Gold: Bull Markets Climb Walls of Worry
John Ing
Conspiracy theories, self-doubt, testing 2,000 years of history? The Da Vinci Code? No. Gold. Gold bullion's performance continues to defy conventional wisdom. Gold broke $700 an ounce to its highest price in a quarter of a century before retreating in profit-taking. Nonetheless, gold has risen more than 250 percent in the past five years, outperforming stocks, bonds and cash. Gold's move is due to the fact that the US has become the world's largest debtor in history. Gold generally has an inverse price relationship to the US dollar. As global rates inch up, there has been a major realignment of interest rates making non-dollar assets more appealing. The renewed flight from the dollar has been fast and furious, losing 6 percent against the euro in only a month.
Wall of worry
Bull markets climb walls of worry. With gold pulling back almost 13 percent, conventional wisdom is skeptical about gold's rise and sustainability. Such uncertainty has caused many investors to shun gold. Commodities have recently touched new records, reaching levels not seen for nearly two decades. However, when adjusted for inflation, commodities in real terms are even cheaper with crude oil and gold less costly than they were in the 70s. While most analysts are calling for the "pricking" of the commodity bubble, few have "drilled down" for the real cause of the price moves.
Simply, we believe that a commodities super-cycle has just begun. Two decades of neglect and inventory rundown sparked the upturn. We are experiencing a fundamental imbalance between constrained supplies and exploding demand. South Africa, the world's largest gold producer produced almost 11 percent less gold in the first quarter despite higher prices and will produce less then 300 tons this year, an eighty year low. South African production has fallen 40 percent in the past decade. Copper has done even better. The surge has been driven by concerns that China would vacuum up existing supplies, whilst hedge and pension funds have targeted copper and other commodities, seeking better returns than underperforming stocks and bonds. Commodity producers have simply failed to produce new sources of production.
In January 1980, gold hit $700 an ounce. Today there are parallels between then and now. In the seventies, inflation was rising for more than two years and was not seen to be a problem despite a credit expansion to pay for a war and higher oil prices. Inflation subsequently jumped to 13 percent. Gold? Starting at $50 an ounce it peaked at $850 an ounce on January 1980. Today like then, inflation has been creeping up. In April, the US consumer price index reached an annualized 5.3 percent up from 2.2 percent for all of last year and we are again told this is not a problem. Gold also traded at $700 and like then, the rise is also due to a lengthy period of easy money. Oil prices have tripled since 2003. In our view, gold is simply in the midst of multi-year secular bull market accompanied by a boom in commodities not seen since the 70s. Déjà vu.
Too much fiat money, too little gold
Gold is one of the oldest forms of money and a logical alternative to the US dollar. We have a bear market in financial assets and a bull market in hard assets. Gold is a constant or static while the dollar is a variable. Gold is priced in dollars. The price of gold is rising. Yes. But only because the value of the dollar is declining against gold. The greenback has lost more than 40 percent in the last three years and is still overvalued. Commodities too have become the new mainstream asset class and investors are diversifying from underperforming bonds and equities, seeking a hedge against the declining dollar.
In our view, gold's recent rise is all about falling confidence in the dollar, its debasement and the dollar's decline as the world's reserve currency. Gold has inherited the dollar's status as a safe haven. Gold's current run is driven by the wall of liquidity of cheap money and expectations that the central banks and governments will continue to inflate to avoid the damaging effects of higher interest rates.
America has flooded the international monetary system with dollars and dollar denominated securities to finance an enormous current account deficit to go with its massive budget shortfall. Their lack of savings and a policy of devaluing the dollar has caused record indebtedness of almost $9 trillion as well as and an explosion in liquidity. Once upon a time, hot money might have been playing internet stocks. Today this hot money poured $200 billion into the commodity markets. While these billions could disappear as quickly - newer money arrived with the introduction of ETFs, exchange traded funds with holdings at 443 tonnes for a value of about $9.3 billion.
