The World Economic Crisis and the Outlook for Gold (Dec 4, 2008)
Thank you Mr. Chairman for that flattering introduction and thank you to the conference organizers who have made it possible for us to exchange information and insights into the future of gold here in China and in the global marketplace.
You should know that my presentation today will be posted on my website, NicholsOnGold.com, so you can easily check back in a few days, or a month, or a year – to review my analysis and my expectations for gold.
A few weeks ago, I mentioned to a Chinese acquaintance in New York that I would be traveling to Shanghai. He said, with some excitement that his family was originally from Shanghai and that he still had relatives here. Then he told me about a friend of his grandmother . . . a very old lady who is a fortuneteller of great repute. He said, in all seriousness, that I must visit her before speaking here today on the outlook for gold, just to be sure, and volunteered that his cousin would accompany me and translate.
So yesterday afternoon, we visited the old lady in her new apartment. We were offered tea and sat down together to talk. Finally, I asked: “So where do you see the price of gold next year?” To which the old lady replied: “Well, young man, we’ll just have to wait and see.”
Jeff Nichols addresses China Gold Summit
What the old fortuneteller really meant was this: Global asset markets have jumped into another dimension – a non-linear “Alice in Wonderland” universe – where the irrational and unpredictable have suddenly become the most likely.
Indeed, writing a forward-looking speech – at this moment of unprecedented worldwide economic crisis and uncertainty – has been like trying to hit a fast-moving target. Today, the price of gold has less to do with ordinary supply and demand fundamentals . . . and much more to do with fear-driven investment and speculative demand at the margin.
Every country is now affected by the spreading recession. From day to day, the business news worsens, bankruptcies and unemployment mount, one central bank after another cuts interest rates, new fiscal initiatives and other policies are undertaken – some of them seem wise, others may prove to be less so – and the United States, still by far the world’s largest economy and dominant political force, is in the midst of changing Presidents and changing directions in Washington.
Where We Are . . . Where We’ve Been
The International Monetary Fund is now forecasting that 2009 will bring the first aggregate decline in global economic activity since World War Two. It will also be the first synchronized slump with the United States, Europe, and Japan all in the same sinking boat.
Economists and policymakers are at sea in unchartered waters. Since they don’t know how deep and long-lasting the recession might be, they don’t know how extreme their actions to combat the slump should be.
So far, in one country to the next, economists and policymakers have been slow to recognize the severity of the recession and slow to react.
At this time of extreme global economic crisis and financial risk, we might expect to see the price of gold moving sharply higher.
But apart from the brief period earlier this year (coinciding with the collapse of the American investment bank Bear Stearns) — when gold shot up to a new all-time high just over $1030 an ounce — the yellow metal has not performed true to course.
Instead, the first quarter advance proved to be a bubble with large-scale institutional speculators driving the price first sharply higher . . . and then sharply lower over the next seven months.
Looking at the numbers, gold began the year at just under $850 an ounce. Since then, it soared like an eagle to over $1030, fell back to a recent low briefly under $700 an ounce, rallied to $820 last week, and has since fallen partway back to trade around $770 in the past few days.
In spite the lack of direction and day-to-day price volatility in the gold market this year, at least we can say that no other asset class has held its value quite so well.
Negatives for Gold
In my view, gold’s decline in recent months has been a direct consequence of the unfolding global economic situation. In a sense, gold has been an innocent bystander to the financial hurricane hitting Wall Street and financial markets around the world.
Gold’s own positive fundamentals – and even its role as a safe haven in turbulent financial seas – have simply been overwhelmed by massive selling of virtually all securities, commodities, and other investment assets and a flight to cash and near-cash alternatives in the form of U.S. Treasury debt.
Let’s take a look at the main factors and forces that have conspired to push gold lower in the past half-year:
Much of gold’s weakness in recent months can be blamed on indiscriminate shedding of long commodities positions by hedge funds and other institutional players in order to raise cash, increase liquidity, cover big losses in equity and other asset markets, or simply wind down and return cash to their investors.
