Beyond Iraq

Iraq news has dominated the gold market since late last year, and may continue to do so for several more months. It is quite possible that the related hype and fear explains much of the acceleration of the gold price and the increase in its volatility. For example, gold at $380 was trading approximately 15% above its 200-day moving average, the largest premium in the last 15 years.

The shares of gold mining companies have under-performed the metal by a substantial margin. For example, the shares of senior North American producers trade at a premium of only 12% to their average net asset value (NAV), according to BMO Nesbitt Research. This is well below the 38% average of the last two years, and at the low end of a five-year range. The NAV premium is one of many useful valuation measures. Its current low level suggests that share investors doubt that the recent highs in the gold price can be sustained. It is one of many indicators depicting a consensus that Iraq is responsible for the run up in the gold price. Another sign of skepticism is the recent torrent of equity financing, especially by the Canadian intermediate and junior producers. The near exclusive reliance on the investor-unfriendly "bought deal" method of raising funds favored by Canadian investment bankers suggests a bet on lower gold and share prices by industry insiders.

While it is difficult to escape the impact of war news on short-term money flows and sentiment, the rationale for allocating assets to the gold sector transcends Iraq. The bull market in gold commenced six months before the peak of the NASDAQ bubble, and will mark its fourth anniversary in August of this year. The gold price had moved from $252 in August of 1999 to $295 in May of 2001, several months before 9/11. In May of 2002, gold surpassed $320, several months before Iraq became front-page news. Geopolitical developments have no doubt heightened investor anxiety. But even without these developments, the global investment landscape is threatened by storm clouds.

Paramount among these is the overvaluation of the US dollar. The US currency topped out versus a trade-weighted average of other currencies in May 2001, and has been in steady decline since. Thanks to dollar overvaluation, US consumers have enjoyed a decade long influx of attractive imported goods and low inflation. Thanks to dollar overvaluation, our trading partners have enjoyed increasing exports and strong domestic economic conditions. A weakening dollar changes all this. Fear of further dollar weakness will be self-reinforcing to the extent it triggers divestment of massive dollar asset positions accumulated by non-US governments and investors over the past two decades. The dollar represents 76% of world central bank reserves. As was the case with the dot COM stocks, the US dollar is over owned and over valued. The dollar will weaken substantially, and lead to higher US inflation along with weaker foreign economic conditions. In its January 3rd, 2003 commentary, Bridgewater noted that "a drying up of private demand combined with support from official sources is a classic warning sign of an imminent collapse in a currency. We believe we are on the precipice." Official sector support for the dollar is especially strong in Asia where dollar trade surpluses are huge and growing. According to Bridgewater, the US is now relying on the official sector for 40% of capital inflows, the highest in ten years.

The problem posed by a weakening dollar for our trading partners and by extension, the world economy, is deflation. It is not surprising that world central bankers are beginning to call for radical actions. On November 13, 2002, Greenspan announced "there's no meaningful limit to what we could inject into the system were that necessary." In a now-famous speech, Federal Reserve Governor Ben Bernanke promised to crank up the printing presses to stave off deflation. His words were echoed by Charles Bean, chief economist of the Bank of England, in a November 25, 2002 speech entitled "The MPC and the UK Economy: Should we Fear the D-words?" High-level officials of the Japanese Ministry of Finance (Haruhiko Kuroda and others) have been advocating that the Japanese Central Bank target 3% inflation as their paramount goal targeting. The Federal Reserve has been creating credit at an annual growth rate of 26% over the last three months, significantly above the already high trailing twelve-month growth rate of 10%.

No wonder investors are running for cover. Miniscule bond yields offer little protection against the prospect of an orchestrated devaluation of the world's key currencies. A paradigm shift in the relative valuation of paper and tangible assets is underway. In such a shift, the list of safe havens is short. A new generation of investors, still conditioned by overripe 1990's platitudes extolling paper assets, will discover what a previous generation had learned and forgotten---the merits of gold.

That we are in the early stages of a dollar sell off has been obscured by Iraq news. Hope flourishes that war fears are simultaneously dampening economic activity and stock market expectations. This view assumes that hostilities in Iraq will be surgical, short, and without longer-range economic implications. The historical precedent of a repeat of the first Gulf War is priced into the markets. In the build up to the 1991 war, gold and oil rose while the stock market sagged. But three months before the first cruise missiles were launched, these trends reversed. Gold resumed the downtrend that had been in force prior to investor awareness of Iraq. Let's hope optimistic expectations as to the military result for a second Gulf war prove justified, but it would be wrong to extend the analogy to market outcomes. At the very least, the financial markets can tolerate nothing less than a highly successful military campaign.

