In GOLD We Trust
Source: Erste Group, Ronald Stoeferle (6/23/10)
"2009 was an exciting and lucrative year for gold investors."
2009 was an exciting and lucrative year for gold investors. Our first target price of USD 1,300 was almost reached, but to reiterate an earlier statement—our actual target is USD 2,300/ounce. The gold price broke the USD 1,000 mark on a sustainable basis and increased by 24% y/y in USD terms and by 20.5% y/y in EUR terms. But 2010 and beyond should turn out even more interesting for gold—and we would like to discuss the reasons in our fourth annual Gold Report.
Gold has outperformed all other asset classes in the past 10 years, gaining an annual average of 16.5% since 2001 (or 13.5% in euro terms). Although copper and oil recorded similarly positive performances, their volatility was considerably higher and the trends more erratic. Since our first recommendation in 2007 at USD 650, gold has outperformed every other asset class by a long way. And the 2010 development has been outstanding as well—the precious metal has increased by 10.5% (in USD) or 28.5% (in euro), respectively, as of June 1, 2010.
Amid the global crisis of confidence, investors seem to be re-discovering the fact that gold has been used as money for thousands of years. In periods where "black swans" are no singular occurrences but are practically coming in flocks, the status of gold as a safe haven has yet again proven its worth. Gold is the money that has won the favor of the free market over the past millennia. Gold has always been a seismograph for the health of the financial and monetary system, as well as inflation. Although the focus is currently on the Eurozone, the turbulences should not distract from the problems in the U.S. and Great Britain.
Gold is an excellent measure of the quality of paper money. It contains no liquidity risk, and it is globally accepted and traded around the clock. There is also no credit risk associated with gold, and gold cannot turn worthless. The urge to own gold is based on two basic human requirements: on the one hand, the need for safety, and on the other hand the longing for beauty. These two motives are a constant in history. The economy develops in cycles. In times of prosperity and growth, confidence surges, and so does the risk appetite. In such periods, the need for safety is relegated to the sidelines. This behavior is currently undergoing a radical turn-around, and we believe that the REMONETIZATION of gold has now finally begun.
"Gold and Silver Are Money. Everything Else Is Credit" - J.P. Morgan
The statement that gold is "a bubble" has cropped up many times. We wholeheartedly reject this contention and will give you a number of reasons on the following pages as to why the parabolic phase is still ahead of us. And usually where the "bubble statement" is made, the claim that it is already too late to invest is not far either. But who bought for example shares at the low of the bear market in 1974, or oil in 1994 at USD 14? On the following pages, we shall give you a range of reasons why gold is still far from developing a bubble.
There are those who claim that gold is a bad investment. This would surely be a sound argument for anyone who bought gold at its cyclical high in 1980. But the most explosive increase only lasted three months (end-1979 to the beginning of 1980). The story changes once we compare gold to equities. It took the Dow Jones index until 1954 to pass its 1929 highs. The Nikkei index is still more than 75% below its all-time high of 1989. The Dow Jones has increased by a cumulated 1,400% since 1971, whereas gold (not being fixed anymore from 1971 onwards) soared by a factor of 40.
Gold is often portrayed as the investment of doomsday prophets, pessimists, and fear mongers who are hoping for the collapse of the financial system. However, they tend to forget that gold is an excellent portfolio insurance with a history dating back thousands of years. Nobody taking out fire insurance would wish for their house to burn down. The goal is only to protect oneself against the negative consequences, and in doing so, one pays a premium. However, it is crucial to hold the insurance policy before the actual damage occurs. As the saying goes "hope for the best, but prepare for the worst."
"Betting against gold is the same as betting on governments. He who bets on governments and government money bets against 6,000 years of recorded human history" - Charles de Gaulle
The following chart shows the development of gold in 10 performance deciles of the S&P 500. The fact that on 40% of the weakest days of the S&P 500, gold not only outperformed the market in relative terms but also recorded the best performance in absolute figures, illustrates that gold is an excellent "event hedge."
In 2009 we saw a paradigm shift: the central banks turned into net buyers for the first time in 20 years, even though gold had been repeatedly called "too expensive." Especially the Indian and the Chinese central bank were seen on the buying side yet again, whilst the Central Bank Gold Agreement (CBGA) hardly reported any sales. We think that this structural shift heralds a new phase of the bull market.
In an environment where the one-eyed man is king among the blind anyway, gold—certainly more than a one-eyed—should definitely retain its excellent outlook. One could also say that it is not gold that appreciates, but paper money that depreciates, leading to an ever increasing amount of monetary units required to buy one ounce of gold.
