/oz.

The long term (five years) to USD700/oz from USD600/oz.

For 2013, we are introducing an average price forecast of USD725/oz.

Higher on tight supply

After recovering from a drop below USD380/oz in early February 2010, palladium prices surged to just above USD800/oz by the end of 2010. Prices continued to climb this year, rising to a high of USD859/oz by late February. They subsequently dropped to a year-to-date low of USD690/oz on 17 March in response to the earthquake and tsunami in Japan, which caused the suspension of that country’s auto production and cast doubt on the auto industry’s demand for palladium. Influenced by a pullback in commodity prices generally, palladium prices tumbled to USD697/oz by 5 May.

Palladium has benefited from the recovery in global auto production. The industry traditionally absorbs more than half of annual palladium production, required for production of autocatalysts and particulate filters. Gasoline-fired engines require substantially more palladium in their PGM loadings than diesel-fueled vehicles. Gasoline vehicles are favored in most of the emerging world, notably China and India, as well as in North America, where demand has been

Commodities Global 10 May 2011

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HSBC economic and metals price forecasts

 

2003

2003

2004

2005

2006

2007

2008

2009

2010

2011f

2012f Long term

G-7 IP

% pa

1.0

1.0

2.6

1.9

3.5

3.5

-2.2

-12.9

6.9

4.1

4.2

Global IP

% pa

4.6

4.6

6.3

5.3

6.3

6.3

1.5

-6.1

12.4

6.4

6.3

Aluminum

USD/t

1,433

1,433

1,270

1,886

2,557

2,557

2,571

1,587

2,160

2,534

2,600

2,204

Copper

USD/t

1,768

1,768

2,866

3,682

6,702

6,702

6,965

4,930

7,339

8,970

7,493

5.069

Nickel

USD/t

9,634

9,634

13,845

14,749

24,052

24,052

21,070

14,727

21,665

25,434

22,04

15,428

Zinc

USD/t

772

838

1,058

1,389

3,263

3,263

1,873

1,543

2,072

2,181

2,314

1,741

Aluminum

USc/lb

61

65

78

86

116

116

117

72

98

115

118

100

Copper

USc/lb

71

81

130

167

304

304

316

224

333

407

340

230

Nickel

USc/lb

307

437

628

669

1,091

1,091

956

668

983

1154

1000

700

Zinc

USc/lb

35

38

48

63

148

148

58

70

94

99

105

79

Gold

USD/oz

210

364

410

445

604

604

872

990

1,225

1,525

1,500

1,250

Silver

USD/oz

4.60

4.88

6.66

7.29

11.55

13.55

14.97

14.80

19.00

34.00

29.00

20.00

Platinum

USD/oz

539

692

846

897

1,139

1,106

1,574

1,210

1,725

1,850

1,750

1,625

Palladium

USD/oz

337

200

230

202

319

356

351

265

525

825

750

700

IP = Industrial production Source: HSBC

relatively better than in the primary diesel-fueled markets of Europe. The US and Chinese auto markets, together, account for the bulk of palladium autocatalyst demand worldwide. Based on HSBC research forecasts of auto production, we expect that auto industry growth in palladium consumption this year will moderate considerably from 2010 but remain positive.

The overwhelming bulk of palladium mine production is derived as a byproduct of platinum production in the case of South Africa and nickel output in the case of Russia. Together, these countries make up the vast bulk of global palladium mine production. By our calculations and based on producer comments, both regions should increase palladium output this year. Such increases appear likely to be modest, however, as producers face a variety of challenges, including falling ore grades, inadequate infrastructure, and constraints on power and fresh water. Also, concern about the level of Russian palladium stockpiles, and therefore the potential for a large decrease in Russian exports, remains a factor. Prices are well in excess of marginal costs of production, however, and producers are making every effort to increase output wherever possible.

The launch of a US-listed PGM exchange-traded fund (ETF) by ETF Securities last year was highly successful and is absorbing a significant amount of available above-ground stock. Palladium ETF demand has been static this year. Industrial demand has been robust, in keeping with the recovery in global industrial production. Based on HSBC macroeconomic forecasts of continued industrial expansion this year, we believe that industrial off-take for palladium will increase. The combination of industrial demand and reduced Russian stockpile sales has the potential to tighten underlying supply/demand balances and maintain high prices for the rest of the year, we believe.

Commodities Global 10 May 2011

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HSBC gold outlook

Gold pulls back on commodity price correction after hitting record highs on concerns about highly accommodative monetary policies, deficit spending, USD weakness, and elevated geopolitical risks Prices should remain elevated as investor demand offsets impact of increased mine and scrap supplies and weak jewelry demand We are raising our average gold price forecasts and introducing an estimate for 2013

Boosting our gold forecasts

We are raising our forecasts of average gold prices for:

2011 to USD1,525/oz from USD1,450oz.

2012 to USD1,500/oz from USD1,300/oz.

The long term (five years) to USD1,250/oz from USD1,050/oz.

For 2013, we are introducing a forecast of

USD1,450/oz.

Gold prices, 1971-present (USD/oz) 1800 1600 1400 1200 1000 800 600 400 200 0 Apr-74
Gold prices, 1971-present (USD/oz)
1800
1600
1400
1200
1000
800
600
400
200
0
Apr-74
Apr-80
Apr-86
Apr-92
Apr-98
Apr-04
Apr-10

Source: Reuters

An ill wind blows good for gold

Despite the recent pullback in gold prices, we remain positive on the metal going forward. Gold prices will be determined largely by the interplay between monetary policy, inflation expectations, the direction of commodity prices, the evolving sovereign debt crisis in the euro zone, similar concerns regarding US debt levels and fiscal policy, and geopolitical risks.

Gold prices, 2005-present (USD/oz) 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 Apr-05
Gold prices, 2005-present (USD/oz)
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
Apr-05
Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11

Source: Reuters

Commodities Global 10 May 2011

How confident investors will be in government to remedy global economic and geopolitical challenges, and the direction of the foreign exchange markets, also will be important factors in determining gold prices. In this atmosphere, traditional supply/demand factors including mine supply, producer hedging policies, and jewelry and industrial demand may take a second place to macroeconomic and geopolitical influences and investment demand on gold. We believe that on balance, these factors will keep demand for gold elevated for the rest of the year.

As outlined by the HSBC macroeconomics team, US monetary policy is likely to remain accommodative, even after the end of the Fed’s QE2 program, scheduled for June. Meanwhile, inflation fears based on surging commodity prices and loose US monetary policy are increasing inflationary pressures in the emerging world. This is supportive of gold. Although core inflation is not rising in the OECD nations, commodity inflation to which gold is sensitive is increasing sharply. The food crisis declared by the UN and popular uprisings in the Middle East introduce a geopolitical dimension that is further supportive of gold. Though the recent pullback in commodity prices was steep, this does not indicate a reversal in the long-running commodity bull market, we believe.

Investment demand was firm for gold until May. We believe that high prices contributed to the decline in ETF and physical bullion demand. At lower gold prices, ETF demand should recover. Also, demand for coins and small bars implies that retail and institutional demand is still underpinning the gold rally.

Jewelry demand has risen from multiyear lows. But the combination of high prices and economic uncertainty will limit demand growth this year, we expect. The continued recovery in gold demand in the emerging world may be tempered by high prices.

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The main source of physical supply, mine output, is set to increase this year and next year, as high prices encourage greater output and producers increase reserves. Dehedging, an important source of demand for a decade, is all but disappearing. The official sector turned into a net buyer of gold in 2010 after two decades of heavy sales. Central banks appear likely to increase net purchases this year in an effort to diversify their foreign exchange holdings. This may be an important bullish development for gold.

Gold’s status as a safe haven and portfolio diversifier has been confirmed by the increase in investor demand since the beginning of the economic crisis. However, if US monetary policy were to be tightened and commodity prices ease and geopolitical tensions fall, the rationale for owning gold would fall with a commensurate impact on prices. The balance of factors argues for higher, rather than lower, prices over much of this year, in our view.

For gold, we anticipate a wide trading range this year of USD1,300-1,650/oz , with a possible spike to USD1,700/oz. At prices above USD1,500/oz, we expect jewelry demand would weaken and scrap supply increase. Conversely, we would expect any price decline below USD1,300/oz to encourage greater emerging-market demand for bullion. The new dynamics for investors have renewed their demand for gold as both a safe haven and a hedge against inflation. Eventual normalization of the global economy and ultimate tightening of monetary policies explain our view on gradual price declines from 2012 onward.

Gold should rebound

In 2010, the gold price rose for a 10th consecutive year. The rally was driven by a recovery in some sectors of physical demand and continued global economic uncertainty. The gold price rose 29% y-o-y to USD1,405/oz after hitting what was then an all-time high of USD1,430/oz on 7 December

Commodities Global 10 May 2011

2010. The average price for the year was USD1,225/oz, up from an average of USD973/oz in 2009. Gold also outperformed all other major asset classes and most other commodities. This year, prices corrected to USD1,308/oz, a year-to- date low, on 28 January. We attribute this sharp but brief drop to a shift in investor sentiment. Well-received Portuguese and Spanish bond auctions and positive comments about the US economy by US Federal Reserve Chairman Ben Bernanke increased investor appetite for “riskier” investments and triggered a flow out of gold. Long liquidation on the Comex and a decline in the holdings of the largest gold-backed exchange- traded funds (ETFs) were visible signs of the change in investor demand. Gold would have penetrated USD1,300/oz, we believe, were it not for robust physical demand in Asia. Heavy exports globally of bullion to China, India, and other parts of Asia from December 2010 through February this year not only sustained the gold market when Western investor sentiment dimmed, but helped push the metal price to new highs later in the year.

Bullion prices recovered in February, spurred by accelerating commodity prices, notably oil. Rising petroleum prices were tied to unrest in North Africa and the Middle East. Regime change in Tunisia and Egypt, demonstrations throughout that region, and civil war in Libya amplified safe- haven demand for bullion. Underpinning the rally were concerns that popular discontent in the Middle East would disrupt the smooth flow of oil from the region. A move into gold by investors also was triggered by the aftermath of the earthquake and tsunami in Japan in March, which caused widespread destruction and significant damage to nuclear plants that leaked radiation.

Until the Mideast upheavals began, gold prices reflected closely the course of the financial and economic crisis. Prices have more than doubled

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since the onset of the subprime mortgage crisis in mid-2007. Gold benefited from its stature as a safe haven and its lack of counterparty and credit risk as the initial subprime mortgage crisis morphed in a full-blown credit and financial crisis with the collapse of Lehman Brothers in 2008.

Gold benefited further as governments and monetary authorities across the globe slashed interest rates, boosted spending, and implemented unprecedented measures such as quantitative easing. Investor concerns shifted from counterparty and credit risk to anxiety that highly accommodative monetary policies and rising government debt levels would inevitably bring back high inflation rates. Gold remained a popular alternative to paper assets throughout 2009 as investors sought out bullion for its inflation hedge properties. Gold investment remained robust as the economic crisis developed into a sovereign risk crisis in 2010. A second round of quantitative easing by the Federal Reserve gave gold a second wind later in the year, helping to propel gold prices to new highs.

More recently, fiscal concerns and events in the Middle East have helped push commodity prices up, buoyed further by rapacious demand for commodities in much of the emerging world. This momentum led the surge in gold prices to record levels above USD1,575/oz by early April. A price correction took gold back to USD1,462/oz in early May.

The price correction has blunted – but not reversed – the gold rally, in our opinion. For the rest of this year, we expect elevated geopolitical, inflation, and sovereign risks to support bullion prices. Longer-term, we anticipate an eventual end to the current highly accommodative monetary policies. This could gradually undercut the gold market as real interest rates rise and the safe-haven bid for gold diminishes. Increased fiscal restraint by the world’s major economies

Commodities Global 10 May 2011

also should eventually curb gold rallies, but we believe that heightened sovereign risk worries will buoy gold prices in the near term. A flattening of the US yield curve may be the most visible expression of a tightening of monetary policy and an easing by gold prices.

The following chart shows how well gold performed in relation to other asset classes during the economic crisis.

Gold: Safe haven among asset classes, 2008-end April 2011

Returns Returns for for Various Various Asset Asset Classes Classes 2008-Present 2008-Present 100.00% 100.00% 80.00%
Returns Returns for for Various Various Asset Asset Classes Classes 2008-Present 2008-Present
100.00%
100.00%
80.00%
80.00%
60.00%
60.00%
40.00%
40.00%
20.00%
20.00%
0.00%
0.00%
-20.00%
-20.00%
-40.00%
-40.00%
-60.00%
-60.00%
Jan-08
Jan-08
Jul-08
Jul-08
Jan-09 Jul-09
Jan-09 Jul-09
Jan-10 Jul-10
Jan-10 Jul-10
Jan-11
Jan-11

S&P 500 Gain (Loss)

S&P 500 Gain (Loss)

T-Note Gain or Loss

T-Note Gain or Loss

Gold Gain (Loss)

Gold Gain (Loss)

Lipper Muni Index Gain (Loss)

Lipper Muni Index Gain (Loss)

Source: Reuters

Geopolitics and gold

In addition to reflecting the global economic and financial climate, gold is a barometer of geopolitical and even social risks. We believe that the severity of these risks is increasing and is likely to have a commensurate effect on gold prices for the rest of this year.

