Gold at $510 an Ounce
GOLD: IS IT FOR REAL THIS TIME?

May 9, 2002

Gold edged over $300 an ounce, to its highest level in three years coinciding with a breakdown of the US dollar and a breakout of the euro.F Although, gold regained its luster, yet the most common question asked of us, "Is it for real this time?" In recent weeks, gold has twice broken through the $300 an ounce barrier before pulling back, raising concerns that the current rally is temporary. Bull markets climb walls of worry, so we are not surprised about the cautiousness of the marketplace. It is our view that several factors have converged with the planets finally lining up to make precious metals more attractive than they have ever been in nearly twenty years.

Japanese Gold Rush

Japanese citizens have been buying gold, tripling their purchases in the first quarter in the wake of fears of a banking collapse. Yen based gold was an effective hedge last year, increasing almost 20%. Japanese demand for bullion also swamped the paper market with open interest in the TOCOM market rivaling that of COMEX.

Japan is the world's second largest economy and narrowly avoided a meltdown last month due to some last minute tinkering. Japan has not fixed its shaky financial system, despite pledges to clean up the bad loans estimated at $1.5 trillion yen or almost ten times what the government officially stated. Japanese investors, facing financial ruin have so far switched less than 1% of their $11 trillion in savings into bullion. In February, Japan bought 20 tonnes of gold, up from 10 tonnes in January and 3 tonnes in December and purchases this year should exceed 200 tonnes or so.

Meanwhile, prices have fallen for three years in the worst deflation since the Great Depression. The government and the Japanese central bank have exhausted the traditional policy tools. Interest rates are virtually zero, with billions of dollars sitting in money market funds. The banks are not lending money because of their heavy debt load. The government itself has a heavy debt load, which now stands at 130% of annual GDP and is gun-shy about issuing new bonds, cutting taxes further or even inflating the money supply. Public spending continues to focus on propping up the system rather than getting the economy working. Japan finds itself in a box. What is needed is the government to securitize the billions of debt as the Americans did when they bailed out their savings and loans industry. In addition, the government should allow the weaker banks to fail. Instead, Japan is focusing on near term tinkering rather than face up to the scale of the problem. Last month the government targeted short sellers thinking they could chase them from the market. It's not about the short seller, it's about Japan's debt. Gold is a good thing to have as an insurance policy.

Crisis of confidence in capital markets

The Enron collapse sparked a wave of paranoia and new questions about "trust" in accounting, the accountants, regulators and even analysts. The financial system is undergoing a crisis of confidence amid renewed scrutiny by the regulators and investors alike. Greed is no longer good - what a concept. It's not enough to talk of perceptions of growth but in this post-Enron era, the new focus is on fundamentals, earnings quality, trust and experience - concepts of yesteryear. In such an environment, gold with its transparency is a good commodity to have. Ironically the darkest hour for the financial system could be the brightest for gold.

Greenback bubble has burst

At long last, the US dollar's seven year bull market is ending amid concerns about the US current account deficit, mixed signals on the economy, artificially low interest rates and capital market concerns. The US borrowed more than $1 billion a day to finance last year's current account deficit of $417 billion or 4% of the nation's gross domestic product (GDP). In February, the trade gap jumped 12% to $31.5 billion, the widest gap in 10 months and could hit a $435 billion or 5% of GDP this year. The International Monetary Fund warned, "when countries run sustained current current account deficits in the range of 4%-5% of GDP, they eventually reverse, and the consequences in terms of the real exchange rate, can be significant".

Current account deficits are a cause for concern because they are unsustainable and with the weakness in the greenback, the investment appetite for the dollar seems to be shrinking. The dollar declined nearly 2% against the yen to a three month low and four month low against the euro. The US dollar index broke 116, a critical level. Yield hungry global investors, who once funded the US deficit, are now staying away because American rates are among the lowest in the world and their equity market amongst the worst. Also, capital inflows are slowing, due in part to the repatriation of Japanese funds. Japanese companies are dumping US assets in order to re-liquefy balance sheets. Finally, Greenspan confirmed that US interest rates are artificially suppressed in order to subsidize the economic recovery. The bond vigilantes realize that this short-term band-aid approach is ultimately inflationary posing negative implications for the greenback. The lack of Fed tightening is fatal for the dollar because investors sense they are going to be paid back in dollars with less purchasing power. Consequently, US treasuries are not the place to hide, and like the Japanese and Argentine experience, gold is an effective hedge against the US dollar collapse. Between 1985 and 1987, gold doubled when the US dollar fell by half.

Fourth oil shock?

Gold spiked amid concerns that the surge in oil prices and simmering Middle East tensions would not only dampen economic recovery hopes but also escalate market risk. We might be facing the fourth oil shock in thirty years. The first, occurred in late 1973 when OPEC slapped an oil embargo sending oil prices, gold and inflation higher. The second oil shock occurred in late 1978 after the Iranian Revolution, which coincided with a run-up in inflation and gold prices. The third shock was in 1989, following Iraq's invasion of Kuwait, which temporarily sent prices skyrocketing. However, the common denominator other than the usual unsettled Middle East geopolitical climate was that the global economy always sank into a recession after the oil shocks. Now with oil prices rising almost $10 to $30 a barrel, investors seem to have forgotten the oil shocks and its consequences. Gold was a good thing to have then, as it is now.

