The global expansionist stance of the major Central Banks together with overvalued markets and currencies is supporting gold's fundamentals. World demand for gold continues to increase in part due to the unwinding of gold hedges, Asian demand and a pick-up in investment demand. The underlying fundamental supply/demand equation remains strong with an annual supply around 2,500 tonnes but demand at 4,000 tonnes. Indeed, world gold production has been lagging demand for years with the gap historically filled by central bank sales. However this year the unwinding of hedges and central bank reduction of lease arrangements have added demand to the market. The current stock market value of all the gold stocks in the world is less than $60 billion, a fraction of IBM's or even McDonald's market value. The value of all global equities is many times this and gold shares make up less than 1% of all equities today.
Gold for thousands of years has been used as money, and in recent months we have witnessed a shift in investor psychology. Capital preservation has become much more important than capital appreciation. Gold does well during these periods. For two decades, the powerful US economy kept the dollar strong and gold prices low. That has changed. Lack of confidence in the financial system following the $8 trillion meltdown in the stock market and the threat of war are pushing gold prices up and individuals back into the gold market. We believe a domino-like deflation of the world financial markets will cause the pendulum to swing from paper assets to hard assets. Gold will trade at $510 an ounce next year based on expectations of a continuing bear market, improving supply/demand fundamentals, chronic geopolitical tensions and of course, a collapse of the US dollar.
Investors for some time have accused us of constantly looking at the dark side, probably because we have been perennial gold bulls and bearish throughout the late nineties. The glass is really half full and our naysayer stance is based more on a pragmatic view. But, lets explore the bull case.
Lower Interest Rates Will Boost The Economy
The bulls argue that lower interest rates will boost the economy despite the fact the easing that began over a year ago has not worked. The Fed expended what's left of its monetary ammunition by cutting interest rates for the twelfth time in the wake of a collapse in consumer confidence. Economists were concerned that the drop in consumer confidence, to its lowest level since 1993, is a prelude to a pullback in consumer spending which accounts for roughly two thirds of US economic activity. Our view is that the sluggish economy parallels the Japanese malaise, a country left with a moribund economy mired in a deflationary trap despite near zero interest rates. There is growing concern that the US economy is in the same quagmire the Japanese economy was in 10 years ago.
In the past twelve months the Fed has attempted to reflate the US economy, expanding reserves throughout the banking system, and reliquefying a badly bruised system hurt by telecom losses and a mountain of corporate debt left over from the nineties. Money has exited the stock market and moved into the bond market as a safe haven refuge from plummeting stock prices during the three-year bear market. Foreign demand for corporate bonds became an important source of capital inflows that helped fund the US current account deficit. With negative real interest rates, investors sacrificed quality for yield. The explosion in Canada's income trust market reflects this appetite for yield. But why hasn't the drop in interest rates not kickstarted the economy? Banks needing profits with which to write off their bad loans are finding it difficult to lend to strong enough companies. Instead investors have increased purchases of safer fixed-income securities causing an explosion in the derivative markets, allowing many borrowers to bypass the banking system. But this bubble is poised to burst as the underlying corporate credits begin to unravel facing a massive liquidity crisis because the capital markets are closed to them. For example, this contagion has also engulfed the banks and insurance companies following the energy, telecom and utilities losses. And long rates are beginning to creep higher as foreigners unload dollar securities, due more to attractive valuations elsewhere. Of equal concern, a lower dollar is a natural consequence of lower interest rates.
The Stock Market Is Cheap, Or Is It?
The bulls' argument is that the stock market has already discounted the above problems. The S&P is currently trading at more than 30 times, trailing reported earnings and the overall yield is less than 2%. That is not cheap. Another myth is that since this bear market has lasted the longest since the Great Depression, we must surely be at the end of it. The market is still overvalued and our belief is that the end will come when investors do not want anything to do with stocks, bonds and instead seek refuge in the safe haven of cash. Indeed, the market has not factored in the possibility of an uptick in interest rates in the wake of a falling dollar or a financial crisis when one of the too "big to fail" banks does just that - fail. That is when the market will bottom.