In our 14 January research note, Golden Risks:

The World Economic Forum identifies major risks to the world economy that may influence gold prices, we discussed a WEF report, Global Risks 2011, which outlined economic and geopolitical risks facing the global economy as assessed by 580 world leaders and decision makers. These risks hold potential ramifications for gold. The WEF found that the financial crisis had greatly weakened economic positions of governments, societies, and institutions, particularly in mature economies. This has reduced the capacity of the

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world to absorb any major new shocks or meet global challenges.

In addition to reducing overall global economic resilience, the financial crisis has led to a rise in geopolitical tensions and raised global social discontent, according to the WEF, increasing risks across a range of economic, geopolitical, social and even climate categories. This is likely to mean that economic and geopolitical events, even relatively low-level events, may have an exaggerated effect on gold prices, as governments and institutions struggle to cope with fresh challenges when they have depleted resources in the wake of the financial crisis.

An additional factor addressed by WEF is the interrelationship between risks, and its report suggested that because of globalization, risks for contagion have grown significantly. This might hold important implications for gold prices. Increased contagion is likely to boost gold’s sensitivity to global economic and geopolitical events and to make gold prices more volatile than would otherwise be the case. This helps explain our expectations of a relatively wide trading range for gold prices this year of USD1,300-1,650/oz , with a possible spike to USD1,700/oz.

The WEF report identified economic disparity and global governance failures as significant risks to the world economy. The was confirmed by the World Bank, which found that income inequality as measured by the Gini Index, a traditional economic measure of income inequality, over the past decade increased most rapidly in emerging economies, notably but not exclusively in India, China, and Indonesia. Income inequality also increased across the OECD world for the same period.

The growth in income inequality broadly coincides with the long-run rally in gold prices. During periods when income inequality is relatively stable or narrowing, gold prices tend to

Commodities Global 10 May 2011

weaken. This could be because growing inequality is often associated with rapid economic growth, rising commodity prices, and sometimes higher inflation. Narrowing income inequality tends to occur against a backdrop of more-stable and less inflation-prone periods.

Typically, economic disparity also is highly connected to asset bubble collapses, fragile governments, inefficient economies, corruption, and general social immobility. Data collected by the WEF suggest that economic disparity and geopolitical conflict reinforce each other. Asset bubble collapses, in particular, stimulate interest in gold as a safe haven. According to the Council on Foreign Relations, income disparity, corruption, and social immobility are the principal drivers of the wave of protests against governments in the Middle East this year.

We found it interesting that gold prices dropped to their low for this year of USD1,308/oz in mid- January after well-received Spanish and Portuguese bond auctions reduced euro sovereign risk. Gold prices subsequently surged in response to the popular discontent that began in Tunisia and quickly spread to much of the rest of North Africa and the Middle East. It is no coincidence that gold prices have accompanied worries that the Libyan civil war and popular discontent in the oil-producing Gulf states would disrupt global oil supplies. The surge in oil prices was crucial in preventing gold from breaking below USD1,300/oz earlier this year. Oil prices have spurred higher gold prices before, notably in the 1973-74 and 1979-80 energy crises. We visit the impact of commodities on gold throughout this report.

History has shown that gold prices are sensitive to geopolitical and social dynamics, as well as economic and financial events. The WEF report stated that the severity of these risks is increasing, and we believe this is likely to have a commensurate effect on gold prices for at least the rest of this year.

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The intensity of geopolitical challenges and how they are faced will help dictate the direction of gold prices. The US National Intelligence Council, a center for strategic thinking, and the European Union’s Institute for Security Studies recently concluded that current frameworks for international cooperation leave the world ill-equipped to keep pace with mounting geopolitical challenges without extensive reform. This implies that geopolitical risks will continue to bolster gold prices.

The golden ghost of Malthus

The Reverend Thomas Malthus, a British scholar, is regarded as one of the founders of political economy. In “An Essay on the Principle of Population” (1812), he postulated that population growth was exponential but that agricultural growth was arithmetic. Thus, any sharp rise in population would eventually lead to a food shortage, which would ultimately be self- correcting. To date, technological and scientific advances and rising productivity have prevented Malthus’s prediction from coming true.

Malthus’s theories have been amplified and applied to natural resources, and they are periodically revived, typically triggered by fears of too-rapid depletion of world resources. These periods usually coincide with prolonged bull markets for gold. The last such period was the 1970s, when the world was rocked by food and energy crises. The Club of Rome, a global think tank, produced in 1972 a now-famous report, “The Limits to Growth,” which attempted to model the consequences of a rapidly growing world population and finite resource supplies. The dominant thesis later in the 20th century was that the market would always solve the problem – high prices would encourage technological advances, and producers would find new sources of supply. This view generally coincides with low or stable gold prices.

Commodities Global 10 May 2011

The rise in per capita commodity consumption in the developing world, brought on by rising prosperity, has led to unprecedented demand for commodities. Fears of depletion of natural resources again have taken center stage. Escalating commodity prices and worries that the world is depleting the stock of natural resources is encouraging demand for hard assets, including gold. This is likely to remain the case for as long as commodity prices remain elevated, we believe.

As gold is a commodity and a traditional hedge against inflation, its prices have been strongly influenced by the steep rise in commodity prices. The charts overleaf show how prices of metals and food have risen over the past few years. We believe that it is no coincidence that the increases in prices of metals and foodstuffs have broadly coincided with the long-running rally by gold.

Food price increases have created social discord and raised political tensions across the emerging world, where consumers spend a significantly higher proportion of their incomes on food than in the developed OECD member states. This also is a contributing factor in the outbreak of popular unrest in North Africa and the Middle East. The combination of rapid increases in population and growing prosperity leading to higher per capita incomes is putting unsustainable pressures on the world’s resource base, according to the most recent report by the UN’s Food and Agricultural Organization (FAO).

The FAO earlier this year declared a global food emergency, mostly in response to droughts in Russia, Ukraine, and Kazakhstan, a suspension of grain exports from Russia, and flooding of grain- producing regions in Australia, all of which hurt grain harvests. The FAO had last declared a food emergency in 2008. The withdrawal of food subsidies across much of the emerging world at that time sparked food riots in more than a dozen countries and coincided with a robust gold rally.

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The FAO also identified shortages of clean water and fertilizer, high energy prices, and a lack of investment as chronic impediments to increasing food output. Any resource-driven crisis, even if it is one of a relatively small scale, typically is likely to be supportive of gold prices.

An increasing share of global GDP is generated in the emerging world. A feature of economic growth in these nations is a growing appetite for commodities. As these nations continue in a commodity-intensive phase of development, HSBC macroeconomics expects commodity demand to remain high. Meanwhile, increases in income are triggering a change in diets, notably a switch from carbohydrates and vegetable protein to animal protein. This is putting pressure on the world’s grain supplies and increasing agricultural prices. We regard the rise in food and other commodity prices as an important element in gold’s rally. And for as long as food prices are likely to remain high, they will be a bullish factor in determining gold prices, we believe.

Macroeconomic influences

Economic challenges good for gold

In Global Economics Quarterly: An economic oil slick (31 March 2011), HSBC chief economist Stephen King and the macroeconomics team stated that just as the global economy was picking up steam, the world was presented with a new set of challenges. Commodity-inspired price gains were threatening the economic recovery in the developed world while contributing to heightened political instability in parts of the emerging world. In our opinion, the combination of rising commodity prices, increased inflationary expectations, and elevated geopolitical risk is tailor-made for a gold rally, and largely explains that market’s ascent to new highs.

Commodities Global 10 May 2011

Metals prices have risen sharply

Index, 2004=100 Index, 2004=100 450 450 400 400 350 350 300 300 250 250 200
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Source: Thomson Reuters Datastream

One reason the commodity rally has had such a bullish impact on gold is the timing of the commodity upswing. Mr. King pointed out that never before had there been such a large increase in the cost of raw materials so soon after the end of a deep and protracted recession impacting most of the Western world. The suddenness of the commodity rally changed inflationary expectations, according to Mr. King, thereby contributing to demand for gold as an inflation hedge. Such a large rise in commodity prices also could puncture business and consumer confidence, Mr. King said. If so, we would expect gold to be a beneficiary. The recent pullback in commodities, while steep, is not of sufficient magnitude to allay inflation fears, especially if the retreat proves to be short-lived in the near term.

Unorthodox policies help gold

In an effort to stave off a repeat of the Great Depression and jump-start their economies, Western central banks have pursued highly accommodative monetary policies. These include unconventional policies, including a huge increase in bond purchases via an expansion of central bank balance sheets. Fear of the inflationary consequences of these policies has stimulated the demand for gold.

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Foodstuffs: Recent price increases eclipsed those in 2008

Index, 2004=100 Index, 2004=100 220 220 200 200 180 180 160 160 140 140 120
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Source: Thomson Reuters Datastream

According to the HSBC economics team, this approach has been partly successful. Asset prices have recovered, and consumer and business confidence has risen. But while low interest rates and easy credit have led to a rebound in activity in the developed world, it has stimulated far greater growth in the emerging world. Unlike the situation in the developed world, emerging economies are not shackled by debt. As a consequence, they have responded vigorously to easy global monetary conditions. The vitality of emerging nations, combined with investor unease about the printing of money, has led to increased demand for commodities and other non-paper stores of value, such as gold. This helps explain the heavy demand for gold in both the emerging and developed worlds and the resulting price rally.

The rise in commodity-led inflation has led financial markets to begin to price in an increase in interest rates. Some OECD central banks, including the European Central Bank, have raised rates, and prospects have diminished for an extension of the second round of the Federal Reserve’s quantitative easing program, scheduled for 30 June, according to the HSBC economics team. Despite this, monetary policy in Western economies remains highly accommodative and is still gold-supportive.

Commodities Global 10 May 2011

The experience of emerging nations is different, according to Mr. King. The focus on inflation in these countries is more pronounced, particularly given the effects of inflation on the less well-off. The rise in commodity prices has hastened a tightening of monetary policies in the emerging world. Emerging nations have favored unconventional tightening policies, including “quantitative tightening” and a clampdown on domestic credit, in addition to conventional rate increases.

The Chinese authorities have employed a combination of reserve requirement increases and supply-side measures aimed at cooling food prices, according to the HSBC economists. These authorities have repeatedly raised reserve requirement ratios in an effort to soak up excess liquidity, and growth of the broad money supply and new loans has eased since the Chinese central bank began its tightening policy. Other emerging- market central banks are monitoring China’s success in managing inflation and may follow suit, according to the HSBC economics team. If the Chinese authorities fail to rein in inflation, gold is likely to be a beneficiary.

The Middle East shock, oil, and gold

Unrest in North Africa and the Middle East has buoyed oil prices. As with other commodities, the rapid rise in oil prices comes shortly after the end of a stiff recession. Typically, oil prices do not rise until years into an economic recovery. The recent correction in oil prices of USD10 per barrel to USD95, though steep, still leaves prices historically high.

According to the HSBC macroeconomics team, the impact on oil prices, caused in part by the uprisings in the Middle East and North Africa and the risk of economic dislocation following the earthquake and tsunami in Japan, threaten the world economy with a near “perfect storm.” These upheavals have greatly benefited gold by increasing inflation concerns and elevating

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Oil prices are sensitive to small fluctuations in supply

USD World oil price USD 140 140 Lower Production 120 120 100 100 Feb base
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World oil price
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Source: Oxford Economics, HSBC

economic uncertainty. Oil prices are very sensitive even to slight disruptions in supply. The chart immediately above forecasts the effects of tight supply on prices.

Between the rise in oil prices and the disaster in Japan, the biggest threat to the world economy is higher oil prices, according to the HSBC economics team. This is also positive for gold. Higher oil prices lead to a redistribution of global income away from oil-consuming but high- spending economies such as the US and toward oil-exporting and high-saving nations such as Saudi Arabia. The propensity in oil-consuming countries to purchase gold is high and increases with higher oil prices. More important, perhaps, the wealth transfer from higher oil prices leaves oil producers with excess savings, which can be invested elsewhere in the world. In a period of economic and political uncertainty, there is likely to be a flight to hard assets, including gold.