Super-sized economy has to go on a diet
America's massive current account deficit puts an enormous burden on its trading partners, particularly China and Japan. The US trade deficit at $900 billion last year was a reflection that America is living way beyond its means, spending far more than it earns. Since 2001, Mr. Bush's spending has increased 7 percent every year. This super-sized economy has to go on a diet.
To pay for this deficit, the United States has to sell stocks, bonds, and goods to foreigners. American households' savings rate went negative for the first time since the Thirties. Alarmingly the Americans owe foreigners more than $5 trillion since 1999. The current account deficit at seven per cent of GDP is more than twice than that of the mid-eighties. That gap put another way, represents how much more America consumes than it produces. And the recent drop in the dollar will not cure these global imbalances.
The Americans are deeply in debt and are still talking about tax cuts and to solve the energy crisis, hand over $100 bills to their citizens to offset the high cost of gasoline. Amazingly, the lawmakers were happy to go deeper into debt and borrow even more from foreigners. That increase in debt and the resultant abundance of cheap money is a prescription for a weaker dollar and higher gold prices.
With rising global interest rates, the greenback faces competition as investors seek higher yielding currencies elsewhere. The stock markets of countries with even larger current deficits such as Iceland and New Zealand have been decimated this year. Since May, the Indian market has fallen a record 20 percent with a current account deficit at only 3.6 percent this year. The United States is not immune to the risk of a comparable sell off. And, with the Asians intervening less and less in the markets, the greenback no longer enjoys the benefit of the flow of funds, the interest rate gap narrows further.
Growing dependence weakens and isolates America
And that is the problem. The United State's huge and growing foreign indebtedness and its reluctance to curb its appetite for cheap oil and cheap debt is causing a huge global imbalance reinforcing the commodity super-cycle. The world's superpower is being financed by foreigners of which many are also its competitors for ever scarcer national resources.
Rather than browbeat China for its success in growing its economy, Bush should be looking for ways to solve this made-in-America problem such as the development of energy sources, conservation or fiscal policies that are not dependent upon others but on its own productivity.To blame China is easy but also misleading since the increase in China's trade surplus since 1996 is only one sixth of the increase in America's deficit.
President Hu's first official visit to Washington was noteworthy more for its symbolism rather than resolving both countries' complaints. President Hu for example visited Seattle before Washington, sort of business before politics. At the White House "welcome" ceremony, the well-staged introduction was interrupted by a Falun Gong supporter, of all things. And, President Hu's next destination was Saudi Arabia, sending a message to the Americans that oil is the real issue. The Americans blew their chance. Instead of a recipient of a $16 billion shopping spree of American goods and a book, "The Art Of War", President Bush should have tackled the real issue, energy and the interrelationship between both countries.
China bashers also raised the issue of China's banks' indebtedness of $900 billion despite the success of the Bank of China's $10 billion IPO. Built up over two decades, The Chinese bank debt was due to reckless lending. While myopic, the US Treasury and Western institutions are focusing on the absolute amount. In recent years however, China has restructured and reduced their banks overall liabilities. Few realize that under the Chinese banking system, the Government of China stands behind their Chinese banks. A failure would not be only a "loss of face" but cause a massive bank run. That could not be said for other jurisdictions such as Germany when the Herstatt Bank was closed in 1974 or in the United States when many savings and loans in Texas failed.
US dollar loses its status as a reserve currency
Sweden's central bank recently reduced its dollar holdings to 20 percent from 37 percent, putting the proceeds in euros. US Treasury data showed a decline in capital inflows to $69.7 billion and foreign purchases of US Treasury notes and bonds falling to a three year low to $3.1 billion. And that is not all. Foreign institutions, including central banks sold a net $6.3 billion of treasury notes and bonds in March, the largest amount of selling in a year. The Arabs recently have shifted part of their reserves of dollars into other currencies, particularly the euro and of course gold. Japanese holdings of US Treasuries have fallen by $74.5 billion since December. Asian central banks have been buying gold instead of dollars and rumors persist that China will diversify its reserves from dollars into gold. That said, the Chinese hold a large portion of their reserves of almost $1 trillion of reserves in dollar denominated securities. China has about 1 percent of its reserves in gold, compared with 15 percent in the European Community. Even Russia having surpassed Saudi Arabia as the world's largest producer of oil and with reserves of $243.3 billion, has not only questioned whether the dollar should retain its status as the world's main reserve currency, but pledged to raise its gold reserves from 5 percent to 10 percent of foreign reserves. Oh yes, Russia will accept only rubles for its oil and natural gas and will have the world's third largest reserves, surpassing Taiwan.
