Point and Counter Point

July 16, 1998

Investors buy gold for six major reasons:

  • As an inflation hedge
  • Safe haven in times of economic and financial market instability
  • Currency hedge
  • Portfolio diversifier
  • Commodity based on supply and demand fundamentals
  • And in developing countries, A form of Saving.

For any of these reasons, there are valid arguments that gold should not or should be currently purchased:

INFLATION HEDGE: The present risk is deflation, not inflation, as witnessed by the sharp drop in commodities and flattening yield curve. Any inflationary pressures that may have mounted in the US will be offset by the Asian crisis which will worsen. It is just a matter of time before China devalues. The dollar will continue to gather strength as a safe haven and corresponding increasingly cheaper products flooding the US will further reduce inflationary expectations. This together with a reduction in exports will significantly reduce domestic industrial profits which is likely to collapse the US stock market. Kauffman, Roach and kind have been crying wolf so long that they are rightfully ignored. Even if there were inflation, as there are better alternatives such as inflation indexed bonds, gold would not benefit unless it was hyper-inflation which is out of sight. Recently, every time the Fed raised rates because of a threat of inflation, gold went down as it became more expensive to hold.

Counter Point: The risk is inflation, not deflation. Fed Governor Roger Ferguson sees no threat of US deflation. US inflation has been temporarily contained by a strong dollar and by a safe-haven flight into US bonds that has artificially lowered rates and in turn caused a spurious flattening yield curve which will enhance longer term inflationary pressure. The CRB has been affected by low oil prices which have more to do with over-production than as a result of deflationary forces caused by Asia. Currency devaluation is ipso facto inflationary in the subject country and steps to correct Asian economic problems are expansionary and inflationary. Public pressure is being galvanized to make them more so. In addition, Asia has engendered a perceptible tidal change in global CB attitude. The former roar of fighting inflation is now a hardly a whisper. Yet, unemployment in the US is near a 28 year low and decreasing in Europe. This containment of inflation will not last, particularly with the wealth effect of the stock market to contend with. Robust domestic consumer demand will offset any Asian export shortfall, and price pressure on services which are not affected by Asian imports will continue. In addition, the dollar's strength has occurred only because of capital flow into the US which will not be sustained.. If there are further Asian devaluations, or devaluation of other currencies, the US trade deficit will expand and more capital investment must flow to US to offset the deficit, which is unlikely. If Asia recovers, there will be a stop of, if not a return to, foreign investment from that region which outflow will not be offset from other regions. In either case, there will be a recognition that the dollar is substantially over-valued on a trade-weighted basis and because of a US 1.5 trillion foreign debt. The dollar's LT downtrend will then resume aggravated by investment into the nascent Euro, causing inflationary pressure, a sharp rise in bond rates, a rise in Fed rates to combat inflation, and a steep fall in the stock market. The Fed is then likely to attempt to correct the market drop by reduction in short term rates with gold as a beneficiary.

SAFE HAVEN: The Asian events and Gulf War evidence that gold has lost its role as a safe haven. Pundits correctly foresaw the Asian economic and financial crisis and resultant market instability, but instead of gold benefiting as predicted, it has dropped in value, ironically for this reason. Nothing has sparked investor interest into gold as a safe haven during recent times and there is no likelihood that it will perform this role under foreseeable events.

Counter Point: The reason gold has not fulfilled its role as a safe haven is due to it being priced in dollars and dollars being a proxy for gold. Once the dollar comes under pressure, and less valuable relative to gold, gold will resume this role. In addition, the Gulf War was a non event as there was no question of the outcome - the stock markets rose when it started. Russia, Iran-Iraq, and Saudi Arabia are political, financial and/or economic instabilities waiting impatiently to come on stage.

CURRENCY HEDGE: Asian investors have clearly demonstrated that they prefer US debt investments as a currency hedge as they flocked to these instruments instead of gold. This will be expected of other investors as well.

Counter Point: Gold has been at a disadvantage to the dollar due to its interest bearing debt instruments. But once the dollar and instruments come under pressure, and there is capital loss risk with these instruments, gold by default will have greater allure as a currency hedge.

PORTFOLIO DIVERSIFIER: Even gold fund managers now shun gold stocks. When there are sell-offs, gold stocks fall with the general market. Nothing suggests that institutions will diversify into gold, a non-performing asset. It is not enough to be a contrarian, one must have a valid reason to support a contrarian position which is lacking in the marketplace.

Counter Point: Psychology in the market can turn overnight. Once there is a clearer recognition of the attendant risks associated with the equity market, its relationship to a declining dollar with its affect on inflation and interest rates, and with financial instruments in general, gold will benefit.

AS A COMMODITY BASED ON SUPPLY AND DEMAND: Gold demand is centered in a few Asian countries which due to devaluation and economic problems gold has not only become more expensive but one has a lot less to pay for it. And there is dishoarding. This will cause a sharp drop in demand which will not be offset elsewhere as jewelry is a mature product. --- Bank supply will continue. The trend in central bank behavior is to replace gold with U.S. Treasury bonds, Japanese government bonds and European bonds. Even if Central Banks do not sell, leasing will supply abundant gold to the market. It is a sign of the times that the best an investor can hope for is that a major CB will not sell. He dare not expect it would buy, which it would do if gold were such a valuable asset. There is little evidence that a state currency benefits by the amount of gold held in reserve, but there is plenty to suggest it is irrelevant. Thus, demonitization will continue with adverse supply consequences and with the Dollar and Euro replacing gold as a reserve base. --- Producer Supply: Currency devaluation has benefited high-cost producers in RSA and Australia which will encourage hedging supply and prevent mine closure and a consequent meaningful reduction in production unless gold drops significantly lower.

Counter Point: Those who contend that gold will be demonitized and no longer form a meaningful financial role overlook that there have only been three great international currencies that have not had a fall-back value based on either gold or silver: the Chinese chuen, the British paper pound and the U.S. paper dollar. As a monetary asset, gold is not dependent on supply and demand for price as is a commodity. Historically, its value is set in relation to general price and there is no valid reason why this relationship should not continue. Once inflation comes out of the closet, or the rate of international capital flow sharply increases arising from currency risk or falling or hyper-volatile equity markets, banks will be less likely to sell or lease; and demand for jewelry due to its intrinsic value is likely to increase. (LBMA) chairman Peter Fava expects gold to reach $320 end of year due to central banks becoming net buyers. Gold dishoarding should by now be abated and the dishoarding is bullish for the longer term. Producer supply will be reduced because of cost reductions in exploration and development, which will offset, at least in part, any reduction in demand and aggravate any increase thereof. Additionally, and importantly, offsetting transactions arising from a reduction in the gold carry trade, leasing, and short sales will place a heavy mandate for gold at the beginning of the move.

SAVINGS: Savings input will be reduced in those countries where in place due to the high cost of gold arising from devaluation. Moreover, why should one be encouraged to save in a asset that relies on wars, failure of government, financial or economic instability, or other catastrophes to increase in price. Such savings is a most unseemly investment that only attracts moronic doomsayers who have a perverse view of society, a propensity to revel in catastrophes, a distrust of government and its leaders, and who are imbued with a self-sense of preservation brought about by paranoia.

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