Higher oil prices also lead to losses of business and consumer confidence and changes in inflation, which increase safe-haven demand for gold. The rise in oil prices, which can act like a tax in oil-consuming nations, may lower incomes and curb discretionary spending on luxury items such as gold jewelry. In this regard, higher oil prices may be negative for gold demand.

Commodities Global 10 May 2011

Gold and the US Treasury yield curve Gold and the US debt-to-GDP ratio (USD/oz) 1600
Gold and the US Treasury yield curve
Gold and the US debt-to-GDP ratio (USD/oz)
1600
3.5
1,800
90%
1400
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80%
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70%
800
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60%
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0
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30%
Gold (USD/oz) - LHS
10yr - 2yr (% ) - RHS
Gold (LHS)
US Gross Federal Debt as a % of GDP
Source: Reuters
Source: Reuters, Congressional Budget Office
Apr-01
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Apr-87 Apr-91 Apr-95 Apr-99 Apr-03 Apr-07 Apr-11 A monetary conundrum is good for gold As discussed

A monetary conundrum is good for gold

As discussed in previous editions of our Precious Metals Outlook, inflation expectations and monetary policy wield enormous influence on gold prices. Although the European Central Bank recently raised rates and countries in the emerging world are pursuing various forms of quantitative tightening, the US Federal Reserve is unlikely to tighten monetary policy, according to the HSBC economics team, even if it does not extend its second round of quantitative easing (QE2) and chooses instead to maintain an accommodative monetary policy for the foreseeable future for fear of setting off a recession in light of substantially higher oil and other commodity prices.

The chart at upper left shows that as the US Treasury yield curve steepened, gold prices had a tendency to rally.

The conundrum facing US monetary policymakers is that if they tighten policy, they may be criticized for acting prematurely and possibly snuffing out economic recovery. If they leave interest rates low, they may be blamed for stirring up inflation and boosting commodity prices. Given the history of oil price-related recessions in the US, the Fed is more likely to choose to keep rates low for the foreseeable future, according to HSBC Economics. This would likely extend further support to the gold rally.

Fiscal concerns are good for gold

We discussed the bullish impact of the eruption of the euro sovereign-risk crisis on gold in our 14 May 2010 report, Precious Metals Outlook:

Golden sovereign (risk). Gold is benefiting from deepening government deficits and accommodative monetary policies. If investors believe the authorities are using fiscal policies excessively, this poses a significant risk of rising uncertainty in the private sector. One channel for this uncertainty is likely to be the gold market.

Concerns about mounting government debt levels are not limited to the peripheral euro-zone nations. Gold has attracted significant safe-haven buying in the wake of action by Standard & Poor’s; though S&P affirmed its AAA credit rating on US sovereign debt, it revised its long- term outlook to negative from stable. Sovereign risk concerns are supportive of gold prices. At the height of the Greek crisis in May 2010, German banks sold a record number of gold coins, and gold prices surged above USD1,200/oz. Even small countries with sovereign debt problems can have a positive effect on gold. With a GDP of USD330.78bn, according to the latest national figures, the Greek economy is roughly the size of that of Washington state, which has a GDP of USD338.33bn, according to the latest US data.

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Commodities Global 10 May 2011

The chart at the top right of the previous page shows that as the US debt-to-GDP ratio moved above 60%, the gold rally accelerated. The chart at the bottom of this page shows the increase in US government liabilities. A change in the credit rating of the US, the world’s largest economy and home of the world’s reserve currency, could be “risk-sapping event,” according to HSBC chief US economist Kevin Logan and G-10 currency analyst Robert Lynch. In a research note, Messrs. Logan and Lynch outlined the long-term fiscal problems faced by the US: The federal deficit is likely to average about 7% of GDP for the next three years. On current trends, the US debt-to- GDP ratio will surpass 90% by the end of this decade. In addition, interest payments on debt outstanding are likely to rise to 20% of federal revenues, making any long-term solution to the deficit problem that much more difficult to achieve. It is the financial market’s reduced confidence that a long-term solution to the debt problem will be found that has helped propel gold to new highs.

The ugly sisters’ currencies and Cinderella’s golden slipper

In Currency Outlook: The ugly contest turns uglier (7 April 2010), David Bloom and the

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HSBC currency research team outlined the lack of a clear positive choice among the Big Four currencies: the USD, EUR, GBP, and JPY.

Gold seems to be one of the “Cinderellas” in the currency “ugly sister” contest. In a pre-crisis world, the foreign exchange market would likely be looking to sell the USD, Mr. Bloom said, based on US economic fundamentals. However, the situations in Portugal and Ireland, as well as Greece, mean that it is difficult to turn naturally to buy the EUR. Meanwhile, the UK has its own fiscal problems. The JPY is not a good candidate for purchase due to recent coordinated intervention by the Group of 7 nations. The unintended consequences, the HSBC currency research team said, are that the market is bullish on currencies of OECD and emerging-market commodity-producing nations and the CHF. Gold and currencies of EM and OECD commodity- producing countries have had a positive correlation going back well before the financial crisis. In this climate, appreciation of these currencies would benefit gold. Strength in these currencies also helps explain some of gold’s rally. The chart overleaf shows what the HSBC currency research team describes as the smaller OECD “good currencies” versus the four major

US government debt outstanding has doubled since 2004

USD bn US Gov ernment Debt Outstanding USD bn 16,000 16,000 14,000 14,000 12,000 12,000
USD bn
US Gov ernment Debt Outstanding
USD bn
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Source: Bloomberg, HSBC

Commodities Global 10 May 2011

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Gold tends to move positively with “good” currencies

Good versus Ugly currencies trade weighted (Jan 1 2009=100)

Good versus Ugly currencies trade weighted (Jan 1 2009=100)

124 124 Ugly contest currencies (USD, EUR, GBP and JPY) Ugly contest currencies (USD, EUR,
124 124
Ugly contest currencies (USD, EUR, GBP and JPY)
Ugly contest currencies (USD, EUR, GBP and JPY)
120 120
Good currencies (AUD, NZD, CAD, NOK, SEK and CHF)
Good currencies (AUD, NZD, CAD, NOK, SEK and CHF)
116 116
112 112
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Source: HSBC currency research, Bloomberg

124 124

120 120

116 116

112 112

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104 104

100 100

96 96

“bad currencies.” The team defines “good” currencies as traditional safe havens and those of commodity-exporting countries and “bad” currencies as the four most heavily traded OECD currencies (see the chart immediately above).

Even if the US economy begins to recover and the Fed starts to unwind some of its ultra- accommodative policies, a sustained USD rally should not be expected, Mr. Bloom said. According to the currency team’s analysis, if the US economic recovery accelerates, then the US current account deficit will start to start to widen again. This implies that overseas investors will acquire yet more US assets at an increasing rate, and it may well be that this can be achieved only if US assets are made less expensive through a weaker dollar. Based on the historical dollar/gold inverse relationship, a weaker USD is a long-term recipe for strong gold prices.

Macroeconomic themes

The currency markets are supportive of gold. Each of the major four freely traded currencies – the USD, EUR, GBP, and JPY – has its own drawbacks. This makes gold – a widely accepted

surrogate currency – and emerging-market currencies a viable alternative for investors.

If history is any judge, the decade-long gold rally will not end until the Federal Reserve changes current accommodative policies, the USD stabilizes, and progress is made on reducing the US government budget deficit and restraining growth in the debt-to-GDP ratio. Lower commodity prices and a reduction in geopolitical tensions also would help take the steam out of the gold market. Conversely, any further decline in investor confidence regarding monetary and fiscal policies is likely to translate into higher gold prices. Also, as commodity prices resume their advance and geopolitical risks remain elevated, investors are likely to return to gold, we believe.

Commitments of Traders reports still show a commitment to gold

In the Commitments of Traders reports issued by the Commodity Futures Trading Commission, net speculative long positions in gold, in our view, have been a reliable barometer of investor attitudes toward the metal. Speculators have been net long gold on the Comex since the genesis of the bull market in 2001. Despite being overall net long,

Commodities Global 10 May 2011

positions are often subject to considerable volatility and fluctuations, which can visibly affect gold prices. We believe this helps explain gold’s price volatility.

Net long speculative activity in 2010 reflected price movements for that year. Net long positions hit a low for the year of 21.3moz in the week of 9 February. This coincided with the low for gold prices that year of USD1,043/oz, touched on 5 February. Both prices and net long speculative positions recovered notably thereafter. Net long speculative positions reached 30.3moz – just 800,000oz below the record high – the week after gold hit a then-record high of USD1,270/oz on 21 June. Long positions fell to 21.9moz by late July, in line with a drop in price below USD1,200/oz to USD1,157/oz. Net long positions rebuilt thereafter, peaking at 30.3moz in late September. Long speculative positions eased moderately in the following months but remained historically high, touching 27.9moz when gold hit the then- record high of USD1,430/oz in early December.

Early this year, changes in net long speculative positions reflected the steep drop in prices. Net positions fell throughout January, dropping to 19.3moz by the end of the month, just as gold hit its year-to-date low of USD1,308/oz. Since then, net speculative long positions have grown by more than 6.6moz to 26.6moz, as prices surged to all-time highs toward the end of April. The latest data showed a reduction in net longs to 24.0moz as of 3 May, as gold prices retraced more than USD100/oz, after reaching a record high.

Net long speculative positions represent about c747t of gold, a little less than one-third of global mine output. Net long positions have been historically high for many months, staying well above 20moz since July 2009, with the exception of just two weeks in January this year. As net long speculative positions remain at such high levels, the sheer weight of long positions may encourage

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speculative liquidation. Between early December 2009 and early February 2010, net long speculative positions fell from a record 30.8moz to 21.3moz, a decline of 9.5moz in just three months. This is equivalent to 295t of gold, more than the annual output of Australia, the world’s second-largest gold producer. The liquidation helped drive gold from a then-record high of USD1,226/oz to below USD1,150/oz. A similar liquidation occurred between November 2010 and January this year with a commensurate effect on prices. Net long speculative positions fell from 30.3moz to 19.3moz, a decline of 10.7moz, as prices dropped from a high of USD1,430/oz in early December to USD1,308/oz by the end of January. More recently, a 2.7moz in net long speculative positions from 19 April to 3 May helped knock gold off its record highs and down

cUSD100/oz.

Even with the recent decline in net long positions, the sheer size of these speculative positions may invite further temporary bouts of liquidation, with the commensurate effect on prices, the long- running accumulation of long positions clearly coincides with the multiyear bull market. We believe the increase in net longs has played an important role in gold’s record-breaking rally, is consistent with an increase in demand for safe- haven assets, and reflects heightened investor uncertainty. The following chart shows the combined ETF and net long speculative positions.

Gold: ETF and net speculative positions 1700 1700 1700 120 120 120 1500 1500 1500
Gold: ETF and net speculative positions
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Gold Price Usd per oz (LHS)
Source: HSBC, Gold Bullion, ETF Securities, CFTC
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Commodities Global 10 May 2011

ETFs: Don’t be fooled by liquidation

A notable feature of the gold market has been the

popularity of gold exchange-traded funds (ETFs)

with investors. Despite liquidation this year, the ETFs continue to hold a substantial amount of bullion. Of the 10 gold ETFs that we monitor, combined off-take as of 6 May stood at 2,040.4t

of

gold, or c80% of the world’s annual production

of

gold. This is down c28t from the all-time high

of

2,068.4t in ETF holdings reached near the end

of

2010. The low in ETF holdings year-to-date is

1,980.5t, plumbed on 24 February.

A

feature of the gold ETFs this year is an increase

in

volatility. We do not view the liquidation in

ETF holdings – modest as it is – as necessarily bearish. We believe some of the liquidation may be attributed to investors’ switching into allocated

accounts and other forms of bullion holdings. Thus, the declines in the ETFs do not represent an overall drop in gold investment.

Despite an increase in volatility, swings in holdings from the gold ETFs are still modest by comparison with the Comex. Traditional futures and options trading is typically more volatile and more subject to short-term fluctuations than ETF trading. This can make swings on the Comex more influential in determining short-term price movements than the ETFs, despite the Comex’s considerably smaller market position.

ETF holdings notably overshadow long positions on the Comex. Comex longs are little changed on the year and account for about 747t, while ETF demand is down c28t at 2,040.4t from the beginning of the year. Though the pace of demand may be slackening, gold ETFs still account for the equivalent of more than c80% of global annual mine output. In aggregate, the ETFs also are the sixth-largest holders of gold in the world, behind the central banks of the US, Germany, France, and Italy, and the International Monetary Fund.