Often these sellers were not holding individual commodities but baskets or indexes that included gold – so gold got dumped along with everything else. In other words, gold was sold not because it was singled out as an unworthy holding but simply because it was a component in the indexed baskets of commodities held by many hedge funds and institutional traders.
Large-scale bullion speculators have also sent gold reeling over and over again by selling the metal short on futures exchanges at moments of technical vulnerability.
This selling by funds and institutional speculators was amplified and accelerated by the lack of market liquidity, automatic program trading, and the continuing reassessment of global economic prospects suggesting further deep declines in demand for one commodity after another.
Moreover, some wealthy private investors and private family funds were reportedly liquidating gold and silver holdings to raise cash and cover their losses on equities, real estate, and other investments.
In addition, the decline in inflation and inflation expectations due to the fall in oil and other commodities prices and the increasingly gloomy economic outlook dampened demand for gold among some who look to the metal as an inflation hedge.
Golden Spring
Does this mean that gold is suddenly no longer a safe haven in turbulent times . . . or a hedge against inflation . . . or a useful portfolio diversifier? Of course not — but it does demonstrate that at times of panic even the yellow metal can fall victim to developments in other asset markets.
Now, not withstanding the latest price retreat, it looks like the intensity of commodity disinvestment is diminishing. Quite possibly, the commodity holdings of hedge funds and other large-scale players are nearing depletion . . . so there’s not much remaining to sell. The vaults are nearly empty, so to speak — and, to the extent that these were actual physical positions, the gold has presumably moved to stronger hands.
Recent data on COMEX, TOCOM (the Tokyo Commodity Exchange), and Exchange Traded Funds suggest that the October-November wave of sustained liquidation of long gold futures positions has abated and may be nearing an end with the emergence of some fresh buying and a decline in short selling.
Golden Dichotomy
Perhaps the most positive leading indicator of gold’s future price is the continuing strength of individual investor interest in the yellow metal in contrast to the institutional selling I mentioned earlier.
Household investment in gold – as a safe haven, inflation hedge, and portfolio diversifier – is booming in most markets. Although the major mints of the world are working flat out, coin retailers continue to report shortages of the popular gold bullion coins – the American Eagle, Canadian Maple Leaf, the South African Krugerrand, and the Austrian Philharmonic. And, similarly, bar fabricators report strong demand, high price premiums, and long delivery times for small bars heading to the Middle East and Asian markets.
In recent months, we’ve seen strong physical demand from ordinary investors and savers driven by fear, rushing for the safety and protection historically offered by gold.
Importantly, these buyers are not traders looking for quick gains but scared people seeking to protect their wealth, their savings, and their retirement nest eggs.
And this strong household demand is global – not limited geographically to any country, region, class, or station. People everywhere are buying gold as an insurance policy against the unknown.
Somehow, I don’t think they are all wrong and the wizards of Wall Street who are selling gold are all right! Rather, this wave of gold interest is a harbinger of gold’s ultimate ascent.
Official Sector – Stealth Buyers
I’d like to say a few words about the official sector – central banks and sovereign wealth funds – since these players may have a big impact on the gold market in the years ahead.
On average, the central banks of the world hold around 10 percent of their international reserves in gold.
However, the percentage of gold in total reserves varies greatly among central banks and from region to region. The major Euro-zone nations together hold about 58 percent of their assets in gold. In contrast, the Asian nations as a group hold only about 2 percent of their reserves in gold.
China, America’s biggest creditor – with some $1.4 trillion invested in U.S. Treasury securities – has only one percent of its reserves in gold. Japan has only 2.1 percent of its reserves in gold, and Taiwan has about 3.8 percent of its reserve assets in gold.
Another big holder of U.S. debt is Russia with about $330 billion in reserve assets, of which only 2.1 percent is in gold.
If I were advising the central banks of China, India, Japan, Russia and other nations with a low percentage of reserves in gold, I’d be saying buy, buy, buy whenever the market presents an opportunity.
One can imagine, especially with today’s world economic and political situation, the central banks of these countries with large U.S. dollar holdings might like to diversify, if only to reduce risk.
Unfortunately, any attempt to purchase in the open market significant quantities of gold relative to the size of their international reserves would be terribly disruptive and self-defeating.
