Chirag Mehta is Fund Manager (Commodity), Quantum Asset Management
Going back to why gold has climbed for 10 straight years, and from that long term perspective, not much has changed for gold. Pledges of monetary interventions in unlimited quantities and time horizons exemplify the ill conceived ideologies. The main reason we believe that gold’s fundamentals are probably intact is because of the policy-making theories, mainly the theory that the economy can be made stronger via more monetary inflation, further credit expansion and more government spending.
The main influencing factor in the gold market today is the massive and unrealistic heap of sovereign debt throughout the western financial system coupled with a paper currency that is positioned as the reserve currency of the world, which however can be issued and abused by a single government. These high levels of debt, combined with slow economic growth compel central banks around the world to ‘print’ more dollars and other currencies (in order to pay the bills), stimulate the economy and inflate away the debt burden with an intentional plan of currency devaluation.
The Euro zone is currently like a financial time bomb as sovereign debt slowly positions itself towards a massive explosion of epic proportions. The peripherals are unable to break through the vicious cycle of austerity and slow growth. The Euro will only survive until these economies can withstand the de-leveraging afflicted on their economies. The intended lending by ECB to European banks in order to ease liquidity and resolve the crisis is much in vain as you cannot solve the debt crisis by issuing more debt and or creating money out of thin air. It’s just an extension of the measures undertaken by the Fed towards more monetary debasement. Issues like lack of internal policing and commitment from its member nations renders the possibility of a credible fiscal union meaningless.
Negative real rates still prevail, and with the economic outlook still showing no signs of real improvement, these negative real rates will not fade away easily as any increase in interest rates would cause considerable strain to already hampered public finances.
To sum up, there doesn’t seem to be any material change in the fundamentals that have led to the Bull Run in gold. The factors that have caused a sharp decline in gold prices seem to be more temporary in nature. This is most likely a corrective, consolidative phase in gold prices which has been an integral part of the move and should not come as a surprise.
Head winds
There’s a view that with stronger economic recovery there would be reduced demand for gold. Yes a stronger recovery would certainly diminish the probability of further monetary infusions but would risk run away inflation on account of the monetary excesses infused over the last few years. The Fed has strategized to avoid withdrawing until a firm recovery is at hand which could indeed be late and only result in high inflation. Also, there is no surety of return to a surplus world because the U.S even in its boom years was still running deficits leading to a weaker dollar and thereby an increase in gold prices.
The long term trends
The relatively high prices seen over the past few years are well supported by fundamental factors. We believe that gold is rightly increasing in nominal value being the only currency whose supply is highly constrained. In simple words, gold is simply adjusting to changes in global monetary conditions. When a central bank increases their money supply, the price of other currencies adjusts upwards. This is true for all currencies including gold.
Long-term trends in gold prices are driven by changes in the overall level of confidence in the monetary system and the economy. Therefore, to analyse gold over the long term, it needs to be seen as a monetary asset rather than a commodity. Given the current economic backdrop, where governments are struggling with problems like rising deficits and unsustainable debts, it is indeed logical for gold prices to increase in value. Gold prices are clearly trending upwards over the long term. The macro-economic and supply-demand drivers point to a continued increase in gold prices.
Though we have seen demand from key consumption centers (like India and China) remain subdued for a while; it’s likely to bounce back strongly. We are already seeing revival in Indian demand in the second half of the year. Even China would resume the trend of high consumption growth as the economy stabilizes and also a high probability exists for diversion of savings into gold in a low interest rate environment that at times drive real interest rates negative. Investment demand has been robust and would continue to grow lending support to gold prices. Broad themes that would drive gold prices are currency debasement, rising inflationary fears and diversification of investments and reserves to gold.
With other governments following the same path, and with other countries consciously trying to weaken their currencies for competitive reasons, there is a spiral of competitive devaluation underway. This provides little confidence for holders of those fiat currencies. So it is not surprising to see gold prices are on the rise and infact gold prices are rising in other currencies such as Euro, sterling and Indian rupees, is a credibility test of gold being a store of value. Gold as a percentage of total investments is still very miniscule. Even a small shift to gold can lead to large price increases. If concerns surrounding Quantitative Easing, monetization and European sovereign debt defaults trigger another broadly based loss of risk appetite, investors would no doubt want to increase their gold holdings.
The uncertain macroeconomic environment and looming inflationary threat over a long term reiterates the need for gold in one’s portfolio. Make a strategic allocation to gold because it’s the counterweight to paper money which is continuing to lose credibility as a store of value.
DISCLAIMER: The views expressed in this column are his own and do not represent those of either Quantum AMC or Afternoon Despatch & Courier.