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Combined ETF and Comex holdings are the equivalent of 2,787t of gold, or about the level of annual mine output. We anticipate that demand for allocated gold and other sources of bullion may limit any increase in ETF off-take to c230t this year. After increasing to a record 1,360t in 2009, total investment demand in 2010 edged down to 1,297t, by our calculation. We forecast this may fall to USD1,100t this year. Despite the decline, investment demand remains high on a historical basis. We believe that based on investor concerns, demand for ETFs and coins and bars will be sufficient to help usher gold prices higher this year. That said, at substantially higher gold prices, demand for these products could moderate, and this should help cap rallies.

Trends in supply and demand

Gold supply: Producers dig high prices

With gold prices significantly above costs of production – and likely to remain so for the foreseeable future, we believe – producers have an enormous financial incentive to increase output. Despite a more than doubling in the gold price in less than four years, production only recently surpassed that in the banner year of 2001. According to the GFMS precious metals consultancy, gold production in 2001 totaled 2,646t. In the most recent “World Demand Trends” produced by GFMS for the World Gold Council, 2010 output was tabulated at 2,659t. We estimate that additional gains this year will push production further above 2001 levels.

Producers have had to contend with challenges contributing to sluggish output. We have examined these obstacles in greater detail in previous editions of our Precious Metals Outlook. They include a chronic shortage of skilled and technical personnel, notably geophysicists, geologists, and mining engineers; long waiting times for essential equipment; declining ore grades and dwindling reserves in the mature

Commodities Global 10 May 2011

producers; and longer permitting and regulatory processes. Power constraints and a lack of fresh water also are curbing production notably – but not exclusively – in South Africa. Although the global financial and economic crisis has helped contain certain cost pressures, prices of key inputs, notably cement, steel, power, and fuel, are rising again.

Prices remain comfortably ahead of costs. This has allowed producers to absorb increases in costs, while maintaining production at higher levels than would otherwise have been the case. Projects that would have been rejected as too expensive just a few years ago were deemed feasible as gold prices climbed to new highs.

Despite these obstacles, we anticipate further gold output gains this year. More production is scheduled to come on stream, as investments made earlier in the mining cycle translate into greater output. Until now, the long lag time between investment and output has prevented a meaningful production response to high prices. High gold prices also have led to the restart of operations that were on care-and-maintenance schedules and have encouraged producers to bring forward production schedules wherever possible. Based on available company data, we expect production this year will grow by c90t, or c4%, to 2,750t. This represents a 25t increase from our previous 2010 forecast of 2,725t. We believe there are sufficient projects in the works to boost gold mine output until 2014. The chart above right shows gold mine production.

In previous editions of our Precious Metals Outlook, we examined work by Sabrina Grandchamps and Lucia Marquez, HSBC equity research analysts in metals and mining, on the effect of higher prices in investment and reserves replacement. According to these analysts’ report, Global Metals & Mining: From Safari to Siberia (28 March 2009), declining trends in traditional

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Gold mine production (metric tons)

2800 2700 2600 2500 2400 2300 2200 2001 2003 2005 2007 2009 2011f
2800
2700
2600
2500
2400
2300
2200
2001
2003
2005
2007
2009
2011f

Source: GFMS, WGC, HSBC

gold-producing regions have spurred a new wave of investment in other regions, leading to growing mine supply in other parts of the world. Furthermore, in their 4 May 2010 report, African & CIS gold miners: Takeaways from reserve replacement trends in 2009, the analysts found that a majority of gold mining companies in and outside of HSBC’s gold equities coverage have been able to replace ounces mined with the help of higher gold prices.

The renaissance in production is likely to be temporary, we believe. Producers still have to contend with a host of challenges that will inevitably limit production. Based on current mine production schedules, global production is likely to peak around 2014 and ease gradually thereafter. Long-term declines in output due to falling reserves will be most pronounced in the mature and developed producers, notably South Africa, the US, Canada, and Australia.

A slow climb

According to US Geological Survey (USGS) data, the majority of all the gold ever produced has been mined since 1900, with the bulk of this production coming from just four countries: South Africa, the US, Canada, and Australia. A feature of the market has been the relative decline in production in these traditional producers. In particular, falling grades and difficulties in replacing reserves have limited output from these

Commodities Global 10 May 2011

traditional producers. In the next couple of years, we believe, aggregate world production will rise; this includes production from some traditional producers. Following is a discussion of the near- term outlook for some of the larger producers.

US: The USGS survey estimates that US gold mine production in 2010 grew c3% to 230t, compared with 223t in 2009. This marked the first increase in domestic production since 2000. Increased production from new mines in Alaska and Nevada and from existing mines in Nevada accounted for much of the increase. These increases were partly offset by decreases in production from mines in Montana and Utah. US production may increase c2% this year to c235t, as production from Barrick Gold’s Cortez Hills project in Nevada approaches full capacity.

South Africa: Output in South Africa, formerly the world’s largest gold producer, fell 6.4% in 2010 to 191,833.7 kg, according to the South African Chamber of Mines. Production costs are relatively high due to the strong ZAR and the expenses involved in running the world’s deepest mines, some of which are 4 km below the surface. Additionally, grades are generally low, compared to most other large producers, and labor costs are high by international standards.

Safety-related stoppages have also hindered production. Recent calls for the nationalization of the mines by the youth wing of the ruling African National Congress (ANC) – although rejected by the senior party leadership – has nonetheless had an adverse impact on international investment in the gold mining industry. New production at deep mines in the Free State and West Rand will offset closures from aging facilities this year. According to Statistics South Africa, gold production in February declined 2.3% annually, following 3.2% growth in January. Statistics South Africa issues changes only in percentage terms. Despite evidence that output is bottoming, it will be

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difficult for the industry to arrest the long-running trend of output declines.

Russia: Russian gold companies produced 19.98t of gold in the first two months of 2011, up 13.9% from a year earlier, according to the Gold Industrialists’ Union. Mined output in January- February increased 12.6% from the year-earlier period to 16.38t. Output of gold as a byproduct of other metals increased by a substantial 95.1% to 12.27t, while refining from scrap was essentially unchanged at 2.37t, according to the Industrialists’ Union. Output in 2010 fell 1.4% to 201.3t, but the union has indicated that production will recover this year to 205-207t, based on increases in new projects.

Australia: The Australian Bureau of Agricultural and Resources Economics (Abare) has forecast an increase in domestic gold mine production of 14% this year to 274t. Growth will be supported by the ramping up of Newmont’s Boddington mine, which, according to the Abare, may produce 25t of gold this year. Several other new projects are forecast to contribute to production. Abare’s forecast for 2012 grows 3% to c282t. Several midsize operations in Western Australia are expected to boost domestic output. This new output should more than offset declines from some operations that nearing the ends their lifespans.

Abare is optimistic about production in 2013 and 2014, which it expects to rise to 291t and 314t, respectively. This is based on the projected start- ups of large-scale projects in Queensland and the Northern Territories. Production is expected to flatten in 2015 and 2016 at 315t for each year, as lower production from existing facilities offsets increases from new projects.

China: China extended its position as the world’s largest gold producer in 2010. According to the China Gold Association, domestic gold

Commodities Global 10 May 2011

production increased 8.57% last year to a record high of 340.88t. As discussed in our previous editions of Precious Metals Outlook, China appears unlikely to hold on to its top position in the longer term. Although numerous, China’s gold mines are small by international standards, and they have relatively short lifespans.

The Chinese gold producing industry has gone through a bout of government-sponsored consolidation. China’s top 10 gold producers

accounted for nearly half of total output last year. Meanwhile, the number of gold producers has fallen to slightly more than 700 from 1,200 in

2009. According to the USGS, China has less than

two-thirds of the gold reserves of the US, despite producing two-thirds more gold than the US in

2010. This implies that China does not have a

sufficiently large reserve base to sustain production at current levels for the longer term. The lack of well-defined reserves and the paucity of world-class projects make it likely that Chinese production will peak in 2012-13 and begin to

decrease thereafter.

Peru: Peru’s gold production in February fell 16.% from a year earlier to 12.5m grams, according to the of energy and mining ministry. The decrease was attributed to lower production from some larger producers, including Minera Barrick Misquichica, Minera Yanacocha, and Compañía Minera Ares; their production fell 51%, 29%, and 20%, respectively, year-on-year, according to the mining ministry. These declines make it likely that 2011 output will come in below 2010 levels.

Official sector: The pendulum swings

After many years as heavy net sellers of gold, the official sector has swung from an important contributor to supply to a source of net demand. Based on data from the Bank for International Settlements and our own estimates, we believe that the official sector in 2010 was a net buyer of

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gold for the first time in more than two decades, absorbing c50t. This compares to net sales of c30t, according to the Bank for International Settlements (BIS).

According to BIS data, the signatories to the third Central Bank Gold Agreement – once significant sellers – sold only 7.1t in the first year of CBGA3, which ended 26 September 2010. This did not include the sale of a small amount of bullion for the minting of gold coins. For the CBGA3’s second year so far, the signatories have sold less than 1t. This is a significant turnaround in policy from sales patterns just a few years ago. Combined sales from the first two CBGA agreements from 26 September 1999 to 26 September 2009 totaled 3,884t of gold, or an average of 388.4t per year. This was more gold than the annual output of South Africa, the world’s largest gold miner at the time. The lack of appetite for sales within the CBGA in the last two years is an important bullish development for gold.

Under the rules of the agreement, the CBGA signatories have a sales quota of 500t annually. Given the paucity of sales to date and statements by the two largest holders of bullion in the CBGA, Germany’s Bundesbank and the Swiss National Bank, that they have no intentions to sell any more gold, it is unlikely that the signatories will collectively sell anything more than a very moderate amount of gold this year.

Although official sector sales were already slowing ahead of the global financial crisis, we believe that its onslaught – and gold’s strong price performance during that period – led reserve managers to reassess their gold sales intentions. We see little likelihood that the signatories of the CBGA will resume any level of meaningful sales in the foreseeable future. Other large official- sector holders of gold, including the US and Japan, also have said that gold sales are off-limits.

Commodities Global 10 May 2011

The International Monetary Fund replaced central banks as the main supplier of official sector gold in

2010. The IMF executive board approved sales of

gold that the IMF had acquired following the second

amendment of its articles of agreement in April

1978. This amounted to 403.3t, about one-eighth of

the IMF’s total holdings at the time of approval.

In November 2009, the IMF sold 200t to the

Reserve Bank of India, followed by 2t and 10t to the central banks of Mauritius and Sri Lanka, respectively. The IMF announced in February 2010 that phased sales of gold on the market would be initiated to dispose of the remaining 191.3t. If another official-sector buyer could not be found, the gold would be sold on the open market through the CBGA. On 7 September 2010, the IMF sold 10t

to

the Bangladesh Bank. This reduced the amount

of

gold that needed to be placed on the market. In

December 2010, the IMF concluded the gold sales program, with total sales of 403.3t. The IMF has no further plans to sell gold.

With no further sales forthcoming from the IMF and the likelihood of only moderate sales from the CBGA, any significant purchases of gold by central banks would result in net purchases of bullion by the official sector.

Outside the CBGA, the main purchases reported

in 2010 were from Russia. According to BIS data,

the Russian central bank purchased 139.8t of gold.

A handful of other countries, including the

Philippines, Venezuela, and Thailand, also accumulated gold. China may also have accumulated gold from domestic sources, but this has not been reported to the BIS. In early May, data from the Mexican central bank showed its purchase of 3moz of gold in Q1 as part of its foreign exchange reserves.

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With the exception of the Mexican purchase, official data show little official-sector activity so far this year. We consider it likely that the data have not yet caught up with some of the transactions. Emerging-market central banks are likely to increase gold holdings, both as a means to diversify away from the USD and as an overall strategy of portfolio diversification, we believe. The continuing rapid accumulation of USDs in their foreign exchange reserves by many emerging-market central banks may accelerate this process.

We believe that central banks around the world are adopting an increasingly favorable attitude to gold and may therefore absorb a significant amount of bullion this year from the international markets. The Chinese monetary authorities will likely refrain from making any direct international gold purchases for fear of dislocating the market, in our view. Rather, we believe, China will quietly accumulate gold from domestic production, which the central bank is not obliged to report to the BIS.

The rapid growth in foreign exchange reserves, mostly in US dollars in emerging nations, implies that central banks will have to buy gold if they wish to maintain their current balance of gold to foreign exchange holdings. In the absence of any major sellers, we estimate that the official sector could absorb net 300t of gold this year.

Scrap: A major source of supply

The absence of official sector sales leaves the scrap market as the most important source of secondary gold supply. Scrap supplies have tended to rise in tandem with gold prices. The scrap market grew from c600t in 2000 to c1,653t in 2010, according to data compiled for the World Gold Council by the GFMS precious metals consultancy.