The following chart also highlights the clear downward trend of most fiat currencies relative to gold. The currency basket contains equal weights of U.S. dollar, euro, Swiss franc, yuan, Indian rupee, British pound, and Australian dollar. The downward trend is clearly intact and is in fact right on the trend line as we speak. There is little reason to believe that the downward trend would diminish in the near future, which is why we of course stick to our positive assessment of the gold price.
In 2010 the gold price has now also de-coupled from the U.S. dollar. The latest development shows that a stronger greenback does not necessarily entail a weaker gold price. In spite of the dollar rally the gold price remained high and even set a new all-time high. This is even more remarkable in view of the weak seasonality, and might suggest a new phase in the current bull market. Bull markets in gold are also characterized by two extremely strong human emotions: fear and greed. The combination of these two factors should trigger a parabolic increase in the last phase of this trend, and as a result we expect the gold price to reach our long-term target price of USD 2,300 at the end of the cycle.
Numerous aspects remind U.S. of the last big bull market in the 1970s. In line with the development in the past decade, central banks were then selling massive amounts of gold prior to the last bull market (especially from 1961 to 1972). The following chart documents the increase in money supply, inflation, and the outperformance of gold in this period.
In a historical context, every reflation cycle led to another asset bubble; in the 1970s it was commodities. There are many signals that suggest that we may be facing a similar development to 1974. A drastic shortage in gold supply, growing risk aversion, a lack of trust in paper money, a substantial increase in money supply, and—sooner or later—the recovery of the global economic growth could lead to a development of a comparably parabolic nature. On top of that, while the mining industry has somewhat recovered, the margins are still low, and some of the marginal costs are dangerously close to the spot price of gold. But at the moment we seem to be going through a phase of re-evaluation of policies among the Western central banks; the time of big sales is definitely behind us, while the emerging markets are still buying. This means that as far as increases go, we might shortly be in for the phase with the biggest momentum. As a result we expect the gold price to reach our long-term target price of USD 2,300/ounce. The gold price increased by a factor of 24 during the bull market in the 1970s. In relation to the current bull market, this would mean a gold price of USD 6,000.
Gold in the Context of the Financial Crisis
The paradox is the trigger of the crisis, i.e. too cheap money, is now being treated as its medicine. This could be regarded as an absurdity of historical proportions. Three years ago probably nobody would have expected the Federal Reserve to take USD 1,250 worth of mortgage-backed securities (MBS) onto its balance sheet. This is certainly not a step that would be beneficial to building confidence in paper money– and neither are the countless desperate stimulus and bailout packages of the past few years. On the other hand this represents a clear argument in favor of gold and should thus ensure a positive environment for gold investments.
The following quote is an impressive reminder that history tends to repeat itself:
"We have tried spending money. We are spending more than we have ever spent before and it does not work. . .We have never made good on our promises.. . .I say after 8 years of the Administration we have just as much unemployment as when we started, and an enormous debt to boot!" - Henry Morgenthau, Secretary of the Treasury during the New Deal, May 1939
The Federal Reserve has not been publicly audited a single time since its incorporation in 1913. Now, after years of discussion, a watered-down proposal seems to be close to signing, although it will still have to pass the Senate. The Fed has so far shown dismay at the idea, and only Jeffrey Lacker, President of the Federal Reserve in Richmond, has had open ears for the proposal. The claim that the stability of the value of money was the highest priority seems like a case of cheap talk. Since the incorporation of the institution in 1913, the dollar has lost 95%, and 82% since the end of Bretton Woods in 1971. On top of that, government debt has increased by a factor of 44. The closure of the "golden window" on 15 August 1971 by President Nixon was tantamount to the U.S. declaring bankruptcy, and the U.S. dollar lost almost 40% relative to the German mark within 20 months. The depreciation against gold was even more dramatic: in 1971 USD 1,000 would have still bought you 25 ounces of gold, 10 years later the same amount only bought you two ounces.
The question of the optimum timing to abandon the zero-interest rate policy is difficult to answer and - as is often the case - would require the benefit of hindsight. In their study "Exits from recessions" 5, the two U.S. economists John Landon Lane and Michael Bordo show that the Federal Reserve tends to raise interest rates too late. Even in "normal" recessions that were not accompanied by severe banking and financial market crises the Fed would usually react too late. Since the end of the 1960s, the Fed has attached greater importance to the labor market. Only once the labor market had recovered on a sustainable basis, would the Fed increase rates. The current situation is somewhat similar to the period of the late 1990s. At the beginning of 1997 the fed wanted to start to gradually increase interest rates. The Asian crisis, followed by the Russian crisis and the LTCM collapse rendered the increases obsolete, in fact, the Fed even continued to cut rates, which further fuelled the NASDAQ bubble.