These superficial media-centric speculations overlook fundamental realities. As recently stated by eminent market observer Richard Russell (1/24/03) "the bear market started in 1999. This bear market is about correcting a 25-year-old bull market. This bear market is about overvaluation, over stimulation, too much debt, too little savings, a falling dollar, a Fed chairman who didn't know what was happening, and a Fed that never took away the punch bowl." It is difficult to know what the consensus view is at the moment, but Greenspan's most recent "guidance" is probably fairly representative. In recent congressional testimony, Chairman Greenspan blamed economic sluggishness on the Iraq situation. The expectation that sustainable relief lies in a resolution of the Iraq conflict, while plausible to many, lacks rational foundation.

The sweep of a secular bear market cannot be understood in purely economic terms. Financial and economic developments interact with and are in turn influenced by social and political forces. For the past several years, a place for gold in investment portfolios seemed justified based on purely economic considerations. Early advocates merely tacked on geopolitical risk as part of a pro forma litany of concerns that any potential investor might wish to consider.

This moment, however, demands more than token consideration of non-economic issues. The world of 2003 differs vastly from that of the early 1990's. It is true that the purely military equation seems more favorable than 1991. Aside from this single facet, however, the picture is muddled. In 1991, a unified nation and international coalition faced the unknown but greatly feared military capabilities of the Iraqi regime. The domestic economy was sluggish but on the mend. The stock market rise, well into its third year following the 1987 crash, was interrupted for three months by the prospect of a Gulf war. Following the fall of the Berlin Wall in 1989, the global prestige of the United States and the free market system seemed limitless. The credit cycle, powered by the twin boosters of Federal Reserve credit injections and celebration of the triumph of free market economics, was primed to enter warp speed.

Today, an administration that had gained office in the most closely contested election in history, leads a divided country against the same Iraqi regime, whose conventional military capability is lightly regarded by comparison to a decade earlier. The justification for military action is hotly debated. Relations with many former coalition partners are fractious. The prospect of military action by a narrow coalition "of the willing" lacking UN support is real. The weak domestic economy is a growing source of political contention. Stocks have been declining for three years and are in the early stages of a secular bear market. The post mania discrediting of the business community has taken on a life of its own. Several developing countries have abandoned the free market model and prospective candidates for similar action is growing. The credit cycle is sloping downward as investors and institutions move away from a "trust anything" mentality to "trust nothing."

New also, global terrorism portends economic, political and social implications that we have yet to fully grasp. The widespread esteem formerly enjoyed by business and financial institutions will be difficult to restore in the near term. To date, perspective on these and other crucial issues has not been forthcoming from the usual pundits and partisans. Perhaps clarity has been stifled by the immediacy of too many critical events in time and space. Illuminating comments offered by Edward Danks, a former Presbyterian pastor now overseeing church missions in Kenya, stand out by comparison. During a recent visit (2/1/03), he said: "The storm of terrorism that has broken upon us brings with it one of the greatest tests we have ever faced as a nation….perhaps the greatest since the Civil War.

Terrorism throws into conflict our "Freedoms" on the one hand, and our "Security" on the other. Must we set aside some of our "Freedoms in order to assure our "Security"? Or will we risk our "Security" by continuing to affirm our "Freedoms"? …. It is no easy question. Second, there is the collapse of morality and ethics in the corporate world…..The collusion between investment management, banks, corporations and accounting firms has been catastrophic in its impact upon our nation."

(www.norotonchurch.com). According to Danks, these two developments, together with the scandal plaguing the Roman Catholic Church, challenge core Western social beliefs and political alignments. Rather than business cycle and stock market outcomes, the bedrock of social conventions is in play.