Commodities Global 10 May 2011

Although the bulk of recycled gold traditionally comes from the emerging world, supplies from the OECD nations have risen as a proportion of market share in the last few years. According to data compiled by GFMS for the World Gold Council, scrap supply in 2010 was c20t below the 2009 level of 1,672t. Thus, scrap supply was largely unchanged, despite a 29% increase in the average price of gold in to USD1,225/oz from USD973/oz in 2009. This argues against the notion that scrap supplies are purely a function of the gold price.

A

modest improvement in employment in much

of

the OECD world may be limiting distress scrap

sales. More important in the midst of still-high gold prices, merchants and other scrap market participants may be holding on to material in the hope of resurgent prices. This may explain why in the face of high prices, the market was not deluged with additional scrap supplies.

The scrap market traditionally performs an important function as a balancing mechanism in the physical markets. Merchants typically

mobilize bullion stocks during periods of escalating prices, thereby increasing supply, and they reduce scrap supplies when prices are low. We credit the appearance of substantial amounts

of scrap in 2008, 2009, and 2010 with helping to

supply bullion to the growing investment markets,

notably the ETFs. Without the contribution of scrap, the physical markets would be in a significant deficit, according to our supply/demand model.

High prices eventually will stimulate additional supply, in our view. Also, while merchants may have been holding supply back from the market as prices rose, the recent correction may trigger a flood of scrap as holders rush to secure still-high prices. We forecast scrap supply this year at c1,650t, similar to the level in 2010. This represents a c350t increase in scrap volume from

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our previous estimate of 1,300t for 2011. Additional scrap supplies are likely to play a role

in tempering the rally, in our view.

Gold demand: Back from the brink

Dehedging: The final act

A long-running feature of the gold market has

been the industry trend toward dehedging, the process whereby producers buy back or otherwise close out previously established hedges.

Producers’ reversal in hedging policies dates back

to the beginning of the current bull cycle in 2001-

02. The pace of producer buybacks is slowing markedly as a greatly diminished global hedge book leaves producers with little in the way of hedge positions to close out.

According to the Fortis subsidiary Virtual Metals’ “Gold Hedging Report,” the global hedge book in Q4 2010 declined 1.7moz to 4.7moz from the year-earlier quarter. For the entire year, the global hedge book fell from 8moz to 4.7moz, a drop of nearly 40% from 2009. The decline would have been greater had it not been for the initiation of a significant hedge by the Mexican miner Minera Frisco that was initiated toward the end of 2010 but that was not reported until early this year.

Anglogold Ashanti reported in October 2010 that

it had eliminated the remainder of its hedge book,

which stood at 2.4moz. Other smaller hedges were

also wound down by other producers.

The global hedge book is unlikely to be eliminated entirely. Gold hedges in 2010

increased for the second year in a row, albeit moderately. It may be too early to herald a change

in producer attitudes toward hedging. But with

prices well above marginal costs and some new projects requiring some form of hedging to attain project financing, we may see a small recovery in hedging going forward.

Commodities Global 10 May 2011

As producer dehedging slowly fades, an important source of demand is gradually being removed from the market. To this extent, reduced dehedging is gold-bearish. Despite the initiation of some new hedges in 2010, the industry remains collectively bullish, and most mining companies continue to embrace an antihedging philosophy. Consequently, we expect new hedges to be modest. Dehedging will inevitably be a dwindling source of demand, we believe, simply because at less than 5moz, there is little left in the way of hedges outstanding to close out. After contributing c116t of new demand in 2010 and given the small size of the hedges outstanding, dehedging will contribute just c25t to demand this year, we expect.

Fabrication demand recovering

Jewelry consumption historically accounts for the bulk of gold fabrication and is therefore the single most important determinant of physical demand. Jewelry’s share of total gold demand, however, fell to c55% in 2010 from c75% in 2005. Jewelry demand fell sharply in 2009 as the global economic crisis and higher gold prices cut into consumer demand. Led by emerging-market demand, jewelry consumption recovered last year. Despite the recovery, it will likely be several more years before demand reaches pre-crisis levels, we believe.

According to data collected by GFMS for the World Gold Council, jewelry demand in 2010 rose to c2,060t from c1,760t in 2009. The increase was due in large part to a strong recovery in emerging-market demand. Indian demand rose to 746t, an all-time high, from a multiyear low of 442t in 2009. The bulk of India’s gold jewelry purchases occur in the northern tribal belt, a predominantly rural region. A good monsoon and high grain prices boosted rural income and supported jewelry consumption. Demand also was supported by Indian consumers’ optimistic outlook regarding future price appreciation.

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Gold jewelry demand (t) 3500 3000 2500 2000 1500 1000 500 0 2001 2003 2005
Gold jewelry demand (t)
3500
3000
2500
2000
1500
1000
500
0
2001
2003
2005
2007
2009
2011f

Source: GFMS, WGC, HSBC

Chinese jewelry demand increased to c400t in 2010 from 352t in 2009, supported by gains in

inflation-adjusted consumer incomes and more retail outlets for gold products. Other emerging- market nations also increased their demand for gold jewelry. The surge in demand across Asia was supported by rising income, commodity inflation, and USD weakness. This implies that emerging-market buyers view jewelry as a form

of investment in addition to a luxury good.

A feature of the gold jewelry market over much of

the previous decade is the shift in the locus of demand from the less price-sensitive Western markets to the more price-sensitive emerging markets. The majority of the world’s gold jewelry is

purchased in relatively price-sensitive areas of the world, notably India, China, and the Middle East. In most years, high prices curb jewelry demand, and low prices stimulate demand. Last year was a notable exception to this rule: Jewelry demand rose

in 2010 in the face of a virulent price rally. Rather

than a change in market dynamic, we believe, this can largely be explained by the comparison with

weak demand in the previous year.

Logically, there is a limit to how much gold

jewelry consumers are willing to buy in the face

of rising prices. Although emerging-market

demand has been strong until now, we sense a reluctance to increase purchases of more than

Commodities Global 10 May 2011

USD1,500/oz. Even accounting for the recent pullback, current prices still make it difficult for consumers to increase demand, even if their disposable incomes rise.

While inflation may encourage gold purchases for investment, jewelry must compete with necessary expenditures, including foodstuffs and fuel, staples that account for the bulk of consumer budgets in emerging economies. High food and fuel prices, examined earlier in this report, may curb discretionary spending on jewelry. Similarly, the patchy economic recovery in the US and economic uncertainty in much of the OECD world also might limit demand for gold jewelry. The disaster in Japan is already curbing expenditures on luxury items, including gold jewelry.

Global demand for gold jewelry will be largely determined by consumption patterns in the world’s two biggest gold markets: India and China. Combined, they accounted for c60% of global demand for gold jewelry in 2010. Demand in these nations will be a trade-off between rising incomes and inflationary concerns that should support gold jewelry off-take, and high gold prices and rising prices for food and fuel, which could reduce consumers’ discretionary spending on jewelry. Continued liberalization of the retail gold segment in China should support jewelry consumption. In the Middle East, high oil prices should increase consumer incomes and bolster jewelry demand in this important gold market.

Growth in demand for jewelry appears slightly positive so far this year. Sales reports from jewelry retailers in the US, Britain, Italy, Russia, Japan, and Germany indicate that demand grew in the early part of this year. Our views are based on HSBC’s macroeconomic forecasts of global economic indicators that are likely to impact jewelry sales, including GDP growth, unemployment, retail sales, and consumer spending. While we believe that jewelry

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consumption will continue to make a limited comeback this year, we believe gold prices above USD1,500/oz are a threat to further sales growth.

Another spike in gold prices could erode jewelry demand further, while a drop to closer to USD1,200/oz could stimulate jewelry demand. Because prices remain high despite the recent correction, we do not expect jewelry off-take this year to be greater than 2,100t, which would be a c40t increase from 2010. This still would leave gold jewelry consumption well below the peak demand year of 2001, when off-take reached c3,200t. Further price rallies have the potential to depress jewelry demand to levels below those in 2010, especially in the emerging world. Indian demand could be vulnerable if this year’s monsoon season is poor and agricultural incomes decline. See the chart on gold jewelry demand on the previous page.

The decline in gold jewelry consumption during the financial crisis freed up significant bullion supplies, which, instead of being processed into jewelry, went directly into the investment segment. Without this shortfall in demand from the jewelry segment, we believe the pace of investor demand would have driven gold prices even higher than current record levels. Were investment to drop and gold prices to fall to levels near USD1,200/oz, we would expect a commensurate increase in jewelry demand. If prices stay above USD1,500/oz, demand may be constrained. However, if demand is more resistant to high prices than we believe, then the combination of persistently strong investment demand and a resilient jewelry market has the potential to drive gold prices higher.

Commodities Global 10 May 2011

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Gold: Supply/demand balance (tonnes)

 

2003

2004

2005

2006

2007

2008

2009

2010

2011e

Mine production Official sector net sales Old gold scrap Producer hedging Total supply

2,593

2,463

2,522

2473

2,478

2,410

2,584

2,659

2,750

617

474

659

352

484

232

30

-50

-300

939

829

888

1,104

937

1,316

1,673

1,653

1,650

-279

-427

-86

-373

-400

-352

-254

-116

-25

3,870

3,339

3,986

3,557

3,469

3,605

4,024

4,146

4,075

Jewelry Electronics Dentistry Other industrial uses Other fabrication Total fabrications

2,481

2,610

2,709

2,279

2,402

2,193

1,759

2,060

2,100

235

261

281

304

316

293

246

287

300

67

68

62

61

59

56

53

50

50

80

83

85

86

87

91

74

83

85

382

412

428

451

462

440

373

420

435

2,863

3,022

3,137

2,730

2,864

2,633

2,132

2,480

2,535

Bar hoarding Official coins Metals Other retail Exchange-traded funds Total investment demand

178

245

262

226

257

386

216

380

340

105

114

112

129

124

187

231

205

190

27

29

337

59

73

70

57

77

70

15

-39

-24

-24

-32

215

227

333

270

32

119

208

250

211

321

617

302

230

357

477

595

659

633

1,179

1,348

1,297

1,100

Total demand

3,220

3,399

3,732

3,380

3,3533

3,5811

3,480

3,777

3,635

Balance = net investment

650

-180

251

149

-28

-207

544

369

440

Gold price (USD/oz)

364

410

445

604

695

872

972

1,225

1,525

Source: HSBC, WGC, GFMS

Commodities Global 10 May 2011

Silver

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We expect the silver surplus to narrow this year; physical market should be characterized by surging mine output and rebounding industrial demand Investor demand for silver should recover from recent steep price declines based on investor concerns about accommodative monetary policies and heavy deficit spending We are raising our average silver price forecasts and introducing an estimate for 2013

Lifting our silver price forecasts

Our supply/demand model indicates that the silver market will be in surplus by 43moz this year; narrowing from 178moz in 2010. We are raising our average silver price forecasts for:

2011 to USD34/oz from USD26/oz.

2012 to USD29/oz from USD20/oz.

The long term (five years) to USD20/oz from USD15/oz.

For 2013, we are introducing an average price forecast of USD24/oz.

Back to earth

Based purely on the underlying physical fundamentals alone, the silver story did not merit prices in the vicinity of USD50/oz reached in late April, in our view. The subsequent steep retracement to USD34/oz by the end of the first week of May is a more accurate reflection of underlying fundamentals, we believe. According

Silver price (USD/oz) Silver trades directionally with gold (USD/oz) 50 1600 60 USD/o USD/o 45
Silver price (USD/oz)
Silver trades directionally with gold (USD/oz)
50
1600
60
USD/o
USD/o
45
1400
50
40
1200
35
40
1000
30
30
25
800
20
20
600
15
400
10
10
200
5
0
0
0
Silver
100 dMA
200 dMA
Gold (RHS)
Silver (LHS)
Source: Reuters
Source: Reuters
Apr-01
Apr-02
Apr-03
Apr-04
Apr-05
Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
Apr-01
Oct-01
Apr-02
Oct-02
Apr-03
Oct-03
Apr-04
Oct-04
Apr-05
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Apr-08
Oct-08
Apr-09
Oct-09
Apr-10
Oct-10
Apr-11
Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 30

Commodities Global 10 May 2011

to our supply/demand model, the market is in surplus. Silver mine supply will grow, based on production schedules and the increase in base metals from which silver is derived as a byproduct. Other sources of silver supply, notably scrap, will react to high prices and contribute to supply. A revival in hedging policies by some mines will contribute further to supply.

Industrial demand for silver will continue to strengthen, we believe, based on HSBC macroeconomic forecasts of global industrial production. This will be offset by increased mine output and scrap supplies. Jewelry demand might not be able to rise much, due to high prices.

