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Gold to the Rescue! Why is Gold such a good Investment?
By Marco Pietropoli, October 2009
Our significant holdings in Gold and Gold Equities have paid off. Many would argue that the big gains in Gold are yet to come. For now, we have stopped buying Gold and Gold Equities as we have recently broken through on the upside.
So why is Gold such a good investment at present? Well in economic terms Gold is “Cash”. Therefore when the alternatives i.e. Dollar, Euro, Pound and Yen are being systematically devalued by very loose monetary policy, Gold is a real alternative.
Gold, like all Commodities is priced in Dollars. There is a strong negative correlation between the Dollar and Gold. The Dollar has been collapsing this year. Why? You may ask. The US has massively increased their national debt over the last few years .
The fiscal position of the US government is projected to get substantially worse over the next few years even before you count the huge cost of healthcare reform , the state pension liability and the updating of ageing infrastructure . The US is also underperforming economically relative to many other countries.
Is there Inflation?
Gold is a hedge for inflation, which will return with a vengeance in the next few months. So why am I so worried about inflation when all the propaganda both sides of the Atlantic has been telling us that the biggest risk is deflation?
Well history shows that printing money causes inflation. Another way of looking at it is to say that the supply of money has increased substantially, but the economy has shrunk. Therefore there is more money chasing fewer goods and services. Prices have to rise.
I do understand the argument that says if wage inflation is low or negative how can inflation take hold? I would respond by saying that over the next few years it will be inflation that drives wages, not the other way around.
What about Commodities?
So what else is going to cause inflation? Commodity prices are set to rise and could rise very steeply. Commodity prices are negatively correlated with the value of the Dollar, which is likely to stay weak for the foreseeable future and could potentially collapse.
The continuing demand for Commodities from the Emerging Markets is going to be a big factor. The “West” has created a wasteful consumer society of disposable items. This is highly inefficient given that global recycling has not fully evolved yet and won't for years to come.
Historically most of the global population has existed in a sustainable subsistence level of existence in small rural communities. The changes over the last few generations have meant that an increasing percentage of the world population are becoming consumers of disposable items.
How is this affecting the environment?
The global population has grown massively and we are consuming in an unsustainable way as if the natural resources on this planet are endless. We have never really priced in the environmental cost of our activities. This will also have to be paid for at some point.
If left unchecked the costs of environmental clean up further down the road could be staggering. We are polluting the air and the sea at an ever increasing rate. Our impact on the landscape, wildlife and on the overall environment may not be fully understood or acted upon for generations.
Do we have enough energy?
We have become over reliant on carbon based products. There is now a strong indication that global oil supplies have peaked and will run down from here until they eventually run out.
In China, car sales keep rising at quite a pace. The increasing demand for carbon based energy products from the Emerging Markets may well outpace the demand destruction in the US and many of the other developed nations. But if production levels are falling, the reality is that even sluggish global growth will result in higher energy costs.
The per capita use of energy in the Emerging Markets is far less than that of the developed countries. Due to the shear population size of countries like China and India, the increase in global energy demand could be massive over the next generation. As many of the Emerging Markets are likely to grow in energy inefficient ways, at least in the near-term, demand will increase steadily.
Do we have enough food?
There is also a global shortage of food . Inventories are at the lowest they have been in decades and production is threatened by drought . More and more people are moving from living off the land in small rural communities, to being consumers of food items in an urban environment.
High energy and food costs are going to have a massively damaging effect on the global economy as consumptions of these items are in large part non-discretionary and the demand is fairly inelastic. Even if we were to get to 15% unemployment in some economies, 85% would still have their jobs and will need energy to get to work and back. Whether you have a job or not you still need to cook your food and heat your house in winter. Of course in the “West” we are now used to a vast array of electrical items in our homes and at work.
Higher food and energy costs could spark significant civil unrest as was evident last year when commodities had their big upward spike.
What about other commodities?
Infrastructure development in the emerging economies could be a real demand pull for base metals in the coming years. But there may well be downward pressure on prices due to slow growth in the traditionally rich countries.
The shortage of credit will make it very difficult for there to be sustained investment in new production of natural resources and food over the next few years. This will potentially lead to shortage of supply.
How will this affect the UK and the US?
Inflation will rise sharply in my opinion in countries with the weakest currencies and with strong negative current accounts (trades balances). This points principally to the US and UK where import costs are likely to rise sharply. Countries that have currencies linked to the US Dollar may also see sharp rises in inflation due to high commodity prices.