Inflation is back

A study of previous oil crises also shows that the policymakers' typical response to a slowdown was to bring interest rates down. But the Fed cannot respond with another round of interest rate cuts since it has already reduced interest rates from 6.5% to a forty year low of 1.75%. Like the Japanese, there is little ammunition left. Ironically, fears of a return of inflation were muted in part by lower energy costs and the drop in interest rates. Now the with oil prices flirting with $30 a barrel, the recent surge in gold and commodity prices might not be a flash in the pan.

While there are concerns about deflation, nearly every commodity has been in a stealth bull market, including crude oil, copper and even coffee. In the technology sector, basic memory chips are up more than 200% from last year, and there are rumours of shortages. In March, producer prices increased 0.8%, the biggest gain in fourteen months. This should come as no surprise to the monetarist camp, who were warning that the injection of money into system following 9/11 was eventually going to have an impact. M2 was growing at a 12% annual rate, but in the latest three months has slowed down to a still robust 6% annual rate of growth. Gold stocks are up by more than 30% in the first quarter. Gold has long been regarded as a means of insurance against inflation, which erodes the value of paper currency. We believe the current move is a harbinger of events to come.

Hedging is socially incorrect

At long last producers are reducing their outstanding hedge positions. Hedging has become socially incorrect and the reduction of total producer hedges for the second year in a row has bolstered prices. Investors want 100% of the upside and not what some bank will pay for reserves in the ground. With interest rates at forty year lows, the low contango makes it difficult for companies to lock in attractive forward prices. Thus the absence of hedging will be bullish for the gold price.

Arch hedger AngloGold has "aggressively" reduced its hedge book from 14.6 million ounces to 12.9 million ounces and will further reduce to below 10 million ounces. Newmont has become the flag bearer of the non-hedgers and will reduce Normandy's 11 million ounce hedge book by delivery into existing contracts. Ironically, Newmont's hedges are underwater today. Long-term hedger, Barrick will even deliver half of its production this year at spot. Placer Dome, however is the exception, hedging a whopping 40% of gold production over the next five years. This dysfunctional step is not only out of step with the industry, but at $324 an ounce its hedge book will become negative, wiping out $500 million of book profits. The industry has hoisted themselves on their own petard with most of the Australian producer hedges underwater today. When the industry hedged they forced gold prices down, ironically unwinding those hedges will cause demand to rise.

What could go wrong?

Cenral banks could sell more gold. European Central Bank Vice-President Christian Noyer said that the role of gold in central bank reserves was declining, but was still a central part of central bank reserves. "The importance of gold is slowly declining, but it doesn't mean it's not black and white, it doesn't disappear from one day to another". Mr. Noyer is stating the obvious but misses the point. Despite all, gold historically has and will remain a reserve asset.

After all gold has been losing importance since the breakdown 30 years ago of the Bretton Woods agreement. Central banks were net sellers since 1989. Gold sales are a fact of life. However, the fear of large sales was blunted by the Washington Agreement that limited central bank sales to 400 tonnes of gold per year till September 2004. Like the bogeyman, investors are afraid of what they can't see, i.e. more sales. Renewed fears sparked by the Bundesbank's intention to sell more gold after the expiration of the Agreement and the Swiss government's monthly sales temporarily depressed prices. Germany and Switzerland are among the top tier, along with US, France and Italy holding over 590 million ounces or half the total holdings. Yet, the French, Italians and Americans refuse to sell their gold holdings.

If central banks don't like gold, why is gold still the central banks' second largest holding after the US dollar? We believe by capping their gold sales, the Washington Agreement acknowledged gold's important monetary role. The banks earlier found that a free-for-all gold sales amounted to "shooting themselves in the foot" since they still held gold in reserves. In addition, no one, including the central banks want to look like fools, selling gold in a rising market. The UK government auctioned its gold and left $250 million on the table. In a rising market, central bank sales no longer appear to be a smart move. Thus, we believe the threat of more central bank sales is just that, a threat.

Conclusion: Gold at $510 an ounce

Gold is an effective insurance policy, and an inexpensive one indeed. So far it has protected Japanese assets against depreciation, bailed out Argentine investors and protected investors against a collapse on Wall Street. Gold has also proven itself as a safe haven asset in times of political instability. Middle East violence, Argentinean defaults, Japanese bank insolvencies are fanning gold higher amid strong market fundamentals. On a fundamental basis, supply/demand conditions are tight, mine production has plateaued, hedging has become socially unacceptable and the lack of significant gold discoveries means that there will be fewer supplies coming to the market. Demand remains strong, in particular due to the resurgence of Japanese demand. And, a collapsing US dollar supports gold.

We maintain our gold assumptions this year at $325 per ounce with the likelihood of hitting $375 per ounce this year. We continue to believe that we are in the early stages of gold's new bull market, which may last two to three years with expectations that gold will trade at $510 per ounce sometime in 2003. Despite German jawboning, we expect the Washington Agreement to be extended beyond September 2004.

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