Many investors in gold and the shares of gold mining companies had expected that the end of the bull market in financial assets would herald an end to the 18 year long bear market in gold. These hopes were dashed during August this year as the gold price continued to fall even as the US stock market began to crumble. By the end of August gold was languishing at its lowest levels in 19 years despite an almost 20% fall in the US stock market and greater declines in the major European markets.

An explanation for the inability of the gold price to rally in response to the financial turmoil swirling around us has been provided by Martin Armstrong in some of his recent articles. Armstrong, who had previously been bullish regarding the outlook for gold, now believes that the gold price could decline to around $200 by early 2000 before a reversal in the long term trend emerges. His reasoning is that, as the financial crisis engulfing the world grows worse, the overwhelming need will be for cash in order to pay bills. During the Great Depression, gold represented liquidity and could be used to pay bills. All commodities, with the exception of gold, declined during the Great Depression and reached a bottom in 1932 at the same time as stocks. Today, gold no longer represents liquidity and will hence behave like other commodities during times of deflation.

Although I have a great deal of respect for Mr. Armstrong's ability to analyse global capital flows and interpret their effects on the relative values of currencies, stocks, bonds and commodities, I believe there are some flaws in his current thinking. Firstly, gold will rise in value as uncertainty increases and confidence in financial assets declines because it represents liquidity OUTSIDE the financial system. During the Great Depression the US dollar was on a gold standard. Today, the US dollar is backed by confidence in the US Government, economy and banking system in exactly the same way as the Indonesian Rupiah is backed by confidence in the Indonesian Government, economy and banking system When that confidence declines, people will naturally seek a means of storing wealth outside the financial system.

A second error in Mr. Armstrong's analysis is his conclusion that we are entering a period of deflation. Deflation occurs when the supply of money decreases, leading to an increase in the purchasing power of money. Wealth destruction is not deflation. During the past 12 months none of the countries throughout Asia, with the exception of Hong Kong, have experienced deflation. They have, in fact, experienced varying degrees of inflation. The supply of money has increased dramatically in many SE Asian nations, contributing to a reduction in the value of their currencies relative to physical goods, gold and the US dollar. When money has no intrinsic value and can be arbitrarily created in unlimited amounts, it is difficult to imagine how deflation could ever really be an option in today's world. As government after government resorts to the printing press in order to stimulate economic growth, the demand for gold and other physical assets will grow. Even in the US, where the Fed has expressed concern in the recent past regarding the high rate of money supply growth and its inflationary effects, we are now seeing a shift in expectation from an interest rate increase to an interest rate decrease. However, the US economy is not significantly different today than it was 2 month's ago. What has actually changed is that the stock market has fallen at a disconcerting pace. I expect we will see further weakness in stocks over the coming weeks and that the Fed will react to this situation by injecting a substantial amount of money into the banking system, thus confirming that inflation will once again be chosen as the most palatable option and setting the scene for a rally in commodities.

Confidence in the US Government, the US share market and the US economy has remained extremely high during the past year as a large part of the world has collapsed in a heap of financial rubble. Massive currency de-valuations throughout SE Asia, uncertainty surrounding EMU, the unmitigated failure of the Japanese Government to address any of the structural problems facing their economy, and most recently the financial meltdown in Russia have ensured that the US has remained the centre of global capital flows. However, the tide appears to be turning. Between 11th August and 11th September the Dollar dropped by over 10% against the Yen and the focus of dollar-based investment has shifted markedly from equities (and corporate debt) to US Government debt. It is also interesting to note the sharp fall in the shares of US banks, many of which have dropped by 50% from their highs, perhaps indicating a growing fear amongst investors regarding the exposure of banks to derivative related losses and/or Latin American debt.

Money is currently flowing towards the perceived safe haven of US Government debt, a situation which will most likely continue in the near term. However, it is unreasonable to expect that the nominal yield on the debt will drop below the inflation rate and, if the US Federal Reserve reacts in the way I think it will in response to falling share prices, the inflation rate is set to rise significantly. Any further upside potential in bonds from here is therefore somewhat limited. The US dollar, although currently undergoing a large correction, will likely remain king of the fiat currencies simply because the US economy will suffer the least amount of damage as a result of the spreading financial crisis and because the policies of the Japanese Government will guarantee the continued net outflow of investment capital from Japan to the US. In particular, the second stage of Japan's Big Bang reforms due at the end of this year will see the liberation of the 1,200 trillion Yen which currently resides in bank trust funds. With Japanese interest rates hovering near zero, a significant portion of these funds will no doubt make their way to the US and probably give us the cyclical peak in US Treasuries.

Following the July 20th high in the major stock markets, the gold price has remained under pressure as fears of a fire sale of Russia's assets and the perennial concerns over possible IMF gold sales have encouraged speculators to accumulate a record net short position in gold futures. The continued bear market also maintains a healthy demand for borrowed gold which is subsequently sold into the spot market, further depressing the price. However, indications are that a new investment cycle has begun which will be characterised by declining confidence in financial assets and a corresponding shift in focus towards the precious metals and other physical assets. If only a small portion of the trillions of dollars of investment capital which is sloshing around the globe seeks refuge outside the financial system, then the gold price will rally strongly.

Milhouse

16 September 1998

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