Panic has seized the minds of many as the shaking of a credit implosion rumbles through the marketplaces of today’s moneychangers. The ground is giving way beneath them threatening to suck them into a financial hell of derivative defaults and dishonored debts. The penalty is eternal death for hedge funds doomed never to rise again whilst for others they escape those searing flames by the skin of their solvent teeth.
For those scrambling away from this mighty cave-in of debt, to whom do they run to for refuge? The answer paradoxically is to a place which itself seems on shaky foundations – that modern Tower of Babel known as the US Federal Debt. It is an edifice to behold as it rises to the skies and vanishes into the clouds of profligacy and unaccountability. It is now nearly nine trillion dollars high and still rising.
No one can scale it and certainly no one will pay it off even if they were mad enough to try. Like the old Tower of Babel, it will one day succumb to the confusion of tongues of many a foreign creditor abandoning it and that will be the end of that. It will become the habitation of jackals and vultures.
But in the meantime, the hymn of the fund manager is this:
“The US Treasury Market is a strong tower, the moneychangers run into it and they are safe.”
How safe I ask you? The tower in question is short-term government debt issued and traded worldwide. These mature over three months and that is how long nervous investors hope this carnage will last. What if they are wrong and the edge of financial perdition continues to implode towards them?
The markets have taken a few blows these weeks past but not strong enough for some to believe that government debt will totter and fall. We shall see but the economic and financial assaults of the past suggest that it is the Golden Tower than men will resort to when all else fails. In that light let us consider gold.
First we ask what drives the price of gold. Let us look at the facts and statistics of gold demand. Below is a table from the World Gold Council on gold supply and demand up to the end of 2006.click to enlarge
The supply figures are easier to collate than the demand side for the simple reason that the number of mining companies, governments and scrap recyclers is small and they tend to publish their numbers. On the demand side, the much greater number of jewellers, coin dealers, dentists, investment firms and a myriad of industrial users is harder to collect and analyse, even if they published their numbers. Hence we have an “inferred investment” at the bottom of 90 unaccounted tones for 2006. For the purposes of this study, we assume the balancing figure is proportionally distributed across all demand sectors.
Based on these statistics, how would gold perform during a prolonged economic contraction caused by any number of looming threats you may care to mention? One fact that leaps out with clarity is jewellery demand - gold is primarily an object desired for its beauty and value and rightly so. At 2,267 tonnes out of a total of 3,362 tonnes, jewellery made up 67% of total gold demand last year. Of this, India will be the perennial leader of jewellery demand with the USA a close second. We note that jewelry demand is down from a high of 75% in 2004 perhaps because of the higher price of gold. However, based on this fact alone, we can discount the effects of other demand factors such as industrial and dental as secondary to this study.
So, the pessimist may suggest that a credit, fiat or energy crisis would cause jewellery demand to plummet and hence smash the price of gold to smithereens. That seems logical, but another set of numbers suggests otherwise.
The period that interests us most is 1972-1980 when crude oil prices rocketed from $3 to $35, this was a crisis if ever there was one for historic gold prices to feed on. Oil prices delivered a hammer blow to the economy as they tripled in a matter of four weeks in February 1974. We talk about crude oil price tripling in four years between 2002 and 2006 – but four weeks? Think about that.
What was driving the gold price then despite flat or falling jewellery demand? The answer in terms of cause was oil and in terms of effect it was investment demand.
Indeed, to demonstrate the correlation between crisis (oil in this case) and gold, a study by Salomon Brothers back then showed that gold and Saudi Arabian Light crude both notched compound annual returns of exactly 31.6% between 1970 and 1980. The inflationary link between the two is strong. In fact, investment demand for gold consumed over 3,700 tonnes of gold in that decade which represented 25% of all demand. In the manic two years of 1979-1980, investment demand rocketed to 45% whilst jewellery demand slumped by half.
As a comparison to those heady days, gold investment demand hit a low of 5% in 2000 as relieved Y2K watchers dishoarded their bullion coins en masse. Today, investment demand has recovered to a 19% peak last year, but this is still less than half of what it reached in the inflationary 1970s! A look at the table below shows how investment demand in tonnes drove the price skywards while demand for jewellery either stayed flat or fell (data taken from Timothy Green, "The New World of Gold").click to enlarge
The bar hoarding row contains negative numbers to balance the mining, scrap and government sales figures against the perceived demand. The Total Investment row is the sum of Bar Hoarding and Official Coins and is to be compared to the Jewellery demand row. Thus it is assumed that from 1969-1972, investors were selling gold to make up the supply shortfall. That changed dramatically with the first oil crisis in 1973 as investment demand shot up to 799 tonnes in 1974, which would have included the buying up of official coins such as the South African Krugerrand.
Meanwhile, as the oil recession began to bite, jewelry demand dropped from 1020 tonnes in 1972 to a paltry 248 tonnes in 1974. However, the slack was taken up by crisis watchdogs as investment demand leaped from –35 tonnes to 799 tonnes or a total change of 834 tonnes which more than balanced the net drop of 772 tonnes in jewelry. Meanwhile, the gold price nearly tripled between 1972 and 1974.
So, consumer demand typified in jewellery quartered in two years, but it mattered not as investors fled to the safe haven of gold as an early version of Peak Oil hit the Western economies. In fact, strangely enough, the final big move in gold up to $850 in January 1980 did not see the same big investor demand for gold as 1973-1974. The reason was that jewellery demand had recovered to 1031 tonnes in 1978 putting extra pressure on supply but it fell off again as the second Iranian oil crisis arrived and recession followed.
So, moving onto recent years, the investment demand for gold from 1997-2006 was:
Demand in 2006 was at a multi-year high and only bettered by the 1974 figure of 799 tonnes. However in terms of percentage of overall gold demand the combined tables look like this. Since the investment numbers were negative in the early years, I only use coin purchase figures for them.
So take a look at that, in 1974 investment demand was as high as 60% of total demand! That is a taste of things to come as the ground begins to give way under the tower of inflationary debt no longer collateralized by cheap energy and commodities.
Now we see that our 2006 record only does better in 5 out of 13 years in the 1970s bull. In fact, since total demand is now more than twice what it was in the 1970s, we would have to scale up to a demand of 2,017 tonnes to see the kind of investment demand we saw during the 1973 oil shock. The question is what price would the market have to adjust to provide that extra gold? Somewhere north of $1,500 I imagine.
The flight to T-Bill quality has been seen and it was a sight to behold as yields plummeted 2.4% intraday from a previous calm of 4.8%. When the flight to greater and golden quality begins, expect the same fireworks for the sovereign of metals.