But, China and Russia could gradually add to their gold holdings by taking up the output of their domestic gold mines.
Today, a number of countries are employing sovereign wealth funds to invest in a variety of assets ranging from equities and corporate bonds to real estate and gold. Unlike central banks, these funds typically operate anonymously and secretly with no international reporting requirements – and can diversify their countries’ wealth out of dollars with fewer international political consequences and less disruption or influence on the marketplace.
Sovereign wealth funds have been around since 1953 with the establishment of the Kuwait Investment Authority. More recently, in September of 2007, China established a major sovereign wealth fund – the China Investment Corporation (or CIC) – with an initial capital endowment of $200 billion.
Other big sovereign wealth funds include Abu Dhabi (with more than half a trillion dollars in investments), Singapore (with $200 billion to $400 billion invested, Norway (about $300 billion), and Russia (more than $100 billion).
Sovereign wealth funds now control huge resources – by some estimates as much as $3 trillion . . . and if current trends continue these sovereign wealth funds could total as much as $10 trillion in the next five or six years.
One more thing: I think some of the sovereign wealth funds of countries with large and growing foreign exchange reserves already may be “stealth” buyers of gold on behalf of their governments wishing to diversify, if only a little, out of U.S. dollar-denominated assets.
Although there is no hard evidence, it is easy to imagine that some of these funds have accumulated gold and other non-dollar investments – and some analysts have suggested the China Investment Corporation may soon will be among the gold buyers.
Deflation in the Air
I want to return now to the unfolding economic situation.
With deflation in the air, gold bulls are separating into two camps — inflationists who see gold as a hedge against future inflation and a decline in the U.S. dollar’s purchasing power . . . and deflationists who see gold as a deflation hedge as money seeks safe harbor in cash and cash equivalents like gold.
These days, everyone knows about inflation having experienced first hand in recent decades . . . but few of us have experienced deflation or understand its causes and effects.
Deflation is a persistent ongoing month-after-month reduction in the general price level, usually characterized not only by falling prices for goods and services but also falling prices for most commodities, real estate, equities, and other assets.
It is caused by declining demand and an unwillingness on the part of consumers to spend. As household spending contracts, industrial capacity utilization falls and business capital investment grinds down.
Deflation is as much a mass psychological phenomenon as it is economic event.
In anticipation of declining prices, consumers and businesses have an incentive to postpone purchases. In turn, this depresses overall economic activity, employment, personal incomes, and the level of demand across the economy. And, with falling demand comes still lower prices – in short, a deflationary spiral.
Most people who think about these things assume that gold prices must fall during periods of deflation. After all, deflation is the opposite of inflation – and since gold rises during periods of inflation, shouldn’t it fall during periods of deflation?
But, paradoxically, gold is both an inflation hedge and a deflation hedge. It is during periods of relative price stability and low inflation rates that gold is least attractive.
Here’s why gold is a deflation hedge:
During periods of deflation, we postpone spending in anticipation of lower prices. Instead, households hoard cash and cash-equivalents such as short-term U.S. Treasury debt, bank deposits, and money-market instruments. Gold is also a cash-equivalent . . . and some will choose to hold more of their savings in the yellow metal, particularly during times of economic stress and uncertainty when gold just feels safer.
Moreover, deflations are also characterized by very low interest rates. Rates are low because the demand for credit is depressed, savings are high, and the Federal Reserve and other central banks will pursue low reflationary interest-rate policies to encourage economic recovery.
As a result, the opportunity cost of holding gold – that is, the income forgone by holding these metals rather than interest-bearing assets – is also extremely low, further encouraging some investors to favor the precious metal over alternatives because of its other attractions and attributes.
Inflation or Deflation
To shore up the banks and other financial institutions, to get credit flowing, and to revive the economy, central banks everywhere are pushing additional liquidity into the global banking system. Even the People’s Bank of China is cutting lending rates and lowering reserve requirements to support business activity, shore up financial and real-estate markets, and encourage consumers to go shopping.
In announcing it’s latest policy initiatives to jumpstart bank lending to consumers and businesses, the Federal Reserve said the money would come from an increase in its reserves — in other words, “quantitative easing.”
