A Case for the Defensive Asset Class: The Global Hedge Position, the Macroeconomic Environment and Geopolitical Tensions

February 5, 2003

Not long ago, Gold Fields Mineral Services, Ltd. published its Gold Survey 2002--Update 2. The report began with the following:

"Dehedging in 2002 added to demand for the third consecutive year with a record 352-tonne decline in net outstanding producer positions."
(Emphasis added)

When producers de-hedge, or close out short positions, they add demand to the market, since they can close out their short positions only by delivering gold in repayment of the borrowed gold. In 2002, global de-hedging, or the net amount of short positions that were closed out by the world's gold producers, added 11.3 million ounces of gold demand. Obviously, in a market in which all of the major gold producing nations combined, on an annual basis, produce less than 65 million ounces, 11 million ounces is a big number.

Of that 11.3 million ounces, 5 million ounces represented short covering by Barrick that took place in only 6 months (from April through July, 2002). Even in normal circumstances, the size of Barrick's position would have been large enough to have a significant impact on price. That impact is magnified by the fact that "the gold market has suffered massive loss of liquidity, giving up roughly 60% of its trading volume over the past few years. This lowered liquidity has been reflected in more pronounced moves..." (Source: Precious Metals Advisory, CPM Group, January 22, 2003).

However, what we have seen is just the beginning. The expected increase in investment demand that would produce a breakout in the price of gold is predicated both on the granting of the injunction against Barrick and J.P. Morgan and also on the idea that investors find very few attractive places to put their money.

  • The dollar has declined 9.2% since its February 2002 peak and many analysts still consider it to be overvalued, conscious of the fact that it is still 22.8% higher than its 1996 low and that, in this environment, money can be expected to flow out of U.S. dollar-denominated investments and into gold and other tangible assets. None of the analysts show much enthusiasm for the euro, pound sterling, yen or any other currency.
  • Interest rates are very low, but few analysts believe that we will see a major rally in rates over the next 12 months, giving little incentive to investors who would like to park their savings in money market funds.
  • The $7 trillion in losses that stock investors have suffered since 2000, along with the revelations of accounting, legal and ethical improprieties, have made shareholders deeply suspicious that the markets are rigged against them. Investors took more money out of stock mutual funds in 2002 than they moved into them, according to Lipper, the mutual fund analysis firm.
  • This has been the longest bear market since the 1940s and the equal of the 1973-74 cycle as the steepest of the post-WWII period. Threats of war, disappointing earnings and continued worries about the economy suggest that markets may get worse before they get better. Corporate earnings are deteriorating, economists are reducing their growth forecasts, a war with Iraq is on the horizon, and the bottom in the stock market may be quite a way off.
  • The outlook is bleak for most of the major industrial economies and for international financial markets.
  • All of this is being played out against a background of military and political uncertainty and the constant threat of terrorism in the United States and Europe.

During such times as these, Harry Markowitz, a Nobel Laureate in Economics and the "father of modern portfolio theory," said that the function of gold and other tangible assets was to serve as a Defensive Asset Class--one that consisted of assets whose appreciation could be expected to be proportionate to the depreciation in financial assets during periods of economic, financial, political and military turmoil. Based on increases in prices of tangible assets, and the renewal of investment demand for those assets, we appear to be at the very beginning of the stage of the economic cycle for which Dr. Markowitz prescribed gold and other tangible assets as the safe haven of choice for investors.

Nearly 40 percent of all gold ever mined was recovered from South African rocks.