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Just a few weeks ago, Mario Draghi,
President of the European Central Bank (ECB), announced that he would do
anything required to bailout the weakest members of the euro zone and in so
doing prevent the euro currency from dissolution. Investors who may have been
previously positioning themselves to withstand a euro crisis seem to be
anxious to believe that such bold actions will prevent the worst.
Consequently, many unwound positions in US dollars and bought back euros. In
the wake of the announcement, the euro rose from $1.22 to $1.30.
Two weeks ago, as signs of recession increased,
Fed Chairman Bernanke announced he would do anything required to stimulate
the US economy, real estate, and the financial markets. Investors, who may
have been previously concerned that the US stock market was set for a
correction (having risen approximately 20% over the past year), took heart
and sent stocks up once again.
But the biggest winners thus far that may have
resulted from these newly communicated intentions are not the euro or the
broad stock markets but rather gold and gold-related investments. In fact, in
the month of September, gold approached its highest price for this calendar
year and came within five or six percentage points of its all-time nominal
high. The GDX Index of gold miners increased nearly 12% and hit a six-month
high.
From my perspective, there are five main reasons
that help explain the current attraction to gold.
First, is the perception that central bank
activism will spark inflation. Although inflation still is
“officially” low, the size and scope of the printing campaigns
just announced is creating an increasingly strong conviction that inflation
soon will break out.
Second, with tensions finally ebbing in Europe
and with the Federal Reserve now so plainly committed to a policy of
quantitative easing, there is an increasing concern that the dollar could
trend lower. A weaker dollar would help push up the price for all
internationally traded commodities, including gold.
Third, the American government appears to have
lost some of its influence on the perceived escalation in Israeli-Iranian
tensions. War risk, particularly in the Middle East is rising. In the
Pacific, tensions continue to rise dramatically between China and Japan over
disputed islands. Gold has traditionally risen during periods of geopolitical
uncertainty.
Fourth, central banks that were once huge sellers
of gold, such as those of India and Russia, are now accumulating it, together
with China. Savvy investors pay close attention to central bank actions.
On the other side of the ledger, there are two
important items that normally would indicate a falling gold price. First, the
EU, with the world’s largest economy, and the US, with the second
largest economy, together with that of Japan, appear headed for recession.
Even the Chinese economy is slowing. The possibility is rising of a worldwide
recession, which normally tends to push down asset prices, particularly for
stocks dependent on corporate earnings. As stocks fall, margin calls and
other demands for cash result in gold holders liquidating portions of their
portfolios. Also in recessions, cash becomes increasingly scarce and real assets,
including commodities, fall in price. As a commodity, gold should fall in
price as recession becomes manifest.
However, some investors may have overlooked an
important consideration. Despite falsely low interest rates, most of the
trillions of dollars created by the Federal Reserve are sitting in bank
deposits or in the bond portfolios of banks. As such, these synthetic funds
have not been the cause of significant increases in consumer prices. It is
not until the banks start lending on the basis of these vast deposits of
funds, will they become an inflationary factor.
If recession were to take hold more broadly,
those who bought gold as a near-term inflation hedge may become significant
sellers as inflation fears take a back seat to margin calls. At some point,
if debt problems re-emerge in Europe, the euro’s basic viability may be
threatened. Simultaneously, continuous action from the Federal Reserve may
finally, and justifiably, bring the US dollar under heavier scrutiny. Under
such conditions gold may be looked upon as a more reliable store of value
than discredited and devalued currencies.
John Browne is a Senior Economic Consultant to Euro Pacific Capital.
Opinions expressed are those of the writer, and may or may not reflect those
held by Euro Pacific Capital, or its CEO, Peter Schiff.
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