The driver of silver prices, we believe, will be investor sentiment. Until recently, investor demand was able to absorb the excess physical silver generated by rising mine output and the decline in industrial demand. Investor sentiment changed abruptly in early May, when a drop in exchange- traded funds’ (ETF) silver holdings played an important role in driving prices lower. Going forward, the role played by the silver ETFs and Comex will be crucial in determining price. If investment demand were to falter further, substantial amounts of silver would move rapidly onto the market, and silver supply/demand balances would record a greater surplus than we currently calculate. This leaves silver highly vulnerable to changes in investor sentiment, in our view.

We believe investor concerns about the potential inflationary impact of the US Federal Reserve’s quantitative easing (QE) program, fiscal profligacy, and geopolitical tensions will keep investors interested in silver. The recent correction in prices also may boost what has heretofore been a mainstay of the rally, strong demand for bars and coins. Also, price-sensitive emerging-market demand may increase, now that prices are back in the mid-USD30s/oz area. We believe that the market has enough momentum to push prices back

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above cUSD40/oz or even higher in the near term, but that such levels cannot be sustained over the course of this year. Therefore, we believe prices may ease further in the second half.

Recovery phase

Propelled by robust investor demand, silver prices almost doubled since touching a year-to-date low of USD26/oz on 28 January. By the end of April, prices had moved within striking distance of the record high of USD50/oz set in January 1980.

The market had been on an almost unbroken upward trajectory since August 2010, when prices broke above USD18/oz. The surge in prices was accompanied by almost unprecedented investor interest and continuing strength in industrial demand. The rally accelerated in the past couple of months, as the eruption of popular discontent in the Middle East and higher oil and other commodity prices drove investors to seek out hard assets, including silver. The re-emergence of sovereign risk concerns in the peripheral economies of the European Union and Standard & Poor’s lowering of its long term credit outlook for the US spurred even greater buying in silver throughout March and April. Prices pulled back sharply in early May as the Chicago Mercantile Exchange raised margins for Comex silver investors. Prices fell to USD34/oz in the first week of May, a decline of c33% from the recent high near USD50/oz.

The silver/gold ratio

In the course of its rally, silver outperformed all other major asset classes and most other commodities, including its sister metal, gold. This is evidenced by the fall in the silver/gold ratio to multiyear lows near 30:1 at the end of April 2011. For most of the past 20 years, it has tended to revolve at around 70:1. At the end of April 2010, it stood at 68:1. The ratio had not been that low since the early 1980s, when it was rising after hitting its post-Bretton Woods low of 17:1 in

Commodities Global 10 May 2011

January 1980. The Bretton Woods system for monetary and exchange rate management was created in 1944, when gold became freely traded. From this perspective, silver arguably became expensive relative to gold. The recent correction in silver prices has lifted the ratio to 42:1. This is closer to its long-term historical norm. Over the rest of this year, the ratio may move back to 50:1, we believe.

We find it interesting that even at its high this year, silver remained far below its all-time high, set in 1980, of USD50/oz in real terms. In inflation-adjusted terms the 1980 high was equivalent to cUSD125/oz. From a historical perspective, therefore, there is precedent for silver to trade considerably higher now.

The surge in silver prices earlier this year was due primarily to a sharp increase in investor demand, rather than a compelling change in the underlying supply/demand balances, in our view. The significant rise in silver prices, which began at the end of August 2010, coincided with the US Federal Reserve’s signal at the time that it was debating whether to reintroduce quantitative easing. Concerns about the inflationary consequences of the second round, QE2, and other highly accommodative monetary policies, combined with increased sovereign risks and elevated geopolitical risk, triggered renewed demand for hard assets, particularly the precious metals, including silver. The Fed’s announcement that QE2 would end in June 2011 did not noticeably dim the silver rally. The nearby chart shows the silver/gold ratio, with silver gaining on gold until the silver correction in early May.

Along with gold and the other precious metals, silver has been one of the few beneficiaries of the recent economic crisis. Silver prices were trading in a USD12-13/oz range in the weeks before the eruption of the subprime mortgage crisis in May 2007. With silver benefiting from its safe-haven

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Silver ETF demand (moz)

140 120 100 80 60 40 20 0 2006 2007 2008 2009 2010 2011f
140
120
100
80
60
40
20
0
2006
2007
2008
2009
2010
2011f

Source: Reuters

status, prices have climbed c300% in almost three years. Price corrections, when they occurred, have tended to be brief but sharp.

A restoration of normal economic growth patterns would likely end the silver rally, we believe, especially if it were accompanied by tighter US monetary policies and progress was made on limiting deficit spending in the member states of the Organization for Economic Cooperation and Development (OECD). According to HSBC macroeconomics, there are few indications that the US economy is about to return to normal growth patterns. As long as investors in and outside the US remain uncertain about the US economy and concerned about the possibility of QE-related inflation and the implications of deficit spending, we believe silver is likely to be well-bid.

Investor sentiment will remain the key determinant of prices going forward, we believe.

Silver/gold ratio 75 70 65 60 55 50 45 40 35 30 Jan-10 Apr-10 Jul-10
Silver/gold ratio
75
70
65
60
55
50
45
40
35
30
Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11

Source: Bloomberg

Commodities Global 10 May 2011

Investor demand has absorbed the excess physical silver generated by rising mine output. The silver ETFs have absorbed sizable amounts of bullion in just a couple of years, holding the equivalent of c60% of annual silver mine output, more than twice annual jewelry and silverware demand, and based on our forecast of industrial and decorative demand for this year, about c80% of that segment’s annual consumption.

The chart at the bottom-left of the following page shows investor positions on the Comex and the silver price. Comex positions appear responsive to prices, with long positions generally building on rallies and contracting on downswings. The chart at bottom-right overleaf combines Comex silver and ETF positions. The red section shows the growth in ETF off-take. Demand for ETF products has been fairly static, compared to the beginning of the year, while long positions on the Comex have been more volatile. The combined holdings of all three silver ETFs – the Barclays iShares and the smaller ETF Securities and the Zurich Kantonalbank Bank (ZKB) – decreased by c7.5moz this year to 451t from 458.6t at the beginning of the year.

Net long speculative positions on the Comex, while relatively high, are below record levels. Net long positions reached 330moz at the end of October 2009, about 49moz below the peak of 378.9moz reached in February 2008. Long liquidation drove net long positions lower in late 2009 and early 2010, bottoming out at 189moz in early February 2010. Positions rebuilt by September 2010 to 327mozm just 3moz short of the high for 2009, but fell to 251.7moz as of 25 January 2011. Net long speculative demand surged in the following weeks to a high of 282.3moz as of 5 April. Comex positions have since been subject to net liquidation, falling to 212moz as of 3 May. This included a 50.7moz drop between 19 April and 26 April, the sharpest

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one-week drop since investors liquidated almost c82moz in the week of 6 March 2007.

Although some long positions have been migrating from the Comex to the ETFs, should Comex liquidation continue at the pace of late April, further considerable downward price pressure may materialize in keeping with other periods of heavy liquidation by investors. We believe the reduction in price will encourage further investor demand, and we are doubling our estimate of silver ETF accumulation this year by 40moz to c80moz, though this still would be less than the increase of 84moz in 2010.

If ETF investors continue to liquidate at the pace seen in late April, sizable amounts of silver could continue to appear on the physical market on short notice, with a commensurate impact on prices. It may not even be necessary to liquidate ETF holdings to have a negative impact on prices. The market has become accustomed to substantial ETF demand, and should ETF demand merely flatten, the market would move into a more substantial surplus, according to our supply/demand model. So far, however, silver ETF investors have shown only a modest inclination to liquidate, and most remain steadfast even in the face of substantial price volatility.

Silver consumption for industrial and manufacturing applications soared in 2010 and remains robust this year. This is in line with the recovery in industrial production in the emerging markets followed by the OECD economies. Silver is used in a wide range of industrial processes and applications, many of which are rapidly expanding. These include the electrical and electronic industries, notably batteries, catalysts, bearings, wiring, brazing, and soldering.

Nonindustrial demand, specifically jewelry, is up only moderately from last year, we believe, but photographic demand remains weak. The surge in

Commodities Global 10 May 2011

oil prices has led to an increase in demand for solar panels, which require silver. New applications for silver in the biomedical, environmental, and chemical industries will buoy physical demand this year, in our view.

According to our supply/demand model, silver mine supply will continue growing at a healthy pace for at least the next two years, due primarily to an increase in primary silver mine output and increases in mine byproduct output. Heavy investments made earlier in the mining cycle are increasing primary silver mine production, notably in Latin America. High prices of silver and base metals also provide miners with incentives to increase output wherever possible. Costs of production are very low and are no deterrent to production.

Supply trends

New generation of output at low cost

In the 2011 Silver Survey prepared for the Silver Institute, Gold Fields Mineral Services estimated that silver mine production totaled 736moz in 2010, up more than 17moz from 2009. Silver mine output has been rising steadily for several years, supported by heavy investment earlier in the mining cycle. Also, the rise in prices has made it easier for silver projects to receive financing and obtain additional funds to accelerate production.

With prices far exceeding the cost of production by several multiples, producers have enormous financial incentives to increase production. Company reports by most primary silver producers put the vast majority of their production costs at USD5-8/oz. Some higher-cost production is closer to USD10/oz, with the highest-cost projects that we are aware of not much beyond USD12/oz. Cost pressures may be rising, however. Although prices have been well- contained in the past couple of years, recent increases for essential inputs, notably steel cement and diesel, as well as power, may pressure overall costs higher. Despite these increases, we do not anticipate that costs will rise anywhere approaching a level at which they would discourage production.

Furthermore, the majority of the world’s silver is mined at low or almost no costs. More than two- thirds of silver production is a byproduct of base metals and gold output, which implies that the marginal cost of production at these facilities is close to zero. Thus, silver production is more a function of base-metals output than of the silver price, and it has therefore benefited from increased production of gold and base metals. The high price of base metals also gives base-metals producers considerable financial incentive to increase their output.

Silver: Silver price and total speculative positions Silver: ETF and speculative interest 500 50 800
Silver: Silver price and total speculative positions
Silver: ETF and speculative interest
500
50
800
US
450
moz
USD
45
700
moz
400
40
600
350
35
500
300
30
400
250
25
300
200
20
200
150
15
100
100
10
0
50
5
0
0
Net Spec Position (Moz)
Silver price
Silver in ETF
Net Spec Position (Moz)
Source: HSBC, Reuters, CFTC
Source: HSBC, Reuters, CFTC
Apr-05
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Apr-08
Oct-08
Apr-09
Oct-09
Apr-10
Oct-10
Apr-11
Apr-05
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Apr-08
Oct-08
Apr-09
Oct-09
Apr-10
Oct-10
Apr-11

50

40

30

20

10

0

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Commodities Global 10 May 2011

Silver mine supply (moz) 900 Silver Mine Production (Moz) 800 700 600 500 400 300
Silver mine supply (moz)
900
Silver Mine Production (Moz)
800
700
600
500
400
300
200
100
0
2001
2003
2005
2007
2009
2011f

Source: GFMS, Silver Institute, HSBC

Silver production has therefore also benefited from the search for and development of gold and base metals deposits. Development of base-metal discoveries that contain byproduct silver will continue to account for a significant share of future silver reserves and resources. According to outlooks by base-metals consultants, such as the International Copper Study Group and the International Lead-Zinc Association, as well as company forecasts, base-metals production is likely to grow this year and next year. This will support increases in silver production, especially as some of the new polymetallic mines have high silver byproduct content.

Thus, the bulk of mines will continue to produce silver, virtually irrespective of price. Silver also is an exception to the rule that in the long term, the price of a commodity will tend to move toward the cost of the marginal producer. This explains why the bulk of silver production has been historically insensitive to price changes.

The majority of the world’s silver production comes from Latin America, notably Mexico, Peru, and Bolivia, and we expect this region will increasingly dominate global silver output. Several projects in Russia and increased production at certain mines in North America and Africa also will contribute to strong increases in output this year. Production gains will be partly

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offset by output declines at mature mines, notably in Australia, Chile, and Canada. We anticipate gains in output will far outweigh declines. Based on the most recent company data and investments made earlier in the mining cycle, we are raising our forecast of silver mine output for this year by at least 30moz to c765moz; we previously forecast c755moz. Furthermore, we expect production to continue to climb in 2012 by a similar magnitude, based on company projections. The nearby chart shows mine output.

Other sources of supply: What’s coming down the line?

Until last year, government sales of silver were a gradually diminishing source of supply. In 2010 government sales jumped to c44moz from c15moz in 2009. Russia accounted for almost all of these sales. We attribute the increase in sales to the Russian government’s desire to take advantage of high prices. It is possible that high prices may encourage further government sales this year, but we believe these will not exceed 20moz. Sales have also traditionally come from India, but we believe that if any government sales from this source appear, they will be quickly absorbed by the domestic market.