Gold is also the investment of last resort. So when many other more standard investments look poor, Gold will receive a great deal of attention.
Are equities a good investment?
The Equity markets will come under renewed pressure fairly soon due to realisation of what is to come. We have to accept fairly soon that there needs to be significant and sustained cuts in public spending in many countries. There will be rises in taxation , higher interest rates and higher commodity prices.
This has not been priced in to the Equity markets. What the markets have priced in at present is a”V-Shaped” recovery, when it is clear that most people believe that this is not going to happen.
The consumer, with lack of credit, is unlikely to create increasing earnings for many companies for some time. This is especially relevant if wage inflation is low. The consumer, especially in the US and in the UK, has a significant amount of deleveraging to do for the foreseeable future. Saving rates are still historically low and need to increase. This will have a damaging impact on consumer spending.
Business investment is likely to remain sluggish at best for the foreseeable future. This is due to the uncertainty about the business environment and because of lack of credit.
What about the Banks?
The problems in the banking system are worse than before this crisis began. Massive amounts of public money have not been followed up by a sustained effort to deleverage or change the bonus or risk taking culture of the banks.
The idea of “Too Big to Fail” has only got worse as the bank have been encouraged to merge. Governments have seemed unable to put pressure on the banks to make the necessary changes. A global agreement in this area will be difficult to achieve or implement. I agree with Joseph Stiglitz who suggests that even though politicians may like to make grand statements, the devil is in the detail and in the implementation. It is unclear at this stage whether any significant changes will be imposed on the banking system. It may take a subsequent crisis for governments to really get to grip with the situation.
There is also a contradiction in the approach by regulators and governments towards the banks. They are asking for more funds to be made available for lending especially to Small and Medium sized Enterprises, but at the same time they are demanding that they deleverage. These things can't both happen at the same time.
Many now believe that these large financial institutions are “too big to succeed” rather than “too big to fail”. They have become too powerful. They exert far too great a political influence and affect the efficient running of a competitive economy.
But Stock Markets have been rising!
So why have the Equity markets been rising so much and so quickly? Well when you print lots of money some of it will end up in Stocks. When the alternative of keeping money in Cash/Deposit or in US Treasury Notes/Gilts is very poor, due to the low yields, investors will look for other ways of generating returns.
There has been a stabilisation in much of the economic data that would suggest we have found a bottom to this recession. Also, over the last few months, many companies have managed to increase their bottom line due to drastic cutbacks in labour costs and other expenditure. This has made the market feel more confident about the future. It is difficult to see how further increases in profitability can be achieved without significant increases in top line sales in the coming quarters.
There is, of course, the rational expectation that this time it will be similar to previous cycles of recovery. This is of course unlikely, due to the amount of deleveraging that still needs to take place and the damaging effect of a weak Dollar.
Does massive Public Debt matter?
The ballooning government debt especially in the UK and the US, poses a significant structural problem. The governments are assuming that once the stimulus packages come to an end, the consumer will start spending again and confidence will return. If this does not happen the fiscal positions of these governments will be difficult to keep under control.
I believe that the level of debt and the continuing mounting budget deficits in the UK and the US may well be unsustainable once interest rates rise. The only way that I can see the debt being managed, is to monetise at least part of the problem and inflate your way out. By encouraging inflation and devaluing money you devalue to the debt as well. The huge increase in money supply will make Cash a very poor store of value.
But isn't Property always a good bet?
Property in many jurisdictions is likely to be a poor investment in the next few years. Property prices are a function of a number of different factors:
- - Availability of credit – the credit situation is unlikely to improve in the near term as the banking system still has a great deal of deleveraging to do.
- Population size – the population of many of the Western economies may well reduce in the coming years. As the jobs have dried up, some immigrants will return home. Fewer immigrants may be attracted as well.
- Credit scoring – the days of easy money have gone. People who could have got credit two years ago, simply can't now.
- Availability of mortgage products with low Loan to Values – buying a property with a limited or zero deposit is going to be very difficult. As we have limited savings in the UK , we are simply unable to fund larger deposits on mass.
- Economic activity and employment levels – Unemployment is likely to carry on rising for sometime yet and the recovery will be slow at best.
- Perceived wealth – The richer we feel, the more space we demand. The opposite is true if we feel we are getting poorer.