Not since 1984-1987 when dollars were dumped has there been an alternative to the dollar. Newly appointed Treasury Chief Paulson will bring much needed creditability to the financial markets and also offers expertise in dealing with China. Yet he is unlikely to alter an already weakening currrency. Indeed he is expected to welcome it, allowing the Americans to pursue a new weak dollar policy. Yet with Americans cheapening their dollar as part of a competitive devaluation policy, investors are losing faith in Washington's ability to finance its deficits and with their inflation fight wanting, what is the alternative? That alternative is gold. That is why gold hit a twenty-five year high and is to go higher.
America's insatiable appetite is its Achilles Heel
Thanks to America's insatiable appetite for energy and cheap money, the geo-political balance has shifted from the spenders to the savers, and the consumers to the producers. As prices rise, the balance of power has shifted giving more leverage to America's competitors many of whom give lip-service to democracy preferring instead to follow autocratic and anti-west policies.
The shoe is on the other foot. Former "have not" countries have grown richer by America's appetite for cheap oil and propose to grow richer by nationalizing the reserves held by the private sector many of them American companies. While the state governments appear to have found a new weapon, lost on these politicians is that foreign capital and expertise has underpinned the increase in reserves and production. For example, Iraq has yet to regain prewar production levels. The same could be said for Venezuela and of course Iran's output is nowhere near pre-1979 levels. There is a pattern here. Tearing up contracts, nationalism or bashing oil companies however is not exclusive to developing countries. In the United States, lawmakers too are talking of a "windfall" tax and similarly in Newfoundland, of all places, Premier Williams is threatening to nationalize offshore reserves.
Statism, nationalization or xenophobia will not bring on more oil and gas reserves or production. History shows that oil and gas is a cyclical business. When oil inevitability retreats, will these same governments invest the needed billions to maintain output? We think not. Where will they find the billions of capital and the technology needed to develop reserves? Governments do not have the know-how. Without capital and investment, this golden goose will have been cooked. Higher prices will ensue. That same pattern is occurring in the gold industry where the goose has been cooked in formerly hospitable jurisdictions like Venezuela, Chile, Peru and now Mongolia. Gold is a good thing to have as political risk everywhere increases. Higher prices too are in the offing.
Conclusion: it's a new world after all
Americans' financial profligacy and deepening geopolitical tensions have ushered in a new era. To be sure, America's flirtation with low long term interest rates has drawn to a close. Global commodity prices have risen sharply, and the surplus of liquidity in the East ushers in a new era of high prices. Global growth appears immune. Despite sixteen rate increases and crude oil hovering near $70 per barrel, the US economy grew a whopping 5.3 percent in the first quarter, the highest in two years. Japan's will grow 2.75 percent this year ending almost two decades of deflation. China grew by 10.3 percent in the first quarter. Higher interest rates and rising oil prices have not curtailed demand because governments have allowed even bigger increases in credit. The monetary excesses have simply led to the rapid expansion of hard assets from oil to real estate to copper and to gold.
The inflation in money will continue unabated, particularly since Helicopter Ben once described the Fed as a "printing press", able to "produce as many US dollars as it wished, at essentially no cost." Mr. Bernanke is off to a rocky start as Fed Chairman has abolished the Fed's publishing of monetary targets (M3). Few remember that inflation is a monetary phenomenon. Investors have already added a "Bernanke premium" in the marketplace. Mr. Bernanke is about to learn a lesson - that gold will do better than those dollars created by the printing press.
John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040
jing@maisonplacements.com
8 June 2006
The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.
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