A Weaker Dollar Will Help
Foreign investors have financed America's credit bubble for years. The world's biggest debtor is running twin deficits. The bulls argue that America's widening current account reflects a stronger economy relative to the rest of the world and when the global economy picks up, the deficit will naturally come down. They also argue that a weaker dollar will help exports and the economy.
Twin Deficits Must Be Financed
Our view is that the deficit is the problem, not the solution because deficits must be financed. The United States with its growing deficits and anemic household savings is sucking huge amounts of foreign savings from the major industrialized countries of the world. The Treasury could raise taxes, but neither the mood nor will is there. If the central bank finances the deficit by purchasing treasury securities for its own account, it monetizes the deficit. In October, money base rose 6.7 percent up from 5 percent in September. History shows that when governments monetize deficits, currencies fall sharply, inflation pressures are rekindled and one way or another gold goes up.
The current account deficit went from $100 billion a year to almost $500 billion, doubling every eighteen months. Americans spend far more than they produce. The US trade deficit reached a new record in August growing to $38.5 billion from a revised $35.1 billion in July. The US must now attract a net $1.9 billion a day in foreign capital inflows to sustain this deficit, keep the dollar and equity markets from falling and interest rates from rising. At this rate, the deficit will reach a new record, surpassing the $400 billion deficit in 2001, second only to the previous year's record at $410 billion. When the stock market was roaring the American economy easily attracted the needed investment to cover the deficit. But with the size of the deficit almost 6% of the US gross domestic product, a level generally associated with currency crises in other economies, financing is a problem. The Organization for Economic Cooperation and Development (OECD) and the International Monetary Fund (IMF) both warned that the near record trade gap threatens the global economy and the dollar could fall sharply.
Meanwhile, following the biggest surge in spending in twenty years, the US government posted a budget deficit of $159 billion for the 2002 fiscal year, marking that government's return to deficit spending for the first time since 1997. And, if you add the cost of the impending war, the deficit is likely to be larger. The worry is that chronic budgetary deficits of $200 billion must also be financed. To date the mighty dollar has fallen 14 percent from its peak to three-month lows. With almost 50 percent of its Treasury bonds held by foreign central banks, Americans today owe more to foreigners than themselves. A decline in the dollar is self-feeding.
A Dollar Worth Less Than The Euro
As foreigners lose money because of the sliding greenback, they become less willing to hold dollars assets, causing another decline and so on. It's already started. From August '01 to August '02, equity inflows fell from $190 billion to $70 billion, foreign direct investment inflows from $190 billion to $70 billion and corporate bond inflows fell from $250 billion to $180 billion. Only by reducing the demand for dollars can America tame the deficit and only by reducing the Treasury's insatiable appetite for borrowed funds to finance the deficit can the Americans reduce demand. That will require a painful adjustment.
When capital becomes scarce, interest rates must eventually rise to attract foreign investment and that is something the bulls are not thinking about. Americans must learn to spend less and save more. With a deficit of $400 billion plus, someone elsewhere has a surplus of the same order and magnitude. Recent statistics show that Asia's central banks have been accumulating dollars, but they too are beginning to diversify into euros. A dollar today is worth less than a euro. China and Taiwan have been diversifying their piles of dollars and buying gold. China is believed to buying every ounce that the Swiss sell.
Saddam's Leaving Is Neither As Easy Nor Simple
The bulls argue that the impending war will be good for the US economy because it will be both brief and give the Americans control of Iraq's 112 billion barrels of reserves. However, they ignore the fact that the last war between Iraq and Iran lasted more than eight years and that today, Saddam and his forces are underground. The battleground this time is not the desert but the cities of Baghdad and Tikrut. More disquieting is that a war with Iraq could unleash a new round of terrorism, such as missiles aimed at Israel, the aircraft carrier fleet in the Persian Golf or even Iraq's own oil fields.
It's All About The Oil
Iraq is producing less than 2.8 million barrels a day, down from a peak of 3.5 million barrels and the oil fields need billions to repair the ravages of twenty years of war. So far, only one third of Iraq's seventy-three known oil fields are functioning. And, in addition to the Americans, other countries such as Russia, China, France and even Saudi Arabia have a keen interest in the eventual ownership of those fields. And, there is Iraq's next-door neighbor, Iran that has a strategic interest in Iraq's oil fields. Consequently, while control of Iraq's oil fields would appear to be a simple exercise, the geopolitical balance in the Persian Gulf is likely to be tilted by this war. Our view then, is that Saddam's departure might not be as easy or as simple. Those economists, who are looking for America's control of Iraq's oil fields to finance the $200 billion war bill, must find another way to finance the war. And of course that leaves the Fed with the task of financing the war as it financed the Vietnam War. A bigger deficit will mean a weaker dollar.