Scrap’s changing complexion

Recycled silver is the second-largest source of silver supply after mine production. The largest contributor to silver scrap recycling is the photographic segment. We have discussed in previous editions of our Precious Metals Outlook the long-running decline in silver scrap due to the shift to digital cameras from traditional photography. This trend shows no signs of reversing. Eastman Kodak, Konica Minolta, Sony, and Fuji Film report similar declines in traditional film sales due to the increasing popularity of digital imaging technologies.

Commodities Global 10 May 2011

The most recent sales data from large filmmakers confirmed that sales of silver nitrate-based film continues to decline. In the Silver Survey, GFMS estimated 2010 photographic demand at 72.7moz, a decline of 6.6moz from 79.3moz in 2009. We believe that demand in this category will ease to c70moz this year.

We anticipate lower silver consumption by the photographic industry and commensurately lower recycled silver rates for this and next year.

Other components of the scrap market look set to grow. Although the industrial segment is by far the largest consumer of silver, it accounts for a far smaller proportion of silver scrap supply. This may be because silver is generally used only in small quantities in most industrial and manufacturing applications. This made it uneconomical to recycle at prices below USD20/oz. The surge in prices is changing the calculus of the industrial scrap market. At prices above USD30/oz, we believe, industrial users have sufficient reason to seek to recycle considerably more scrap this year than in previous years.

In addition to the price incentive, environmental legislation initiated in 2009 now requires recycling of a wide variety of electronic products with a silver component, such as cell phones and calculators. This could be a significant development, as about two-thirds of industrial silver demand is for electrical and electronic goods, including PCs, cell phones, and other telecommunications devices. How much more scrap from this segment will materialize is difficult to judge, but even if prices retreat substantially, we believe there will be sufficient economic incentive to increase recycling rates.

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The recycled silver jewelry market has not been a major source of supply, unlike gold, where it is an important source of supply. This may be because the silver supply appears to be far less price- sensitive to recycling than that for gold, possibly because of higher sales margins for silver products. At current prices, we believe, this metric also is changing. Higher prices are encouraging the public to hand in more jewelry and other silver items. Based on our conversations with smelters and refiners, we believe that the public is selling greater amounts of old silver items and jewelry for recycling, often along with gold items. An element of this may be distressed selling and more due to high unemployment than the price of silver. Also, high premiums on coin prices have virtually wiped out the recycled coin market.

According to GFMS, scrap supply rose by a sharp c27moz last year to 215moz. According to our supply/demand model, scrap supply contributed c9moz more to supply than new mine output. We expect that scrap supply may increase c20moz in 2011, based on current high prices. Further increases in scrap supply, along with increased mine output, have the potential to curb the silver rally.

Hedging: New attitude at higher altitude

Similar to gold producers, silver producers have tended to close out or buy back hedges in recent years. Because the bulk of silver output is obtained as a byproduct of gold and base-metals production, the marginal cost of producing the majority of the world’s silver is low. The incentive to hedge is therefore correspondingly low. Prices well above the marginal costs of production also reduce the need to hedge. Traditionally, mining companies have displayed a collective bias against hedging, and the industry still embraces an antihedging philosophy.

Commodities Global 10 May 2011

That said, we detect a small change in attitude by some producers. The rally earlier in the year may have reached levels at which even reluctant producers were willing at least to reexamine their hedging strategies. We detected the initiation of some new hedges toward the end of 2010. According to the Silver Institute’s Survey compiled by GFMS, producers hedged c61moz in 2010. This marked the first net hedging by the industry since 2005. We anticipate that net hedging may contribute c40moz to supply this year. The sudden drop in prices may also encourage producers to implement hedges. Should silver prices drop further, it is possible that producer hedging could exceed our forecasts as producer rush to lock in prices.

Demand trends

Investors demand for silver coins and physical silver bars was strong last year and remains vigorous. Based on our conversations with merchants and dealers, we believe that coin demand will remain robust this year and will rival but probably not exceed the record-high demand year of 2010. According to the US and Royal Canadian mints, silver coin sales remain strong this year. In January, 6.42m of the 1 oz Silver Eagle coins were sold. Although these sales eased in February, March, and April, they remain historically high. The recent pullback in prices may stimulate more retail investor appetite for silver coins. We forecast sales of coins and medals will remain high at c90moz this year but not exceed 2010 levels.

Coin and bar demand as a percentage of total demand is growing but is still modest, compared to jewelry and industrial uses. Nonetheless, we believe that demand for these products accurately reflects widespread retail investor concerns about inflation and USD weakness, fiscal profligacy, European sovereign debt risks, and geopolitical tensions. These concerns are driving demand for

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hard assets, including silver. A prolonged drop in sales may be an early signal that the price correction is not over.

Fabrication: Industrial action

Industrial and decorative demand for silver soared in 2010 from depressed levels in 2009, in line with the recession and the global slide in industrial production. As industrial production recovered, demand for silver is robust in the emerging and developed worlds. We forecast substantial growth in industrial demand for silver this year, based in part on HSBC economics forecasts of growth in global industrial output of 6.4%, with 9.0% growth in the emerging markets and 4.1% in the developed world. We forecast an increase in demand of c65moz to c552moz. In 2010, demand grew c84moz to 487moz, following

a decline in 2009 of c89moz to 404moz,

according to data compiled for the Silver Survey

by Gold Fields Minerals Services.

The electronic and electrical segments account for roughly two-thirds of industrial silver consumption. Using semiconductor demand as a rough proxy for electrical and electronic demand,

it appears that industrial silver demand is surging.

Semiconductor Industry Association (SIA) President Brian Toohey has said that impressive growth in a wide range of products reflects strong demand for semiconductors. An important component of growth was the automotive industry, which was increasing its demand for semiconductors. The world semiconductor market grew 31.8% in 2010, according to the SIA’s reporting of World Semiconductor Trade

Statistics data. The SIA forecasts 9% growth for 2011 and 10% for 2012.

New applications for silver hold the possibility of increased demand in the medium to longer term. We have outlined the potential for increased silver demand from these areas in previous editions of our Precious Metals Outlook. Two of the fastest-

Commodities Global 10 May 2011

growing new uses for silver are biomedical applications and solar panels. The Silver Institute has identified solar panels as holding significant potential. Other new uses include green technologies, security issues, food packaging, and cleaner energy sources. On an individual basis, these new applications for silver are small in comparison to other sources, but collectively, we believe, they will make a modest contribution to demand this year and next year.

Jewelry demand

Retailers reported a recovery in jewelry demand in 2010 and early 2011 from disappointing sales in 2009. Based on our conversations with merchants and fabricators, we believe that demand for jewelry and silverware has increased only moderately so far this year. Silver also could be gaining some market share at the expense of gold from price-sensitive buyers. Had prices remained in the vicinity of USD50/oz, we believe that jewelry demand may have contracted this year. Lower prices should help promote jewelry sales. This may be offset by persistent economic uncertainty in the US and other countries and declines in consumer sentiment, which may discourage consumers from purchasing luxury goods such as jewelry.

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Silver: Industrial and decorative demand (moz)

600 500 400 300 200 100 0 2001 2002 2003 2004 2005 2006 2007 2008
600
500
400
300
200
100
0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011f

Source: GFMS, Silver Institute, HSBC

GFMS estimates that jewelry demand in 2010 totaled 167moz in 2010, up from 158.9moz in 2009. Based on prices, we believe that jewelry demand may edge down to c165moz in 2011. Silver demand dropped to 50.3moz in 2010 from 58.2moz in 2009. Based on high prices, we believe that silverware demand will not exceed c50moz this year.

Indian demand, a major driver of jewelry demand, continues to recover from a near-collapse in imports in 2009. Heavy physical imports were recorded in India in late 2010 and earlier this year. Some of this may be due to a switch from more- expensive gold to silver by price-sensitive consumers. Based on our conversations with

Silver: Supply/demand balance (moz)

 

2003

2004

2005

2006

2007

2008

2009

2010

2011f

Mine production Official sector sales Old silver scrap Hedging Total supply

Fabrication Industrial and decorative Photography Jewelry and silverware Official coins Total fabrication Exchange traded funds Hedging Total demand

597

613

637

641

664

685

718

736

765

89

62

66

78

43

28

14

45

20

184

184

186

188

182

176

188

215

235

0

10

28

0

0

0

0

61

40

870

868

916

907

889

888

889

1,057

1,060

351

368

407

427

456

443

352

487

552

193

179

160

142

125

105

83

73

70

263

242

241

227

222

215

216

217

215

36

42

40

40

40

65

79

101

90

842

831

848

836

843

828

729

879

927

0

0

0

121

95

95

110

84

80

21

0

0

7

24

12

22

0

0

869

868

848

964

962

935

862

962

1,007

Market balance Market balance ex-govt stock sales

1

0

68

-57

-73

-47

137

95

53

-88

-62

-2

-135

-116

-75

13

50

33

Price (USD/oz)

4.88

6.66

7.31

11.55

11.55

14.99

14.99

20.19

34.00

Source: HSBC, Silver Institute, GFMS

Commodities Global 10 May 2011

merchants, we expect Indian demand to remain robust. The price decline from USD50/oz could stimulate further physical off-take. The bulk of Indian silver demand is located in rural areas, and the impact of the monsoon on the harvest and agricultural incomes will remain a strong factor in determining Indian silver demand. High food prices in India have boosted rural incomes and helped support silver demand.

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Commodities Global 10 May 2011

Platinum

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Platinum is likely to remain in a modest deficit in 2011, as we expect a mixed recovery in global auto production and strong industrial demand; investor demand will play a pivotal role We estimate producer output will increase modestly this year, assuming no major production disruptions in South Africa We are increasing our forecasts of average platinum prices and introducing a forecast for 2013

Raising our platinum price forecasts

We are raising our forecasts of average platinum prices for:

2011 to USD1,850/oz from USD1,750/oz.

2012 to USD1,750/oz from USD1,650/oz.

The long term (five years) to USD1,625/oz from USD1,600/oz.

For 2013, we are introducing a forecast of

USD1,650/oz.

Heading moderately higher

Based on our supply/demand model, we expect the platinum market to move from a surplus of 290,00oz in 2010 to a deficit of 30,000oz this year. Although this deficit would be small, we believe that it would be psychologically significant and support prices.

On the demand side, increases in auto production seem likely for the remainder of this year, according to automotive analysts on HSBC’s equity research team, but at a more moderate

growth rate than in 2010. Auto demand increases, the HSBC equity research analysts expect, will come principally from North America and the emerging world, notably China. Jewelry demand may be constrained by high prices, we believe. The decline in Chinese jewelry demand should help narrow the supply/demand deficit that we forecast for 2011. Should jewelry demand falter, this could have a noticeable impact on our supply/demand balance.

On the supply side, higher prices are encouraging platinum production at the margin in South Africa, but producers face a variety of challenges,

Platinum price (USD/oz) 2,500 2,000 1,500 1,000 500 0 Platinum 100 dMA 200 dMA Apr-01
Platinum price (USD/oz)
2,500
2,000
1,500
1,000
500
0
Platinum
100 dMA
200 dMA
Apr-01
Apr-02
Apr-03
Apr-04
Apr-05
Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11

Source: Reuters

Commodities Global 10 May 2011

including a shortage of trained personnel and equipment and the impact of a strong ZAR. Power

supplies remain tight, and should there be another electricity outage such as the one in 2008, the resulting decline in output could trigger a steep price rally. Much also will depend on the number

of industrial stoppages and accident related

shutdowns this year. These occurrences have clipped production noticeably in recent years.

Investor demand for platinum soared in 2010, particularly for the US-based ETFs. Investment will play a critical role in determining prices this year, in our view. Demand into hard assets, including platinum, is channeled by investor unease about inflation, fiscal profligacy, and volatility of financial markets. We expect investor demand to cool in 2011 from the strong gains of 2010 but to remain positive as long as investors remain uneasy about the global economy.

Driving moderately higher

Platinum prices have more than doubled since bottoming out just below USD800/oz in November 2008. Prices moved steadily higher throughout 2009 in response to lower mine output and increased demand from the recovery in global auto production. The rally accelerated in 2010, hitting USD1,752/oz on 2 May, before retracing

to USD1,452/oz on 21 May, as the sovereign debt

crisis triggered fears of a fresh global economic

slowdown. After trading in a broad, sideways range for much of last summer, prices took off again in September, as investor demand for hard assets rose in response to the US Federal Reserve’s announcement of a likely return to quantitative easing. Prices climbed above USD1,800/oz in mid-November before correcting

to USD1,693/oz by late November.