A few decades ago, the U.S. was still the biggest creditor nation. In the 1960s private consumption started to grow faster than production, and wealth was gradually being consumed. Household debt in the U.S. (as measured by the ratio of debt to disposable income) increased from 55% in 1960 to 65% in 1985. In the course of the following two decades debt almost doubled to 133% in 2008. During this period the savings ratios were on a steep decline, which is why private consumption increased faster than disposable income and fuelled the U.S. economy.
This means that deleveraging on a household level cannot be avoided. If it were achieved through an increased savings ratio, this would affect U.S. consumption and in turn the global economy. The other option is to shift the problems to the banking sector in the form of more foreclosures. The process will be painful in either case. The share of public transfers in the household income has recently increased to 17.5%—from 5.6% in 1960. The following chart shows that the U.S. willingness to save experienced but a short renaissance. Currently around 3% of the disposable income ends up on savings books, whereas the historical median is 7.5%. The fact that wealth cannot be created by excessive and hedonistic conspicuous consumption seems to remain unknown to many.
But not only private households are heavily indebted—governments are faced with the same problem. The "Long Term Budget Outlook"6 of the Congressional Budget Office (CBO) paints a bleak picture. The report for the period of 2010 to 2080 (!) starts with the words "Under current law, the federal budget is on an unsustainable path—meaning that federal debt will continue to grow much faster than the economy over the long run. . ." According to the report the U.S. will not be able to produce a budget surplus in the next 70 years.
Even though at the moment the limelight is on Greece and the other PIGS countries, the situation in the U.S. and the UK is just as precarious. We cannot see any austerity measures in the USA. In August 2009 the forecast for the new debt of the coming decade was revised upwards from USD 7 trillion to 9 trillion. From May 2009 to April 2010 debt increased by USD 1,710bn or 11.7% in terms of GDP. A little side note—in 2000, Bill Clinton had announced that by 2010 all U.S. government debt should be paid off. Currently U.S. government debt amounts to USD 13 trillion, which equals USD 42,000 per capita.
If it is impossible to generate a surplus even in prosperous times, clearly the problems are of a systemic nature. Due to compound interest, debt grows exponentially, which causes massive problems in the long run. As soon as debt plus interest is growing faster than revenues, a vicious circle of debt is set off. The following chart illustrates the gradual divergence of expenditure and income (or outlays and receipts).
The U.S. is expected to issue more Treasury bonds in 2010 than the rest of the world combined. The balance sheet of the Federal Reserve has deteriorated dramatically as well. Between December 2008 and March 2009 it purchased fixed-rate securities worth USD 1,700bn, or almost 12% in terms of GDP. The majority (USD 1,250bn) was made up by mortgage-backed securities of highly dubious value.
In one of its reports, McKinsey analyzed 45 deleveraging phases since 1930. In 50% of cases the debt was paid off through a stepped up savings ratio, which would typically lead to deflation almost every time. The growth path has been chosen three times in the more recent history, but this often turned out expensive and bloody, i.e. it would typically involve war. On average the payoff would commence two years after the onset of the financial crisis and last six to eight years according to the study. From 1929 to 1933, i.e. in the thick of the Great Depression, the private household debt fell by 32%. As a result of the reduction of private debt, the public sector had to step up its debt so as to offset the lack in demand. Thanks to these measures, the economic growth rates are positive, but clearly below the potential.
History offers a number of interesting analogies with regard to the status quo. In the Roman Empire, the silver content of the denarius coin was gradually reduced. Bread and circuses, the bloated bureaucracy, and the rising military expenses led the public finances to get out of hand. In addition, the production of goods was moved further and further into the peripheral areas of the empire. The overall tax ratio increased to two thirds of income, and the size and complexity of the administrative organization were constantly rising. Therefore the currency was subject to a gradual depreciation. In the 1st century B.C. the silver content was close to 95%, but by 286 AD the denarius only consisted of 0.5% of silver. The example of the decline of the Roman Empire highlights impressively how swelling bureaucracy and the misallocation of resources can lead to inflation and in the long run to collapse.
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