Against this backdrop, the willingness of individual and institutional investors to prefer paper assets as a store of value will continue its retreat. For the foreseeable future, paper assets will be mired in financial purgatory. The decade and a half from 1968 to 1982 provides a good historical analogy. For those fourteen years, the financial markets were trapped in a trading range, while gold advanced from $40 to $800. Despite the Vietnam War, the Watergate Scandal, the vicious 1973-74 bear market and the late 1970's bout of double-digit inflation, the financial system survived and evolved. It was not the end of the world. The period simply marked a lengthy succession of events that added up to poor financial market returns. It led investors to prefer tangible to financial assets.

World financial wealth held in the form of paper assets stands conservatively at $50 trillion. The investment stock of gold, including central bank reserves, amounts to slightly more than $900 billion at the recent price. Central bank reserves of 33,000 tonnes account for slightly less than half of a very conservatively estimated investment stock of gold. Physical gold theoretically available to the market is at most $500 billion. Central banks, once feared as relentless sellers of the metal, are beginning to rethink their past folly. The net supply of central bank gold has been diminishing. The well publicized 400 tonnes being divested according to the Washington Agreement is being partially offset by the quiet accumulation of others, including the People's Republic of China. Iraq related hype notwithstanding, a significantly higher price target for gold seems appropriate. A reallocation of 1/10th of 1% of world financial assets, or $50 billion, would swamp the physical market, especially if it coincided with recognition by the central bank community that the dollar, rather than gold, is their least attractive asset. A mere $50 billion equates to more than two years of annual gold production, a quantity that could not clear the market within several hundred dollars of today's price.

UN resolution 1441 was adopted November 8th 2002. Greenspan's "virtually no limits" comment came on November 13th. Bernanke's famous speech was delivered on November 23rd. Gold's breach of $330 occurred on December 12th, triggering a lift off to the highest levels in six years. Both monetary and geopolitical factors contributed. While media coverage of the former was scant, coverage of the latter has been incessant. The imbalance in media attention helps explain investor confusion as to underlying causes for gold's strength.

Gold is peerless as a tangible and as a financial asset. Its intrinsic value is not subject to question. Its market price correlates inversely with investor assessment of paper alternatives, including the dollar. It is uncomplicated and straightforward. One does not need to pore through a 200-page prospectus to comprehend all relevant merits and detractions. It is liquid in comparison to income producing real estate, collectibles, and most other tangible assets. It is more compact and transportable than wheat, oil, soybeans or other commodities. Gold is scarce relative to paper. It is difficult, dangerous, and often unprofitable to mine. It does not have a cusip number. In the past three and a half years, it has outperformed all currencies and financial markets. In a climate when trust is receding and belief in fat returns on financial investments is fading, a reallocation of 1/10th of 1% no longer seems preposterous.

What about the dollar? It is being issued at an accelerating pace by a sovereign government managed by former investment bankers, lawyers and corporate executives. Its intrinsic value is subject to their collective interpretation of the mandates of sovereign interests. Its market price, in terms of gold and other currencies, is determined by the collective assessment of those who hold it, especially for investment purposes. The fact that the marginal investment holders of dollar instruments are foreign has been true for decades. New is the fact that the worldview of foreign dollar investors may no longer coincide with the actions or perceived intentions of those who are in a position to maintain or undermine the dollar's intrinsic value. What is also new is that non-US holdings of dollar investments have reached a magnitude where an opinion downgrade would overpower domestic policy considerations, objectives, and initiatives. At 40% of the treasury market float, a foreign exodus would result in higher US inflation and interest rates, irrespective of Federal Reserve or Treasury actions.

Recent expressions of intent by the Federal Reserve pay only lip service to the notion of currency stability. The new focus is reassurance that any action will be taken to avoid deflation. In the 1930's, markets anticipated a sharp fall in the intrinsic value of the dollar three to four years in advance of the actual hike in the official price of gold. For example, the black market price of a $20 gold eagle in 1930 was $30. In the late 1960's, investors anticipated the breakdown of an official dollar link to the gold price. Market pressure forced the London Gold pool to disband in 1968, forcing an increase in the official gold price from $35 to $41. In 1971, the same pressures forced the US to close the gold window. In today's regime of floating exchange rates, the slightest pretext of a gold anchor is gone. The currency's intrinsic value is defined by market faith in the ability of central bankers and national governments to get it right. The advancing gold price signifies shakiness in the foundations of the floating rate/ central planning monetary regime. Without an unimpeachable link to a unit of value beyond reproach, the dollar is no different than an overpriced stock, capable of successful illusion until investors no longer choose to believe.