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Gold and Deflation
August 16, 2010
I have been speaking and writing about gold’s appeal in a deflationary environment – this is a concept that opposes the conventional opinion that the gold price will not rise without inflation.
Those who cling to that singular gold-inflation relationship have not examined the history of gold as money. Whenever there is substantial inflation or deflation, governments tend to either be too slow to react or they overreact with policies, and this is typically good for gold.
Interest earned on 90-day Treasury bills below the inflation rate is a signal for governments to try to stop deflation and reflate the economy. When this happens, gold becomes attractive. We are in such an environment now.
During these periods, governments usually need to increase their deficits by escalating their borrowings to support the economy. This also supports gold as safe money in addition to its beauty as jewelry.
The twin engines of negative real interest rates and government deficits tend to make gold a very attractive investment. Recent research supports our historical findings on what drives gold.
This chart from Deutsche Bank shows that for the past four decades gold (and silver) have performed well in a country’s currency when that country has low or negative real interest rates.
The Federal Reserve’s main interest rate is near zero and inflation is a little over 1 percent, so we now find ourselves in a negative real interest rate situation. The Fed has made it clear that it has no plans to tighten money by raising that key rate any time soon because of the sluggish economy and soft housing market (mortgages are now at a 21-year low), so this condition is likely to endure.
“The decline in core inflation from 2.5 percent two years ago to under 1 percent today will sustain market fears of deflation and hence a more rapid depreciation of the U.S. dollar to arrest any deflationary pressures,” Deutsche Bank’s analysts wrote. “We believe that the road map to resolve deflation is therefore bearish for the U.S. dollar and another factor which will propel gold prices to new highs.”
The Fed this week plotted part of that road map – it said it will pump more money into the system to try to kick up economic activity. As the 2010 midterm election draws closer, there is also a growing call for another round of stimulus spending to try to pull down the 9.5 percent unemployment rate.
Such a move would widen the federal budget deficit, which is already estimated at nearly $1.5 trillion for this year and will roughly be the same in 2011. The U.S. dollar is not only our currency, it is also the world’s reserve currency. Deficit spending puts downward pressure on the dollar, and when the dollar falls, investors tend to turn to gold.
When you add the interest rate and deficit scenarios to the gold seasonality trend – September is historically the best month of the year for both bullion and gold equities – the conditions now appear promising for gold.
We discuss What’s Driving Gold in an interactive presentation – click on the chart to learn more about these critical drivers.
Browse Our What’s Driving Gold Matrix
Being Contrarian on China
August 13, 2010
The news and analysis about economic conditions in China has turned decidedly negative of late after the latest round of key indicators – GDP growth, imports, fixed asset investment and industrial output – showed signs that a broader slowdown could be coming.
The discussion has had a very short-term focus, while the Beijing government has taken a longer view by taking some of the hot air out of the property sector to head off the kind of 2008-09 bust that dragged down the U.S. and Western European financial sectors and eventually their economies.
Others (including us) also take a longer view – here’s a sampling of analysis that doesn’t share the same dire outlook as is dominating the mainstream.
BCA Research: “Chinese banks’ total lending to the property sector has been increasing in recent years, but banks’ credit exposure to the property market is very low compared to other major economies. The large down payments of mortgage borrowers provides a significant buffer between banking sector assets and property prices.”
ISI China Research: “China’s fiscal revenue in the first seven months of this year was 26 percent more than those in 2009 or 2008… yet spending only increased 17 percent … the fiscal strength is impressive. Beijing will have a lot of fiscal ammo in (the second half of 2010).”
CLSA Asia Pacific Markets: “The upside of slowing data is that the potential for further tightening measures recedes even if Beijing is not yet ready for outright easing.”
Ancient Gold, Modern Value
August 12, 2010
A 2,200-year-old gold coin was found recently in northern Israel. No, this isn’t one of those radio commercials you hear all the time about a surprising discovery of a stash of rare gold coins in Europe. This is the real deal.