Gold at $510 an ounce
Gold is attractive relative to the dollar. Our premise is simple. There is considerable risk in the US dollar and investors are less confident with leaving all their eggs in the dollar basket. The US no longer enjoys special status and its economy, corporations, accountants and regulators are under close scrutiny. Gold is the second largest reserve asset in our Central Banks, after the greenback. It is our belief that there has been a long-term structural change and we are at the start of a multi-year decline of the dollar and the beginning of a multi-year bull market for gold.
What is happening to gold is simply the other side of the coin. The huge amount of debt in the world and debt servicing puts immense downward pressure on economic growth. For that reason, central banks have created unprecedented amounts of new liquidity in order to soften the impact of the debt levels without, however, creating real value in the economy. Given the widespread expectation that interest rates must be kept at subsidized low levels in order to sustain the housing boom and protect the domestic economy, this move will lead to a further debasement of the US currency and reinforce gold's new bull market. We believe that the recent increase in the price of gold is due to this diminished enthusiasm for dollar assets. Gold will continue to outperform the world stock markets. Portfolio managers faced with huge losses in currencies, bonds and equities will have no alternative but to invest in gold.
Technical View: $375 Next Target
The charts show that in the first half of this year, gold rose 19%, peaking at $330 in June and the shares rose 66%. Gold subsequently pulled back, but again flirted with $330 in September. In recent weeks gold has broken above its short and long term moving averages. Thus in technical terms gold is expected to push through the $330 resistance level reversing a twenty-year downtrend, closing the gap quickly between $330 and $375 an ounce. In the same period the US dollar index reached a high of 120 before falling to 102 and rallying to 106. With the cut in interest rates, the US dollar index broke a seven-year trendline and is poised to retest 102 and then 85. The move to $375 an ounce then would represent the second upleg, with the move to $510 an ounce representing the third leg.
A 20% Decline In The Dollar Will Push Gold To $510
With the collapse of the Bretton Wood's system of fixed exchange rates in 1971, the dollar went through two extended periods of weakness. Between 1971 and 1980, the Americans ran twin deficits and the US dollar lost 70% of its value against the Swiss Franc, D Mark and other currencies. Gold went from $50 per ounce to over $800 per ounce. In 1985, the Plaza Accord bailed out the US economy and the dollar fell 35% against a basket of currencies in twelve months. At that time the current account deficit was less than 3% of GDP. Gold in the same period went up 66% from $300 to $500 per ounce. To date, gold is up over 19 percent, outperforming Dow Jones and other currencies this year. Since the dollar is expected to decline another 20% from here, a $510 per ounce target next year is reasonable.
Dow/Gold Relationship Suggests Higher Gold Price
At gold's peak almost twenty-three years ago, the Dow Index and gold once sold at the same price. Today the Dow/gold ratio trades at about twenty-six times the gold price. At the top of the bull market in paper assets in 2000, the ratio peaked at forty-five. Historically, the Dow/gold ratio has been at ten to twelve times. The Dow/gold ratio was at one in 1897. We believe a reversion to historic patterns would either see gold go up or the Dow Index down. At ten times, the Dow Jones Index would be at 5000 and gold at $500.
It May Go Even Higher
So gold at $510? It may go higher. When Saddam invaded Kuwait in August 1990 gold flirted with $400 an ounce. Earlier, the second oil price hike of the late 70's coincided with gold over $400 an ounce. History shows that twelve years later gold still is a good thing to have in times of global stress. We believe by the time the first cruise missile is dropped, gold will be at $375 an ounce. Superimpose an avalanche of dollars and yen, upheavals amongst the global banks and massive hedge reversals as the producers and bullion banks scramble to cover their offside gold-carry positions, gold's move to $510 an ounce may be on the low side.
John R. Ing
416-947-6040
The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.
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