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Gold — After the Fall

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Gold has fallen more than $250 from its record high this past March to its recent low last week.  Most analysts are saying that gold has been pulled down by the drop in oil, the bounce in the U.S. dollar, and an easing of inflation expectations.

But, in my view, gold’s swift decent in the past few weeks is a direct consequence of the unfolding global credit crisis.  In short, gold has been an innocent bystander to the financial hurricane hitting Wall Street and global markets.

The yellow metal’s own positive fundamentals – and even its role as a safe haven in turbulent financial seas – have simply been overwhelmed by the massive storm-surge flight to cash and the indiscriminate selling of securities and commodities, selling that has been amplified and accelerated by automatic program trading, short covering, and technical triggers on the way down.

Meanwhile, plunging asset prices are weakening the balance sheets of banks, insurers, and other financial firms everywhere, threatening more surprises, bankruptcies and busts.  And, at the same time, banks and other lending institutions are hoarding cash due to fears of further financial-sector turmoil.  Their reluctance to continue funding even many healthy businesses threatens to send the world economy into a tailspin.

To shore up weak banks and other financial institutions – and stave off a global economic catastrophe – the U.S. Federal Reserve, the Bank of England, and the European Central Bank are all injecting additional liquidity into the global banking system. Even the People's Bank of China is cutting its lending rates and lowering its reserve requirements in an effort to shore up its financial and real-estate markets.

Amid signs of a teetering economy (the latest being the just-reported 1.1 percent drop in U.S. industrial production in August) speculation is growing that the Fed, sooner rather than later, will cut its key Fed funds rate – and this might just be enough to knock the dollar but good and put gold back onto a more sustainable upward trajectory.

I’m no gold bug, but I’m not willing to give up on the yellow metal’s extremely bullish longer-term prospects, prospects that are just as bright today as they were early this year when gold was racking up record prices.

Gold after the fall may be tarnished – but fundamentally nothing has changed about the metal’s increasingly supportive supply/demand situation.

Gold is underpinned by rising physical demand in key global markets, deteriorating macroeconomic and financial environments, accelerating inflation, and tight supply/demand fundamentals.  I believe any renewed decline, however deep, will be short-lived as price-responsive physical demand increases in tandem.

In any event, shaken confidence in financial institutions around the world should soon begin to benefit gold once again as selling of financial assets and commodities runs its course.

Don’t’ be surprised if gold’s upward ascent is just as fast and furious as has been it’s recent decline.  If anything, gold promises to remain volatile.  The credit crunch has reduced liquidity available to precious metals traders and speculators, the result being increased volatility both up and down – and this will continue day to day and week to week.

As sure as day follows night, reflationary monetary policies -- however prudent and necessary -- have long-term implications for global inflation.

In response to prolonged stimulative monetary policies in so many countries around the world, inflation is now accelerating across Europe, Asia, and the Middle East . . . and this is prompting a rise in gold demand, particularly in the traditional gold-hoarding counties (India, China, Southeast Asia, Turkey, and the Arabian Gulf countries).

Importantly, much of the traditional gold-hoarding world continues to enjoy rising prosperity and growing middle classes that will, along with more inflation, translate in to rising gold consumption in the form of small bars and investment-grade jewelry.

Retail gold investors – the “man in the street” so to speak – have a different view of the world and economic risks ahead than do the large institutional players and their armies of analysts.  Unlike the large institutions, the small guy has been buying more gold lately as can be seen in a pick up in physical demand for bullion coins, small bars, and investment-grade jewelry.

  • We've seen this in Europe where demand for small bars and bullion coins is up.
  • We've seen this in the United States where the U.S. Mint had temporarily suspended deliveries of American Eagle gold bullion coins to dealers for lack of supply and retailers are reporting strong buying.
  • We've seen this in India where jewelry demand has picked up early in response to low prices as the festival and wedding season begins.
  • And, we’ve seen this in Turkey and the Arabian Gulf where imports in August were up sharply and activity the souks is booming.

The key for gold, in the longer term, is that inflation everywhere -- in the United States, Europe, Japan, India, China and Southeast Asia, Latin America -- is accelerating.  China and India, the biggest gold consuming nations, each recently reported double-digit year-over-year consumer price inflation rates.  Measures of monetary policy -- growth in broadly defined money supply and real (inflation-adjusted) short-term interest rates -- are already at inflation-fueling levels.

Long-term price prospects remain as bright as ever -- and nothing in the recent market performance has changed our forecast of record high prices in the next few years: We still expect to see gold back over $1000, if not late this year, then almost certainly in the first quarter of 2009.

With the right confluence of economic and geopolitical developments we could see gold as high as $1500 or even $2000 an ounce in the next few years -- and a buying frenzy, such as is often seen late in the price cycles of financial and commodity markets, could briefly take the metal much higher.