Archaeologists from the U.S. uncovered the gold coin while digging near the border of Lebanon. At nearly one ounce in weight, it is the heaviest and most valuable coin ever found in Israel, a state official said. And somewhat oddly, the official added that the coin served a symbolic function and wasn’t used as currency.
The coin dates back to 191 B.C., making it older than the Roman Empire, but gold's history goes much further back than that.
The Sumer civilization in ancient Mesopatamia used gold for jewelry and ornaments for headdresses, and thousands of gold artifacts were found in the Varna Necropolis, a gravesite in present-day Bulgaria that goes back to 4600 B.C. Egyptians are believed to have mined gold as early as 2000 B.C.
It’s believed gold as money originated in China about 3,000 years ago, and that the first pure gold coins came from King Croesus of Lydia between 560 and 547 B.C.
Over the millennia, gold’s prices have changed but its intrinsic value as a store of wealth hasn’t. During these uncertain economic times, it seems that more and more investors are appreciating gold’s protective properties.
Chart of the Week – Is Indonesia Overheating?
August 11, 2010
Indonesia’s 21 percent gain so far this year is tops in the region but is Asia’s hottest market in danger of overheating? Not exactly but there are a few concerns.
Inflation is beginning to become an issue. Food prices are rising at 14 percent a year, energy at 18 percent a year and land prices at 20 percent a year, according to CLSA. CLSA cautions that conventional monetary measures could make matters worse so policy changes—like an anticipated rise in interest rates—must be monitored closely.
This year’s performance has also pushed Indonesia’s valuation ahead of other emerging markets. Stocks in Jakarta trade at roughly 13.5 times earnings over the next 12 months while the MSCI Emerging Markets Index and the MSCI BRIC Index trade at around 11 times, according to a Bloomberg story.
However, it’s important to remember that Indonesia is starting from a very low base. Just two decades ago, only 21 companies were listed and today the country’s stock market remains one of the smallest as a percentage of GDP among major emerging markets.
Investible options are currently limited to energy, telecom and banking sectors and the number of domestic retail investors is less than one percent of the population. As more companies go public and market capitalization grows, increased liquidity should attract more foreign investment.
Domestically, the economy should benefit from its rapidly urbanizing population, rich natural resources, appreciating currency and political stability. All of these should insulate Indonesia’s economy from external headwinds and keep the country on a path of growth for the next five years.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI BRIC Index is a free float-adjusted market capitalization index that is designed to measure equity performance of Brazil, Russia, China and India.
Ready, Set, Gold: Best Months Are Just Ahead
August 09, 2010
Global economic conditions are now favorable for gold as a safe-haven investment. The U.S., Western Europe and Japan are close to buckling under the weight of their sovereign debt loads, government budget deficits remain large and persistent and, as a result, faith in major paper currencies is low.
On top of this, China – the world’s No. 1 gold producer and No. 2 gold consumer – is encouraging gold investing by its rapidly growing middle class, and will likely have to increase imports to meet this new demand.
If history is any guide, gold is about to get even more attractive because we are heading into the fall and winter gift-giving season. This is the time of year that gold jewelers typically do their biggest business. The kickoff is the Muslim holy month of Ramadan, which starts next week and ends with generous gift-giving in early September.
After Ramadan comes India’s post-monsoon wedding season, and in November there’s Diwali, one of India’s most important festivals. During the fall, jewelry makers in the U.S. and Europe stock up in advance of the Christmas shopping season. And in China, there are two big gold opportunities: the week-long National Day celebration starting October 1, and the Chinese New Year in early 2011.
Looking at more than four decades of seasonality, September has been the best month of the year for gold and gold stocks.
The clear trend can be seen on the seasonality chart for spot gold. In a typical year, the September price rises 2.5 percent above the August price. And to make the case even more compelling, the gold price has risen in 17 of the 21 Septembers since 1989, by far the best success ratio of any month of the year.