- Supply of Property – the UK government is planning to increase the housing supply .
Property is still overvalued. At their peak the average property price in London climbed to more than 10 times the average gross wage . Even with the falls in property prices that we have experienced in the last couple of years, prices are still expensive relative to income levels in the UK. This is before you consider that rising interest rates are going to significantly affect affordability.
Without the culture of borrowing we have had over the last few years, you should only really be allowed to borrow up three and a half times your gross wage. Property prices rose for many years at a faster pace than average wages. This simply cannot carry on forever. There has to be a strong re-correction to make property affordable again without the same level of debt to support the market.
Recent irresponsible rate cuts are now encouraging another property bubble. It is a disaster to encourage people to take out lots of debt at low interest rates. Nothing has really changed. Consumers are still being sold products on the basis of underwriting their affordability for the initial deal period (usually 2-5 years) not on the cost of servicing the debt throughout the term. A lot of the mortgage debt in the UK is on a variable rate and therefore it will be a disaster once interest rates rise.
What about Bonds?
Gilts and Treasury notes on a fixed coupon are also a really poor investment over the next few years as the value of the bond is negatively correlated with interest rates and inflation. We are at the lowest interest rates in history so there is only one way that things are going to go from here. Also there will a rapidly increasing supply of these assets due to the ballooning budget deficits.
Index Linked Gilts seem a very good buy at present and we have done very well on these over the last year. There is of course always the risk of oversupply in this area too if the UK government finds that it cannot raise the required funds on a fixed rate.
Corporate Bonds and High yield Bonds are positively correlated with the Equity markets and also negative correlated with interest rates. Both of these are likely to move against you in the next few years.
So if Property and standard paper based investment assets such as Stocks, Bonds and Cash become regarded as questionable, Gold will benefit. As Gold prices rise, other commodities like Oil and Base Metals may also become more viable substitutes as a store of value.
But isn't the Dollar always a safe Investment?
The really big story, which until recently had been systematically kept out of the mainstream press, is the Dollar weakness . The Dollar became the reserve currency by a process that began with UK leaving the Gold Standard in 1914 and was cemented in the Breton Woods agreement in 1944.
At the end of the 2 nd World War all the major economies including Britain, France, Germany, and Japan had been battered into submission. The only major economy with their infrastructure and industrial production intact was the US. They were also late to join the fight and had made good money selling arms. They ended up with most of the Gold and therefore it seemed logical for the global financial system to be based on the Dollar.
This worked fairly well over the last 60 years and they were the biggest and strongest economy and used to have most of the wealth. The situation is now that the US has most of the debt. China the Middle East and the rest of the Emerging Markets have most money and produce most of the products and commodities that are consumed by the traditional Western nations.
So where do we go from here?
A new financial system will have to be organised. As Jim Rogers would say “You can keep putting a band aid on a cancer patient all day long, but at some point you have to accept the situation.”
Propaganda and spin has not made people fully aware of the growing unease in the Emerging Markets with the current global financial system .
As far as I can see the main options for a new global financial system are the following:
- - A global super currency issued by the IMF (or alternative international body). The Chinese have been pushing for some time now for an expansion of the SDR loan notes that are currently being issued by the IMF. Many believe this should be adapted to include the Chinese Renminbi as well as the Dollar, Yen, Euro and the Pound. This would be a more solid way of trading Commodities. The main problem with this is that the IMF is selling some of its Gold . If a new global super currency is going to be credible the IMF should be accumulating Gold not selling it. One of the main benefits of a stable global currency would be to remove the damaging impact to the global economy of sharp fluctuations in Commodity prices.
- The other option that I have been discussing for a while is an ERM type of system starting with the G20 countries. An index could be produced from the system as a basis for trading Commodities. The system could be a stepping stone to fixing currencies and then producing a global currency. The system would have to be flexible enough to allow for the changes in relative strengths in the economies to be accounted for until broader economic alignment could be achieved (this of course may be very difficult to do in a short space of time). It would also need to allow for countries that get the entry level wrong to be re-priced (the UK famously crashed out if the ERM, so lessons could be learnt). The Euro could be the template. Many of course would argue that this is not a great template as the Euro hasn't been fully tested yet. It will be tested to fully in the coming years. The strong Euro will really test the commitment of many countries to sticking together especially in the light of increasing budget deficits. Others will argue that it has been a real success. The primary success in my view was to achieve political consensus, having a far easier way to trade and travel as well as integrating Europe further. This should make conflict between European countries even less possible in the future.
