gold is ready to roll

July 11, 2008
Gold is ready to roll
By Charlie Aiken




Last week the gold price suddenly exploded upwards by $US36 oz in the biggest one-day spike in 23 years, breaking out of a tight trading range between $US880 oz and $US910 oz. Over the last few months speculative long gold positions have been significantly unwound at the expense of the long US dollar trade, as currency speculators have responded positively to the Fed and the US Treasury jawboning up the prospects for the US currency and the economy.

The Bernanke

While it appears the Fed has ended the aggressive interest rate easing cycle by maintaining the Fed Funds Rate (FFR) at 2 per cent, there appears to be little confidence that the Fed will seriously tackle the increasing inflationary pressures in an election year.

Instead the Fed's commentary was big on rhetoric but light on action, with the policy statement suggesting the Fed will attempt to balance "the upside risks to inflation" with the "downside risks to growth." Talk about financial gibberish. That is really Fed-speak for our "hands are tied, we have no other options." The result was a significantly weaker US dollar and a stronger gold price.



Fools gold

Although the recent US interest rate policy has exacerbated the long-term decline of the US dollar, the actions of the current Fed did not initiate the current bear market. The seeds of the current US dollar crisis were sown several years ago by the easy money policies of another Fed chairman. Alan Greenspan slashed the FFR to a 45-year low of 1 per cent, which resulted in a significant deterioration in the interest rate differentials with major currencies, seriously undermining the strength of the US dollar, and contributing to a massive trade deficit.

The loose Fed policy under Greenspan ushered in an era of abnormally low interest rates and low returns, which encouraged an unprecedented increase in risk tolerance, contributing to lowered lending standards and significantly inflated risk asset values.

The end result was the US subprime mortgage crisis, a severe US economic slowdown, a meltdown in world financial assets, a global credit crunch and further weakness in the US dollar. Not bad for a quiet and unassuming central banker who has been cast as a economic luminary. Subsequently, Bernanke's actions have merely exacerbated the US dollar weakness initiated by Greenspan's policies.

However the Fed can't take all the blame. The excessive stimulatory fiscal policies of the Bush Government since 2001 have contributed significantly to the demise of the US currency. The loose fiscal policies of the Bush Administration resulted in huge budget deficits which were also needed to fund aggressive tax cuts and the wars in Iraq and Afghanistan. The budget deficits, combined with a huge trade deficit, completely undermined the dominant status of the US dollar.

Consequently since 2001, a combination of Fed monetary policy madness and US Government fiscal irresponsibility have directly contributed to a loss of faith in the US dollar as the world's reserve currency, supporting a long term US dollar bear market, and spawning a secular gold bull market.

US dollar hedges

Fast forward to the present, and the recent response from global central banks have been massive injections of liquidity, interest rate cuts, and in the Fed's case, a slashing of the FFR to 2 per cent. The huge increase in the global monetary supply has further undermined the reserve currency status of the US dollar, encouraging a switch into US dollar hedges, particularly commodities, including oil, gold and base metals. The significant increase in commodity prices, while partly the manifestation of a weak US dollar, has also contributed to a sharp rise in raw material costs further exacerbating inflationary pressures.

However, due to the significant weakness in the OECD economies, and the fragile state of the global financial system, the Fed and the central banks have been unable to raise cash rates. At least the Fed has already confessed to abandoning inflation-targeting at the expense of economic growth. However, realistically the only real policy open to the Fed is a lip-service commitment to fighting inflation combined with an intention from the Treasury to maintain a strong US dollar policy. Good luck with that.

It is ironic that the policy of a central bank is monetary and currency stability. However we believe the actions of the Fed and global central banks are perpetuating both the weakness in the US dollar, and contributing to a significant rise in inflationary pressures, which are creating a perfect storm for gold.

