19th April 2013
The gold price will recover when the market starts to respond properly to bad news according to F&C director of global strategy Ted Scott. He says one scenario even involves some countries part-nationalising their banks as they adopt radical measures to get money back into the economy bringing inflation and boosting gold.
In a note issued (Thursday 19 April), Scott notes that the dramatic fall in the price of gold on Monday was the biggest since 1983.
He writes: “The recent sell-off is the biggest since gold started its ascent and with a fall of over 20% since it peaked gold has been officially declared to be in a bear market.”
Scott says that analysts have been predicting a correction for the last ten years. Scott argues that investors must decide whether the change is for fundamental reasons or if it represents a temporary setback.
The note continues: “I believe the latter view is correct and the reasons for the recent fall in the gold price are largely tactical and technical.”
He says much of this is because of a “failure to respond to bad news” which would have been previously been bullish for gold.
Bad news: Korea
“From a political viewpoint the increased tension resulting from the sabre rattling in North Korea should have helped gold’s role as a safe haven.
Bad news: China
“Elsewhere, there are signs the new leadership in China is serious about trying to rebalance the economy towards consumption and is prepared to tolerate lower growth to achieve it. The first quarter GDP growth figure of 7.7% was disappointing compared to market expectations.
Bad news: US
“In the US,the economic newsflow was resilient in Q1 to the impact of the fiscal cliff but data this month has been soft, including the key Institute of Supply Management and non-farm payrolls as well as falling consumer confidence as the higher taxes take effect.
Bad news: Europe and Cyprus
“Lastly, there have been signs that the Eurozone debt crisis is worsening again with the botched bailout of Cyprus and expectations that other smaller members of the currency union may require help. Even the news that bank depositors were forced to take a haircut did not act as a fillip to gold.”
With Cyprus, Scott says the speculation about Cyprus selling gold reserves has called into question other banks’ holdings. One big worry is Italy and what would happen if it had to sell some of its gold reserves. The market is also worried that emerging market central banks could cease or reverse their policy of buying gold. However, Scott does not believe that the European Central Bank would risk imposing anything like the Cyprus settlement in Italy or Spain.
The note adds: “The Eurozone authorities understand the risks of a major dislocation of the financial system in Europe and what they are prepared to do to Cyprus they would not countenance for Spain or Italy.”
Scott adds that the US dollar has arrested its secular decline. “Another important reason for the bull market in gold has been its role as a hedge against the decline in the US dollar. One of the main reasons for the weakness of the dollar since the onset of the financial crisis has been the ultra-easy monetary policy pursued by the Federal Reserve. In particular, quantitative easing (QE) has been associated with a lower dollar and a rising gold price and this link has recently been severed.”
He says the globally inflation remains benign while retail demand for gold has slowed down particularly in China though India has remained resilient so far.
However Scott is sure that the strategic case for gold remains strong.
The strategic case for gold
“There are many reasons for holding gold but when it last experienced a major bull market it acted as a hedge against the double-digit inflation of the late 1970s. It is gold’s ability to act as a safe haven that is its most attractive characteristic and why the metal tends to do well in times of economic stress,” the note says.
“The policy being pursued by governments and central banks can be summarised as ‘financial repression’. Lacking the ability to reduce the onerous debt levels through higher economic growth and not being prepared to allow a natural adjustment through default, the authorities have chosen to gradually erode the value of debt over time by suppressing interest rates and investment yields below the rate of inflation. So far they have succeeded in lowering interest rates and yields to historic lows so that in many countries there are negative real yields but inflation, as the IMF put it in its recent report, remains the “dog that did not bark”. Under the current scenario the policy of financial repression will take years and even decades to reduce debts to manageable levels with economic growth likely to remain muted. This is why NCBs will continue to pursue aggressive and unconventional monetary policies until they succeed in creating higher inflation, which they will do. For gold the question is when.”
Scott sees two possible outcomes to the current financial crisis in the absence of sufficient growth.
First that the authorities will continue with their financial repression until it succeeds in creating high enough inflation to erode the huge debt burdens accumulated before the financial crisis.
Second that the authorities change policy and accept that market forces need to cleanse the financial system. This would lead to a major recession and banking crisis as debts are written-off and debtors default but the cathartic nature of such action will create the conditions for sustainable and much lower leveraged growth in the future.
He adds that if the current policy remains ineffective, the next step is likely to be the partial nationalisation of the banking sector to ensure the commercial banks pass the increased liquidity into the broader economy. When this happens inflation is sure to respond and gold will become the asset of choice.
“The recent fall in the gold price has been dramatic but it does not undermine the long term and strategic case for holding gold as an essential component of a diversified investment portfolio. There are several reasons why gold has fallen sharply but they are largely technical and transient in nature. In contrast, as the financial crisis continues to deepen (the IMF downgraded its global growth forecasts again on 16 April) and central bank policies fail to create the growth or inflation to reduce debt burdens, the authorities will resort to even more extreme and unconventional policies. This will ultimately result in the nationalisation of banks to ensure credit growth is reflected in the broader economy resulting in the higher inflation necessary to erode debt. In this scenario, gold is the outstanding asset to hold,” he adds.