A positive outlook for industrial demand and

strength in other commodities, notably gold, buoyed platinum, which reached a year-to-date high of USD1,884/oz in early May, after

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recovering from a fierce but short-lived decline to USD1,654/oz in mid-March. The decline was triggered by the March earthquake and tsunami in Japan, the suspension of a large part of Japanese auto production, and concerns that automotive demand for platinum would also decline. Prices resumed their upward advance in April but fell back again in early May in line with a decline in gold and silver prices, though they remained well above the March lows. Since then, opportunistic buying by investors halted and then reversed the slide. Platinum remains considerably below its all- time high of USD2,300/oz set in March 2008.

The outlook for platinum prices remains generally positive, in our view. Platinum mine output growth is likely to be higher, but limited, and auto recycling levels may decline from 2010, while both auto and industrial demand are likely to continue to grow.

We expect weaker platinum jewelry demand in response to higher prices will free up additional supply for the auto and industrial segments. We anticipate a wide trading range for platinum of USD1,300-1,950/oz this year.

Platinum market deficit in 2011e

Based on our supply/demand model, we expect that the platinum market will remain in deficit, narrowing slightly to 30,000oz this year from 40,000oz in 2010.

On the demand side, increases in auto production are likely for the remainder of the year, HSBC equity research analysts believe. US auto demand is strong but that market is still recovering from very low levels in 2008-09, and auto production in the US remains substantially below 2000-08 averages. Chinese platinum demand for autos will be crucial in determining price. Auto production in China is slowing from very strong levels in 2010, but remains relatively robust. This holds true for most emerging-market nations. European

Commodities Global 10 May 2011

auto production is also pushing higher at a moderate pace. Based on automotive production forecasts by HSBC equity research analysts, we estimate only a moderate increase in automotive demand for platinum in 2011.

Inevitably, high prices are curbing consumer demand for platinum jewelry, despite its attractiveness, notably to the key bridal market. Also, food and fuel prices will crimp consumer incomes and limit Chinese jewelry demand at the margin. The decline in Chinese platinum jewelry demand should help narrow our forecast of a supply/demand deficit in 2011. Should Chinese demand falter further, this could have a noticeable impact on our supply/demand balance.

Investor demand for platinum soared in 2010, particularly for the US-based ETFs. Investment will play a critical role in determining prices this year, in our view. Demand into hard assets, including platinum, is channeled by investor unease about inflation, fiscal profligacy, and volatility of the financial markets. We expect investor demand to cool in 2011 from the strong gains of 2010 but to remain positive as long as investors remain uneasy about the global economy.

On the supply side, higher platinum prices are encouraging production at the margin in South Africa, but producers face a variety of challenges, including a shortage of trained personnel and equipment and the impact of a strong ZAR. Power supplies remain tight, and another electricity outage occur, such as the one in 2008, the resulting decline in output could trigger a steep platinum price rally. Much also will depend on the number of industrial stoppages and accident-related shutdowns this year. These occurrences have clipped production noticeably in recent years.

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Supply trends: Looking flat

Enough supply for decades …

We expect the platinum mine supply to continue to increase as high prices – well above the costs of production – provide a considerable financial incentive to producers to increase output, despite a host of challenges, including rising costs and infrastructure challenges in South Africa that may limit increases in output.

South Africa occupies a commanding position in world platinum production and reserves, accounting for 4.6m oz of output in 2010, or about three-fourths of world mine output, according to Johnson Matthey. The enormous deposits of platinum group element (PGE) in the Bushveld Complex in South Africa can be confidently relied upon to provide a major proportion of global needs for many decades to come, even if the appetite for platinum accelerates well beyond current assumptions.

According to a report published at the end of last year by R. Grant Cawthorne of the School of Geosciences, University of the Witwatersrand, c80% of the world’s PGE are in the Bushveld Complex. The report cited an estimated that Bushveld has sufficient PGE deposits to supply world demand for many decades, even assuming no advances in mining and extraction technology. We found it interesting that the scope of the paper went beyond the usual time frame of most commercial geological studies, suggesting that published reserve estimates are often restricted by rigorous international reporting codes. Nonetheless, even with the limitation of the regulatory codes, the reserves and resources reported by the four major mining companies in South Africa amount to at least 1.2bnoz of PGE, of which more than 50% is platinum, according to Mr. Cawthorne.

Commodities Global 10 May 2011

… but constraints in South Africa persist

Despite abundant platinum resources and high prices, the platinum industry has been growing well below private and government growth forecasts, expanding just 4% per year since 1990. South African producers face a host of challenges to raising output, including rising costs, notably for power, steel, cement, and diesel, high labor costs, safety issues, a shortage of trained personnel, long lead times to secure new equipment, power shortages, increased government regulation and supervision, and a strong ZAR. The following chart shows South African platinum production.

South Africa: Platinum production (moz)

5.4 5.2 5 4.8 4.6 4.4 4.2 4 2003 2005 2007 2009 2011f
5.4
5.2
5
4.8
4.6
4.4
4.2
4
2003
2005
2007
2009
2011f

Source: Johnson Matthey, HSBC

We regard limited power supplies in South Africa as one of the biggest threats to raising platinum output in 2011 and beyond. Platinum mining is a highly power-intensive enterprise, and platinum group of metals (PGM) producers are reliant on Eskom, the South African state-owned energy utility, for the vast bulk of their power requirements. Platinum production – and prices – are extremely sensitive to even modest reductions in power supplies. Eskom has acknowledged that power supplies will remain stretched until September 2012 at the earliest, when the first of six units of the 4,800MW plants under development are expected to come on stream.

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Supply constraints will not ease substantially until 2017, when additional power stations are slated to come on line.

In the near term, Eskom faces the possibility of labor disruptions as the peak winter demand period approaches. Members of the National Union of Mineworkers (NUM) employed at Eskom recently reiterated that they would take strike action against the state power utility in pursuit of a 16% wage increase. An NUM spokesman has said that although there was no time frame for the labor action, it would likely be before midyear. The NUM has said it has 16,000 employees at Eskom, which has a total workforce of 40,000. Given tight underlying supply/demand balances and the paucity of above-ground stocks, we believe that any disruption of power generation sufficient to halt production, even briefly, could have a pronounced impact on prices.

Cost pressures due to a strong ZAR are another challenge with which producers have to cope. The bulk of expenses, including power supplies and labor, are priced in ZARs, while platinum is sold in USDs. Thus, producers are affected by the USD/ZAR exchange rate. Historically, platinum producers have often found themselves pressured by either a low USD price for platinum or a strong local currency. Should the ZAR continue to strengthen against the USD, producers will come under further cost pressure.

Miners are also faced with escalating costs of steel, cement, fuel, and other inputs. Since 2009, platinum prices have risen faster than input prices, and producers have been able to cover their costs easily. Thus, high prices may have constrained production but they have not triggered cutbacks. Any sudden drop in platinum prices to near USD1,250/oz could jeopardize some high-cost projects.

Commodities Global 10 May 2011

Zimbabwe won’t make a dent soon

Zimbabwe has the world’s second-largest PGM reserves after South Africa. The Great Dyke could account for as much as 20% of known platinum reserves and holds the largest platinum deposits in the world after the Bushveld. The prospects for supply increases outside South Africa are limited.

Theoretically, Zimbabwe presents producers with almost ideal mining conditions. The workforce is well-educated and technically proficient, and platinum reserves are easily accessible, lying in scalable formations near the surface. Costs are lower than in South Africa, and working conditions are relatively safe. In practice, however, realizing Zimbabwe’s potential has been slow going. Development of PGM resources has been impeded by inadequate infrastructure, hyperinflation, poor economic conditions, and often ineffective government policies, according to the Zimbabwean Chamber of Mines.

Perhaps the greatest threat to the long-term development of Zimbabwe’s PGM segment is government legislation, particularly the Indigenization and Economic Empowerment Act, which requires foreign-owned companies to cede 51% of their equity to indigenous people. We discussed the law in more detail in Precious Metals Outlook: Golden sovereign (risk), (May 2010). The mining industry in Zimbabwe could stop growing if the government presses ahead with forcing companies operating in the country to be majority-owned by indigenous investors. Earlier this year, Prime Minister Robert Mugabe reiterated his determination to speed up the process under which ownership is transferred to indigenous peoples. Mr. Mugabe’s partners in the coalition government, the Movement for Democratic Change, oppose implementing the law too quickly and are known to have a more pro-mining bias than the Mr. Mugabe’s party. How the implementation of the law plays out may

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have important consequences for long-term platinum production.

The president of the Zimbabwe Chamber of Mines, Victor Gapare, said recently that although the mining industry is central to the country’s economic recovery, inept government policies threaten its viability. Mr. Gapare said that although investors that are already committed to mining in Zimbabwe would likely stay, the indigenization issue could cut off new capital coming into the industry. He said the mining industry needed an additional USD5bn of investment, with much of that required by the PGM segment, to meet its potential. Because Zimbabwe’s domestic financing sources are insufficient, all of this funding would have to come from abroad, he said. Most investors are waiting for completion of the indigenization and economic empowerment provisions before they invest further in Zimbabwe, according to Mr. Gapare.

Despite these impediments, Zimbabwe should produce c1moz of platinum annually in the next 10- 15 years, according to Mr. Gapare. Earlier this month, Anglo Platinum announced the opening of its new USD600m Unki Mine, which the company’s expects will become Zimbabwe’s second-largest platinum producer. Anglo Platinum’s Zimplats division announced last year an investment of USD450m for its expansion program.

Despite production challenges, we expect South African production will grow from 4.585moz in 2010 to 4.75moz this year. Outside South Africa, we see moderate increases in output trends. Johnson Matthey has estimated that Russian platinum production rose to 810,000oz in 2010 from 785,000oz in 2009. We believe it will be difficult for Russian production to total more than 820,000oz in 2011. We also see higher production in Zimbabwe, despite uncertain economic conditions in that country.

Commodities Global 10 May 2011

Challenges not bad enough, though

In response to high prices well above marginal costs of production, producers are increasing output wherever possible. They are expanding output and increasing exploration and production budgets. Despite these efforts, we expect mine supply to be constrained by increasingly frequent industrial stoppages and safety-related shutdowns.

The world’s largest platinum producer, Anglo Platinum, announced recently that its 2011 production target of refining and selling 2.6moz remains unchanged, despite a 5% fall in production in Q1. For the first three months of this year, Anglo posted output of 560,000oz. The decline was attributed to safety-related stoppages. The company said it had initiated plans to make up for lost production. It said it experienced more safety stoppages in Q1 this year than during all of 2010.

Eastern Platinum has announced that production at its Crocodile River mine in South Africa in Q1 fell by 7,365oz to 25,387oz from the previous quarter. An interruption in production due to an internal safety review carried out in January was responsible for the drop in output, according to the company.

Impala Platinum is South Africa’s second-largest platinum producer. In February, the company announced that its platinum sales for the six months ended 31 December 2010 totaled 801,000oz, up 15% from 694,000oz a year earlier. Unit costs were well-contained in the period, at ZAR10,271 rising 4% on an annualized basis as a result of the higher output. Meanwhile, capital expenditures increased 11% to ZAR2.4bn. The company said that a recovery at the giant Rustenburg mine was on track and that Mimosa continued to meet operational targets. The company has said its expansion strategy at Zimplats is making satisfactory progress. The

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company’s long-range production target of 2.1moz by 2014 is remains intact.

Lonmin, the world’s third-biggest platinum producer, reported that for its fiscal first quarter ended 31 December, refined platinum production fell to 81,982oz from 110,786oz a year earlier. The shortfall was due to the rebuilding of its main furnace. The rebuild and modification of the No. 1 furnace were successfully completed on schedule, and the furnace was recommissioned in mid- December 2010.

Lonmin is targeting sales of 750,000oz of refined platinum in the current fiscal year, up from 706,000oz a year earlier. It has a growth profile of 700-850,000oz total PGM. This should be achieved, according to the company, by ramp-ups at the Saffy, Hossy, K4, and K3 operations over the next five to seven years.

Aquarius Platinum, the world’s fourth-biggest platinum producer, said it had increased its attributable production 14% in the three months ended 31 December. Aquarius produced 127,579oz of PGMs in the quarter, a 14% improvement on output from a year earlier and a 3% increase from September quarter production.

Aquarius CEO Stuart Murray said that production was up strongly at the main Kroondal mine, and that both Kroondal and Marikana managed to reduce rand cash costs. Mr. Murray said the reopened Everest mine remained on schedule and continued to ramp up output. That mine was closed in late 2008, owing to a subsidence event. Aquarius remains on target to meet its production guidance for fiscal 2011.

Norilsk Nickel, the world’s largest nickel and palladium producer, is also the biggest producer of platinum outside South Africa. Earlier this year, Norilsk announced preliminary consolidated production results for the fourth quarter and all of 2010. The company reported production of