A global problem

In the meantime, the US consumer price index is rising at double the FFR. However the producer price index, which is projecting future consumer inflation, rose at 7.2 per cent annualised before adjusting for energy and food price rises. (After all, who uses and food or energy in their daily life?) In addition, the latest figures from the Conference Board's June survey of consumer sentiment revealed that Americans believe that inflation will be 7.7 per cent in a year's time. This represents the highest figure in 28 years, and follows expectations of 6.8 per cent in April, and 5.4 per cent in Feb, compared to 5 per cent last Sept.

It appears inflationary expectations are rising rapidly, and becoming embedded, which makes strong Fed policy intervention even more important. However the Fed is restricted to empty rhetoric.

The weakness in the US dollar is supporting a significant increase in global inflationary pressures from Sydney to Shanghai, in base metals to oil and soft commodities. The signs of world inflation are everywhere from OECD countries, to developing economies. We can all feel them in our daily life.

In the EU, consumer prices in the first-quarter rose by 3.2 per cent – the highest since measurements began in 1997. In the UK, producer prices recently rose 7.1 per cent in April – the fastest annual pace since 1986. Even in Japan, inflation is 3.1 per cent, which is the highest in two decades. In Brazil the annualised CPI has reached 6.1 per cent while inflation in Russia and India is over 8 per cent per annum. In the Middle East inflation is soaring with the UAE recently posting double digit increases.

However in China, inflation is broadening past surging food prices, with the April CPI at a 12-year high of 8.5 per cent. More worrying is the PPI, which rose 8.1 per cent annualised. The significance of this trend should not be underestimated considering for the last decade China has been a significant exporter of deflation. A further rise in the Yuan is vital. This would give the Chinese central bank the flexibility to better fight inflationary pressures.

As a result, an usually long period of low global inflation and abnormally low interest rates is past, and sharply rising Chinese, and global inflationary pressures, pose a much greater risk to the global economy than a US slowdown. While inflation is the No 1 enemy of global equity markets, we firmly believe it will drive gold into the third and most powerful stage of the current bull market. Hang on for a wild ride.

Inflation and gold

A brief look at the history of 1970s, which ended with the previous all-time high for gold, reveals that secular gold bull markets are characterised by three distinct waves. The first wave is the outperformance of gold compared to the world's "reserve" currency. In this context, since 2001 the strong performance of gold has supported a 95 per cent+ inverse correlation with the US dollar.

Traditionally, the next wave reflects gold's outperformance against all currencies. In this regard the euro-dollar gold price has risen by nearly 70 per cent over the last 12 months. Considering the significant underperformance of the US dollar relative to the euro, this confirms the recent second wave of the current bull market. In addition, the recent Irish rejection of the EU treaty, and the simmering tensions with Spain and Italy over the EU central bank interest policies, are a reminder that the euro is a flawed currency. We believe a significant weakening of EU economic growth will undermine the support and the faith in the euro, ushering in the third and most powerful wave of the current gold bull market.

The third wave, and this was particularly the case in the 1970s, is characterised by a significant rise in inflation. In this wave, there is complete loss of faith in all currencies, including the reserve currency, and gold soars as the only real-hard asset alternative to paper assets. In a replica of the current environment, the third wave of the late 1970s was similarly characterised by a rampant oil price and very strong base metals prices. Currently the industrialisation of China is also driving oil and base metals, which we believe will add to the intensity of the third wave. We believe gold has just entered the final wave which will result in new inflation-adjusted highs.

Not that word

While on the subject of history, there is no doubt that the current global environment is remarkably similar to the 1970s, without the platform boots and flares. There is no doubt the OECD economies are facing the twin economic evils of slowing growth and rising inflation. This condition is uncommonly called stagflation, a condition which like tuberculosis, was thought to have been eradicated in 1970s. Of course history reveals that the last period of global stagflation in the 1970s led to greatest gold bull market ever. Gold rose from US$20 oz in 1969 to a peak of $US850 oz in the decade ending January 1980.

Oil and commodities

The performance of oil is another that reason for the tight trading range in gold until recently. In the short term, oil has partly taken gold's traditional status as the primary anti-inflation US dollar hedge. As a result gold is trading at multi-decade lows relative to oil.