In September 2009, the gold price jumped nearly 6 percent, well above the long-term average.
September is historically an even better month for gold stocks as measured by the NYSE Arca Gold Miners Index (GDM).
After the typically weak months of June and July, the gold miners start moving up in August and make an 8.3 percent leap in September. In September 2009, the jump was 14.5 percent. Since 1993, the GDM has been up 12 times in September and down just five times.
The strong correlation between the gold price and gold-mining stocks explains much of the average September jump for gold stocks, which have historically offered leverage to the gold price. In up markets, earnings growth has tended to exceed the increase in gold price. In down markets, the leverage works in the opposite direction — gold stocks also tend to decline more when the price of bullion is falling.
This leverage is shown on the chart of how bullion and the miners have fared in late-summer and fall rallies during the gold bull market that began in 2001. These uptrends have generally occurred between mid-July and early October, though in 2004 it extended into late November.
The gold price has climbed an average of 12.4 percent during the 2001-09 seasonal rallies even as the price steadily moved into four digits. As good as that result was, the impact on gold stocks was even stronger – their annual jump averaged more than 26 percent.
In 2010 the trend could be shaping up right on schedule. From a recent bottom of $1,157 per ounce in late July, spot gold had risen more than 4 percent through mid-afternoon on August 6 and the TSX/S&P Global Gold Index had gained more than 6 percent.
Bank of America-Merrill Lynch recently called for $1,300 gold by October-November 2010 as a result of the seasonal demand, and the gold watchers at CIBC World Markets in Toronto see $1,400 gold next year due to strong investment demand and inadequate supply response.
Given the current economic weakness, CIBC pointed out that during the Great Recession, “gold was one of the only investment classes that provided positive returns. This fact will not be forgotten if the next recession materializes.”
Its analysts also say that gold equities look relatively cheap compared to bullion, adding that, for the first time ever, some of the big producers are trading at price-earnings ratios below the S&P 500 Index average.
Going back to 1971, when President Nixon ended dollar convertibility into gold and deregulated the price of gold, gold stocks have tended to outperform the S&P 500 when the federal government runs budget deficits. Through 2019, the annual federal deficit is projected to average around $1 trillion, creating the potential for gold stocks to remain an attractive investment relative to the broader market for years to come.
Based on the long-term record, this may be a good time for investors to consider establishing or adding to a gold or gold-stock position in advance of seasonal demand growth. Historical patterns may be a useful guide and improve the chances for investment success, but of course, there are no guarantees that the fall of 2010 will follow the well-established trend.
The NYSE Arca Gold Miners Index is a modified market capitalization weighted index comprised of publicly traded companies involved primarily in the mining for gold and silver. The index benchmark value was 500 at the close of trading on December 20, 2002. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The Toronto Stock Exchange Gold and Precious Minerals Index is a capitalization-weighted index designed to measure the performance of the gold and precious minerals sector of the TSX 300 Index. The S&P/TSX Global Gold Index is an international benchmark tracking the world's leading gold companies with the intent to provide an investable representative index of publicly-traded international gold companies.
Net Asset Value
as of 09/02/2010
- Global Resources Fund
PSPFX $8.72 +0.08 - Gold and Precious Metals Fund
USERX $17.25 +0.18 - World Precious Minerals Fund
UNWPX $19.21 +0.13 - China Region Fund
USCOX $8.50 No Change - Eastern European Fund
EUROX $9.05 +0.03 - Global Emerging Markets Fund
GEMFX $8.15 +0.01 - Global MegaTrends Fund
MEGAX $7.67 +0.03 - All American Equity Fund
GBTFX $19.86 +0.15 - Holmes Growth Fund
ACBGX $15.79 +0.19 - Tax Free Fund
USUTX $12.61 No Change - Near-Term Tax Free Fund
NEARX $2.27 No Change - U.S. Government Securities Savings Fund
UGSXX $1.00 No Change - U.S. Treasury Securities Cash Fund
USTXX $1.00 No Change