Gold was one of the few assets besides the U.S. dollar, the Japanese yen, and Treasuries to increase in value in 2008. The forces that shaped these returns will persist into 2009, although a few pitfalls could disrupt the yellow metal’s rise. Chief among the threats to gold’s advance is whether the “barbarous relic” recovers its monetary value in the West or whether the ravages of deflation bring gold into line with other commodities.
Supply and Demand
Jewelry accounted for 68 percent of demand in 2007 but declined to 62 percent by the third quarter of 2008 according to the World Gold Council’s Gold Demand Trends 3Q Report (see table below). A small decrease in jewelry demand from developed nations was more than offset by huge gains in investment demand in emerging markets such as China and India and also in the United States. One cannot look at demand in a vacuum, and if we assume that consumer preferences have not changed, the decline in jewelry demand is explained by the weak economy. Due to the volatility of investment demand, holding other variables constant, the implication is that overall gold demand has become more volatile. Net investment ranged from 10 to 14 percent of total demand in 2007, but in 2008, it ranged from 11 to 20 percent. Demand for gold ETFs ranged from slightly negative to 14.5 percent of total gold demand in the past seven quarters.
Just because demand may become more volatile does not mean it is a negative factor, however, especially if it is volatile in the direction of greater demand. Nevertheless, assuming the recession continues for several more quarters, it does mean jewelry and industrial demand are unlikely to recover, with the notable exceptions of countries where jewelry serves as an investment (e.g., Russia). Along these lines, early evidence from India, the largest purchaser of gold, points to a continued drop in demand in 2009.
click to enlarge
Is Gold Money?
Demand for jewelry will decline during the recession, and individuals may pawn or sell their gold to pay bills. Industrial demand will decline as well, leaving two sources of demand—investment and monetary. Investment can either be speculative, such as anticipating changes in supply and demand, or a hedge against inflation.
Gold as an investment could underperform substantially. If deflation lasts for several years and consumer and industrial demand remains low, even a reduced supply of the metal will be unable to stem a decline in price. If the U.S. dollar rallies strongly in 2009, faith in the dollar will increase and reduce the attractiveness of gold. Therefore, we must consider whether gold is money: something generally accepted as a medium of exchange, a measure of value, or a means of payment.
Does anyone consider gold to be money today? The answer is yes internationally but not so much in the U.S., where gold is usually exchanged for the dominant medium of exchange—U.S. dollars. People in the U.S. also do not convert long-term savings into gold to preserve their value. Short of a currency collapse, we are unlikely to see a situation where people return to metals as the medium of exchange, or even as a store of value, if only for the reason that the general population does not believe it. In Asia and the Middle East, however, gold retains its monetary value, especially in countries with currency problems, Turkey being a recent example.
America lost its cultural connection to gold during the Depression, the last time U.S. dollars were convertible into gold. In the 1970s, the U.S. officially abandoned the last vestiges of a gold standard, but anyone old enough to invest still knew the monetary value of gold. Today, this is not the case; older investors are replaced by their children and grandchildren, who grew up during a credit boom that fueled the prices of paper assets. In many of their minds, the connection between gold and money has been severed. (Eastern cultures maintained the link, evidenced by continued high demand for the metal. For this reason, it’s conceivable that a new gold standard may travel from East to West and be imposed from outside rather than from within.)
The case for gold as money is widely available thanks to the Internet, and pessimism over the direction of the global financial system and U.S. dollar bring more adherents over time. Still, many investors favor gold as one of many hedges against a weaker U.S. dollar. The idea of gold as money can be rebuilt though, especially during a deflationary financial panic such as that in 2008, when gold and the U.S. dollar increased in value over time.
Although gold for many individuals lost its value as a medium of exchange, its “store of value” or inflation protection attributes reemerged in the 1970s. But when Paul Volcker slayed price inflation in the early 1980s, gold prices tumbled and remained low for nearly two decades. The 1980s gold highs were based on inflation expectations that never materialized. Investors worried about persistent high inflation for years to come, but tax cuts, deregulation, productivity gains from technology, and the fall of communism delivered a supply-side shock to the economy, keeping the Federal Reserve’s inflationary policies from showing up in the consumer price index. By the late 1990s, the public believed inflation was dead forever thanks to Greenspan, and gold sold for less than $300 per ounce. Furthermore, gold was relegated to commodity status, which naturally led to the argument that oil or other commodities could provide similar inflation protection. Compared this way, gold lost its advantages and retained its weaknesses.