However the official US inquiry into the activities of speculators within the oil market will ultimately result in sanctions and curbs in oil futures trading. The primary driver of oil remains the structural increase in demand from China against a backdrop of chronic supply shortages. However there is currently some speculative premium in the oil price. There is no doubt that the Fed and the Treasury, are determined to add a new transparency to the oil market, which we believe will limit the activity of speculators. It's all politically rubbish and won't in any way remedy the supply side issues in oil, but it could take us$10 off the oil price in the very short term. Perhaps it already has.

We believe the sudden break-out in gold is also partially reflective of the expectation that oil will take a backseat to gold as the ultimate US dollar hedge. Gold remains significantly undervalued relative to oil considering both have closely tracked an historic 10 to 1 ratio implying a current gold price of around $1400 oz.

In addition gold has significantly underperformed other commodities such as iron-ore, coal, and base metals since the all-time intra-day high of $US1030 reached on March 17 this year. However history shows that gold is a late-cycle performer and gold bull markets are long term by nature. The seeds of the last great secular bull market for gold were sown in 1969/70, but gold did not peak until January 1980. The current gold bull market is only seven years young.

Physical demand

There is no doubt the performance of gold has been traditionally driven by weakness in the reserve currency. However it is worth noting that 70 per cent of physical gold buying is driven by jewellery demand, with the balance being mainly investment. Therefore it is not surprising to see reports that Indian jewellery demand was strong at $US880 oz.This level is consistent with the bottom of gold's recent tight trading range.

Since the March high of $US1030 oz, gold has fallen steadily due to unwinding of non-commercial gold positions. However it is important to remember that non-commercial data includes both Exchange Traded Fund (ETF) figures, which include mainly long-only commodity funds, and Comex net long positions, which are predominately speculative. It is interesting to note that ETF gold positions have fallen by just 9 per cent to 24 million ozs since the March high, while Comex net speculative longs have fallen by nearly 25 per cent to 15 million ozs.

This confirms that physical or investment buying from long- only commodity funds, and sovereign wealth funds has remained relatively strong, and the bulk of the selling has come from the speculators. As a result speculative positions have been largely unwound and gold is poised to begin another sharp upward move underpinned by strong investment demand.

New high

The recent 15 per cent correction from the May high is a classic correction in a long term gold bull market and the sudden breakout from the recent tight trading pattern is a bullish signal. The oil price has significantly surpassed the inflation-adjusted all-time high of $US105.90 barrel. However the previous $US850 oz record high for gold in real terms is $2250 oz.

Currently gold is nearly 60 per cent below its inflation-adjusted high, compared to oil which is trading at a 30 per cent premium. In addition, investment demand is strong, jewellery buyers have returned, and the speculators have exited long positions. Gold is at an important inflection point, after a period of consolidation, the recent move represents a new leg of a long-term bull market. As a result a new high in real terms is very possible within the next few years.

Australian gold stocks

In the meantime Australian gold stocks have suffered a substantial P/E de-rating resulting in significant underperformance relative to the North American peer group. This is due to a broad increase in risk aversion by local investors, and a series of domestic production disappointments.

In addition, while it is not just gold companies that are experiencing production disappointments, the recent announcement from Newcrest (NCM) is good news. It appears from the recent guidance that FY09 gold production is expected to be 700-750,000 oz, in line with the markets' expectations prior to the gas incident while costs are forecast to be up just 1 per cent and 2 per cent respectively for this year and next. This is significantly better news than factored in by the short-termists.

As a result my two main gold recommendations remain intact. Newcrest (NCM) remains our preferred big cap play while my small cap recommendation remains Avoca Resources (AVO).

The Australian equity market is attempting to make some sort of short-term trading bottom and therefore we see better short-term upside trading leverage in selected beaten up industrial cyclicals and big cap resources. The medium-term case for quality gold stocks remains absolutely in place. I would continue to accumulate NCM and AVO into any underperformance over the next few weeks.