- Truly free currency movement. The Chinese have been keeping their currency artificially low for many years to make their exports cheaper. This has created significant global imbalances. Other countries have their currencies linked to the Dollar or the Euro. Truly free currency movement would allow for many of the global imbalances to be removed. The problem would still remain of how to trade Commodities. Commodities could be priced in Gold to remove the issue of paper being discredited. In this type of system many currencies, especially the small ones, would be vulnerable to sharp currency fluctuation which could be very damaging.
- The establishment of a World Government/Alliance and the issuing of a global currency.
- Something we haven't thought of yet.
Of course no system is perfect and may well be discredited at a later date, which is of course probable. Maybe the world will find that having everything based on a single currency is too risky.
The main problem with creating a new global financial system is that nothing in global politics happens in a vacuum. The way the world does business and many of the international institutions need reform.
All the global structures we have in place are based on the situation at the end of the 2 nd World War. Now, economic and political power is different and needs to take into account the Emerging Markets rather than simply the old colonial powers, Russia , the US and Japan.
The UN, the World Bank and the IMF obviously need reforming. But we also have a very inefficient system of international politics and trade talks. We get together for the G8, the G20, trade conventions and environmental convections. The idea of centralising many of these groups and functions is a good one. This could be done at the UN for example.
All this is going to take time even if we have a proper understanding of the issues, the right leadership and strong political will. All of which, I'm afraid, are not in obvious abundance.
The demise of the Dollar with no obvious substitute creates a systematic problem. There are only two ways that a transition to a new global financial system will take place. It will either be a smooth transition, or it will be chaos.
Is Gold really that good?
Gold may take over as the main store of value until a new credible global financial system is operational.
Gold is a near perfect metal for investment. Although, I repeat, that we are not actually buying more Gold or Gold Equities at the moment. If we are truly out the worst of this recession then people will demand more jewellery, especially in growing middle classes in the Emerging Markets. If on the other hand the economic situation is going to worsen then Gold is a traditional safe haven and an investment of last resort. The supply of Gold is limited on this planet and production is unlikely to increase substantially in the near term.
What are the downside risks for Gold?
There are risks to the downside for Gold, of course, as with all investments. Commodities in general are very volatile and you should take care not to be too exposed without fully understanding the risks you are taking. Gold Equities are far more volatile than Gold itself, so be prudent.
At anytime a central bank or the IMF could decide to sell some Gold. If this was dumped on the markets it would be bad for Gold in the near term.
Investors still have the same mentality (although it does seem to be changing) to buy US Treasury Bills and Dollars when they sell Equities. This strengthens the Dollar and usually reduces the price of Gold. Another Equity market sell-off could happen at any time. This trade does seem illogical given the relative situation of the Dollar and the US, but should be expected. I believe this standard trade will come to an end at some point soon. When this happens Gold will really have its big rises.
The US Dollar is one of the main carry trade currencies now. As risk aversion sets in again there is likely to be a sharp unwinding of the “ Mother of all Carry Trades ” as Nouriel Roubini is predicting.
A lot of the Gold in circulation has actually been minted with a nominal face value. Many of these coins where made many years ago so the nominal value is quite small. A government has the power to withdrawal the coins and only pay the nominal face value, rather than the value in weight. A government can even demand that you hand over all your Gold at a predetermined price.
You may think this is legal robbery, which it is, but it has happened before. You could regard this as a tax. Many investors believe that if you wish to hold actual Gold, it is better to hold it outside the US due to what happened in the 1930s where the US government confiscated Gold from its people. This could happen in other countries as well. It could have a significant impact on a counterparty meeting their liability for people that hold Gold in the form of Futures or other derivatives. This may affect the counterparty risk in products such as ETFs as well.
There are also distortions in the Gold market. For example we don't really know how much Gold is really held by governments . Gold may have been leased and can be used as collateral for transactions and credit.
How does all of this affect Investors?
No one really knows how all this is going to unfold. All I can say for certain is that we will experience huge volatility in the markets. This is likely to persist until a new global financial system is in place to create stability. Volatility will also be driven by the speed at which information and wealth moves around the modern world.
This will be a very profitable time for those that can get it right. I believe we are well placed for what is to come.
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