About the same time, the Asian crisis and Russian default marked the bottom of the supply-side checks on inflation. Central banks flooded the globe with money to stave off global economic collapse, including the Federal Reserve bailout of Long Term Capital Management. The Federal Reserve also papered over Y2K fears by increasing the money supply, just in case. Finally, in the wake of a weak economy and 9/11, a Federal Reserve more concerned about deflation slashed interest rates further than necessary, and most of the world’s central banks followed suit. Gold, oil, and other commodities rebounded from their lows, climbed to new nominal highs, if not inflation-adjusted highs, and holding gold as a hedge against inflation became popular again. Later, inflation expectations started to creep higher, as inflationary credit spread into every sector of the economy. Gold rallied to more than $650 an ounce by the time the financial crisis started to unfold in the summer of 2007. Gold followed oil and commodity prices higher in the first half of 2008, but the collapse of Bear Stearns in March 2008 sent gold to new highs above $1,000 per ounce, a level it has not reached since.
It’s unclear how long inflationary expectations can last in the face of deflation. Although all the evidence points to asset deflation in the near future, many still believe inflation will return this year, and not just the old 3 to 5 percent variety. But the Federal Reserve’s initial response to the crisis was neutral toward the money supply (assuming asset prices recover)—it mostly swapped bad assets for good assets (Treasuries) following three years of little growth in the money supply. Only in late 2008 did it increase the money supply. Meanwhile, banks reduced credit and consumers became net savers. This year the spike in the M1 money supply is matched by a plunge in the M1 Money Multiplier. In sum, the Fed’s pumping has been an exercise in futility—a lesson unheeded from 1930s U.S.A. and more recently Japan—one that weakens the U.S. economy in the long run.
One can make the case that inflation expectations are so great that even a year or more of deflation will not budge investors. I think this argument is valid, but I don’t know how the marginal holder of gold will react if deflation lasts another 12 months or more. To be clear, I am not denying the inflationary implications of the Fed’s actions, only that they might not materialize in 2009.
Gold Miners May Outperform
Deflation in an economy using fiat currency means defaults on debt, very tight credit, and general economic contraction. Gold historically outperformed during a depression because gold was money, and prices of most things declined more than the price of money, which can even increase as the public shuns risky assets for cash or requires it to repay debts. We saw this effect from July through December with U.S. dollar demand due to global deleveraging. Unlike paper currency, however, gold cannot be produced at the flick of a switch. During a deep recession, production costs will decline. If gold outperforms relative to other assets and commodities, as it did in 2008, gold miners will see their profits increase.
Black Swan Events and Other Unknowns
The ultimate scenario for which investors should be prepared is the collapse or rapid devaluation of paper currencies. Although the chances of this are very small, the losses are too large to ignore and the event itself may be extremely swift. Insurance against fire is a perfect analogy to the prospect of a currency failure.
The Federal Reserve’s policies will probably fail, especially if the federal government continues enacting policies that weaken rather than strengthen the economy. There’s a lot of potential inflation sitting on the Federal Reserve’s books because if those assets lose value, the only way to cover the losses will be to transfer money from the Treasury to the Federal Reserve or to print the money. The Treasury can only obtain money one of two ways—borrow it or tax it. Since borrowing might be difficult after a year or two of trillion-dollar deficits and taxing that much would cripple the U.S. economy, the probability of printing is high. The government may decide, however, that devaluation is a better option than steady inflation.
There is historic precedent for devaluation in America. While most investors probably associate currency devaluation with shaky East Asian economies or Latin American banana republics, the U.S. has also devalued its currency—F.D.R. devalued the dollar at the start of his administration in order to combat deflation. A dollar was redeemable for gold at the rate of $20.67 per ounce in 1933, but after the devaluation, one needed $35 to purchase one ounce of gold.
Roosevelt passed several laws designed to achieve his desired result. He first banned the ownership of gold bullion and later invalidated contractual clauses that stipulated payment in gold. With the maturation of futures markets, business and investors no longer require devaluation clauses in their contracts, but for this reason devaluation would need to be a stealth act because devaluation expectations could cause a run on the dollar and lead to far greater devaluation than the government wants.
Another possible outlier event is the creation of a gold currency or a return to gold as the medium of exchange. A popular conspiracy theory holds that central banks intentionally suppress the price of gold, and it’s supported by the fact that many central banks are sellers of gold. But there is always the possibility that one or more central banks could become acquirers of gold and turn the conspiracy on its head. A central bank that aggressively acquired gold would see its currency rise relative to that of other countries (provided it uses its currency reserves) and could force other central banks to purchase gold to maintain the value of their currencies.
To recap, consumer and industrial demand will be a drag on the price of gold in 2009 as the global economy weakens further. Investment based on inflation expectations could weaken, but the hard money argument will strengthen. (Investors who only fear inflation should invest in metals that are undervalued relative to the price of gold.) Even if gold prices suffer due to deflation, the metal should outperform relative to other assets, but in that case, gold mining stocks will outperform the metal itself. Finally, government actions thus far have increased rather than decreased the risk of a prolonged economic crisis, from which all investors should be hedged. With this in mind, the best gold ETFs for 2009 are iShares COMEX Gold (IAU), SPDR Gold Shares (GLD), and Market Vectors Gold Miners (GDX).