Gold: The Unsung Asset Class

Few investment advisors, or investors for that matter, think of gold as a stand-alone asset class. That’s a shame, because it means most investors missed out on spectacular gains during the last decade. As you can see from the graph below, the last 10 years have been one of the worst on record for stocks, with the S&P 500 having lost 37 percent before dividends. Gold, on the other hand, has returned a pulse-quickening 325 percent over that same time frame.

The last period in which such a wide divergence occurred between equities and the Midas metal ended in 1980. Back then, the rise in gold occurred in the context of raging inflation. The gold party abruptly ended when the Federal Reserve, headed by Paul Volcker, put the brakes on inflation by hiking short-term interest rates to double-digit levels. While that strategy proved successful, it came at the cost of soaring unemployment and a painful recession.

Today, the situation is far different. Gold has risen sharply even though inflation has so far remained contained, averaging just 2.8 percent this decade. In other words, gold has moved higher in anticipation of inflation rather than in reaction to it. Moreover, as the unprecedented moves to get the economy moving again start to take hold, the Federal Reserve will be reluctant to take the steps necessary to squelch rising inflation for fear of risking another very painful downward spiral in the economy, and perhaps our political system as well.

If we return to 10 percent inflation, which is a near certainty if the economy starts to grow by a healthy margin again, gold prices will absolutely soar from current levels. Also unlike in 1980, emerging economies represent approximately half of the world’s output. As a result, the competition for scare resources has never been greater. The inflation that results from this competition will show up in the price of the yellow metal, too.

Commodity demand is highly leveraged to growth in emerging economies. We got a taste of this in the first half of 2008, when prices were rocketing higher and China, India, Brazil and other nations were expanding at 8 percent or higher rates. And we’re starting to see it again today. The OECD nations are mired in the worst recession since the 1940s and the emerging economies are contributing virtually all of the world’s growth.

Car sales are just one example of why commodity prices are rising today. We noted recently that auto sales in China have exceeded sales here in the U.S. for the first time. Yet China’s auto fleet on a per-capita basis is still only about 1/12th the size of the U.S. fleet. There’s room by far for other emerging nations’ car fleets to expand as well. Merely doubling the size of those fleets will require massive amounts of steel, copper, rubber and a host of other materials, ensuring prices for those materials will rise.

And the story doesn’t end with cars. Consumers in those economies are moving into bigger homes, cranking up their new air conditioners and watching their new big-screen TVs, while eating more meat in their meals than their parents’ generation ever would have imagined. All of this is requiring greater resources—and the party is only just getting started.

The graph above offers a glimpse of China’s iron ore imports. The recent surge in these imports is partially due to the need for inventory restocking after drawdowns last fall, and the pick-up in China’s economy since then. But it also suggests the country’s leaders are following through on their promise to invest their assets in commodities rather U.S. dollar-denominated securities. We’ll be looking into this in greater detail in future issues as the implications for inflation and gold prices are staggering.

Comments

[Roger Knights:]

Gold has also proved its worth as a diversifier in the recent meltdown. Bullion is a beta-blocker. Investment funds should wise up.

Jul 09 05:15 AM

[Moon Kil Woong:]

I think China's iron ore consumption has a lot more to do with stockpiling and trying to cycle out of US$ into anything else more than internal demand. The same goes with copper, rare earth elements, etc.

The powers that be care a lot more about their own pocketbooks and exports than the demands of their citizens. When looking at their policies, it's best to keep that in mind.

Jul 09 06:52 AM

[Mono:]

people are mistaking hoarding of natural resources as real demand, you are right. prices for copper are not indicative of real demand


On Jul 09 06:52 AM Moon Kil Woong wrote:

> I think China's iron ore consumption has a lot more to do with stockpiling
> and trying to cycle out of US$ into anything else more than internal
> demand. The same goes with copper, rare earth elements, etc.
>
> The powers that be care a lot more about their own pocketbooks and
> exports than the demands of their citizens. When looking at their
> policies, it's best to keep that in mind.

Jul 09 08:15 AM

[fran:]

gold has been for centuries a store of value; it will continue to be so. man has very few other limited quantity, durable, non consummable "things" to use for exchange.
until a better bartering substance, not controllable by the whims of the "political class" is found, it has its place. perhaps that is why/how nature provided a vehicle with its unique qualities.
the old adage about an ounce of gold and adequate clothing/footwear for sustainance still holds.
could it be the ultimate useable "asset class"?

Jul 09 10:53 AM

[optionsgirl:]

Not only is China's stockpile not indicative of growth, but they are having a growing unemployment problem in China. As their exports decrease, so do their manufacturing jobs. People who migrated to the cities for work are now returning home to the countryside.
There is a lot of information available on this topic. Just google unemployment in China and you will see a bunch of articles on the topic.

Jul 09 12:37 PM

[whidbey:]

We can skip China as a driver of prices. Look to the policies of the Obama administration, and those of G8 members who all apparently feel things are too risky to avoid inflation. We knew that one. The consistent policy of all major developed states is inflation, that coupled a history not wanting to default on debt, makes inflation the easy way out and it is lots of political fun - on the way up anyway.

Jul 09 02:35 PM

[MarvinMBA:]

Investing in the BRIC countries make sense as the USA goes into probably a downdraft that the Stars and Strips will NEVER recover from...Just look at whats happening on the ground in California... many citizens lack a fundamental education...this is no way to become first class...WE LOST IT. Therefore investing outside of the USA makes a lot of dollar and cents.

Jul 09 06:46 PM

[Plebian:]

*1 in 9 Americans is on food stamps...

*California is issuing IOUs for the 2nd time since the 'Great Depression'...

*Illinois is considering the release of 10,000 prisoners because they've run out of money...

If this is not the start of the 'Greater Depression', then what is?....

Fiat money has finally met its match... TIME. Given enough time, all fiat moneys will fail (that is by design). But Silver and Gold are sound money.

Jul 09 07:19 PM