The future is golden

Gold has long been regarded a faithful barometer of economic health, its price inversely reflecting pressures on major currencies and indices. So it is little wonder the precious metal is going through a renaissance as world economies endure possibly their darkest hour since the Great Depression.

To appreciate why gold is called the ‘crisis commodity’, it is worth looking at its performance during recent economic and political crises.

Following the terrorist attacks in the US on September 11, 2001, gold benefited from a flight to quality while in the wake of the dotcom crash of early 2000, gold held its own as equity markets everywhere tanked.

The fears generated by the 1973 oil crisis, 1979 energy crisis, and the 1987 stock market crash similarly prompted increases in the price of gold.

The difference now of course is the extraordinary rate at which the US Federal Reserve and the UK (and potentially Australia) are pumping out freshly minted dollars and pounds to bail out “too big to fail” public and private institutions, and prop up credit afflicted, deflationary economies.

But without any offsetting actions such as tax and interest rate hikes, and in the face of existing budget deficits, these actions may in fact trigger another global phenomenon: hyperinflation.

Figures show that at the end of September 2008, the US held a record deficit of US$1.2 trillion and debt of US$10.6 trillion, the latter up one trillion on the corresponding period and growing exponentially. And these figures do not include President Obama’s US$787 billion stimulus bill or the US$1.2 trillion bank rescue package.

Taking these astonishing figures into account, it is not unrealistic to expect gold to reach US$1,500-2,000 an ounce in the mid-term as investors turn to the yellow metal to preserve and protect wealth against the prospect of major currency devaluations and the associated risk of hyperinflation and compromised credit rankings.

We are already seeing the trend. While in the early days of the crisis gold did suffer from the commodity sell-off, a decline in jewellery demand and an instinctive flight into US Treasuries, a more realistic view has since rallied its price higher against major currencies and it is now regarded as the best performing of the asset classes.

In the past four months alone, gold has risen over 30 per cent against a fall across most major stock exchange indices of over 17 per cent, recently breaking through the historic US$1,000 mark for the first time since March 2008.

Given the unprecedented levels of uncertainty, we are likely to see gold steadily trending higher.

Gold’s reputation as a hedge against inflation and a highly liquid and measurable medium of exchange is based on centuries of tradition. Dating back almost 3,000 years, it is the world’s oldest international currency, having withstood the rise and fall of empires, world wars and great depressions.

Until the US Government abandoned the Bretton Woods gold exchange system in 1971 (in response to fiscal pressures stemming from the Vietnam War), gold had, in various forms, provided a stable benchmark that currencies (and hence debt) could be pegged against and converted to.

However, following Nixon’s decision to end gold’s run as the global reserve currency and replace it with the greenback, that debt has effectively been benchmarked to a paper asset, the purchasing power of which has since dropped more than 80 per cent.

Unlike paper assets, gold carries its own intrinsic value, making it a sound store of value. Testimony to this is that central banks today still hold, on average, around 10 per cent of their reserves in gold, and there are expectations that some governments, such as China’s , will look to bolster their holdings in order to further diversify their heavy exposure to the US dollar.

Australia’s own reserves, at just 4 per cent, are also under-par following the Reserve Bank of Australia’s controversial decision nearly 12 years ago to sell two-thirds of its gold reserves.

The biggest factor affecting the demand for and price of gold is the level of fear and greed in the air. The hint of a recovery, or of rescue plans actually working, sends rays of hope across equity markets and dulls gold’s attraction. But more often than not these ‘silver bullets’ are failing to hit the mark.

Take for instance the Dow Jones Industrial Average’s 4.6 per cent plunge on February 10 in response to US Treasury Secretary Tim Geithner’s underwhelming ‘financial stabilisation package’. Gold, in response, was up more than 2 per cent that day.

Such movements indicate that gold is once more being called upon to restore economic order.

This is not to advocate a simplistic return to the gold standard or to hoard gold bars: the latter is impractical, while should gold be pegged to the debt-inflicted greenback its value would be in the tens of thousands per ounce.

To some degree, the market is self-correcting this disturbing correlation between paper currency and debt. The accelerated demand for gold-tied funds and products, where the core currency of the principal invested is not euros or dollars but ounces of gold, signals a preference for gold as the best wealth-preserving currency.

Without doubt the soft metal is going to cushion the inevitable lows for investors who insist on gold-tied wealth strategies. This is particularly the case if we see hyperinflation take full effect.

Matthias Gaertner is managing director of SuperAlphaFund Financial.