Quantitative easing describes central bank actions to directly increase the money supply by depositing funds with the banks or lending to non-bank enterprises. Quantitative easing is equivalent to printing money – and, in the long run, inflationary.
Most economists — in and out of government and across the political spectrum — believe these emergency measures (and possibly more to come) are necessary to revive the failing economy and prevent a spiraling decline into deflation and depression.
A few economists — myself included — and a larger number of ordinary folks are, nevertheless, worried about the mounting financial cost that has already reached several trillion dollars . . . and the long-term economic consequences of central bank monetary creation, the expansion of government-sector deficits around the world, and the likely inability to pay the piper through increased taxation.
I believe we will see a longer, deeper decline in business activity than most, not just in the United States, but also in Europe, here in China, and around the world.
Unlike most past recessions in the United States, this one was not caused by tight monetary policies and rising interest rates or a downturn in a few industries.
Instead it started with easy money, excessive borrowing and spending by households and business, followed by a housing bust that quickly metastasized into a spreading credit crisis and failure of the financial markets to keep the economic engine lubricated. As previous financial crashes in other countries, Japan for example, illustrate, recover can take many years.
In the United States, more than a few companies will go bankrupt. Unemployment will shoot up. Commercial real estate values will drop. Credit card defaults will rise. Big government will be forced to bail out more big business. There will be new stimulus packages and tax cuts next year – totaling hundreds of billions of dollars –to boost private spending and consumption.
At the same time, we are likely to experience some form of deflation –particularly in commodities, food, autos, and a variety of consumer goods. To be honest, deflation has already hit home — first in real estate, then on world stock markets, more recently in oil and commodities, and, as anyone shopping for the holidays will soon notice, in many retail stores.
But as the economy revives — as it must with massive and unprecedented government stimulus in the United States, Europe, here in China and in most other countries — the prices for many goods and services will shift from reverse to forward . . . and inflation will replace deflation as all those trillions of dollars come home to roost.
Monetary Reflation Today, Price Inflation Tomorrow
I remain bullish on gold because — even as the global economic recession deepens — governments will find the only way out of this mess is to print more money. In other words, to inflate.
The United States Treasury and the Federal Reserve have already thrown a few trillion dollars, more or less, into the banking system and are now also lending directly to businesses and households. And, there’s surely much more to come when the next Administration moves into Washington.
It’s not only the U.S. monetary authorities pumping up the money supply. Their counterparts in every major economy – including the United Kingdom and the Euro zone, China, Russia, Japan and on and on – are doing likewise.
We have never in the history of money seen such an expansion in its supply without, after a period of time, a rapid deterioration in its value – in other words, without a rapid increase in the overall price level. More than any other factor influencing the gold market, it is the inevitable devaluation of money and the corresponding rise in price inflation that will propel gold skyward in the next few years.
As sure as day follows night, reflationary monetary policies — however necessary — have long-term implications for global inflation. Typically, monetary creation affects price inflation with a lag of six months to a couple of years – and in the current environment, the lag could be still longer . . . so it may be some time before inflation is recognized as a serious problem. But gold prices have shorter lags and could begin moving up before rising inflation becomes apparent or worrisome.
Longer term, gold-price prospects remain as bright as ever — and I firmly believe we will see record high prices in the next few years with gold back over $1000 an ounce in the coming year.
With the right confluence of economic and geopolitical developments we should see gold break through $1500, then $2000, and possibly still higher round numbers in the next few years – particularly if we get the type of buying frenzy or mania that often occurs late in the price cycles of financial and commodity markets.
This is hardly an audacious forecast when looked at relative to the upward march in consumer prices over the past 28 years. After all, the previous high of $875 an ounce in January 1980, when adjusted for inflation since then, is today equivalent to more than $2200.
Let me end with a warning about the days and weeks ahead. In the short term, gold remains volatile and vulnerable, if only because market psychology is nervous, anxious, and fearful. In this environment, we could still get a quick sell-off that would bring us back to the recent lows. But, day by day, I think that becomes less likely and, day by day, I think the base is building for a lasting longer-term recovery.
