Gold Market Update

The prices of gold mining shares and gold since our last Update (June 25) continued to consolidate their rapid end-March to mid-May upward moves. They tested their early June lows. During the first half of the year the Financial Times Gold Mining Index rose 13.6 % while the S. & P. 500 Index fell 7.3 %. From the end of March to last Friday the Financial Times Gold Mining Index climbed 16 %, and the S. & P. 500 Index increased 2.7 %. According to Lipper the Gold-Oriented Fund Group was the best-performing group during the second quarter of the year.

Sustainable Rebound or Recession

The 1991-2000 economic expansion was accompanied by unsustainable imbalances and a huge credit expansion. Business and household debt climbed an average 9.5 % a year from $ 9.6 trillion (125 % of GDP) in 1996 to $ 13.8 trillion (135 % of GDP) at the end of March, 2001. The bursting of the high-technology bubble last year began a correction of the imbalances. So far the "recessionary slowdown" has primarily affected the manufacturing sector. Manufacturing capacity utilization sank to 76 % in May, an 18 year low, and for technology, it hit a 25 year low of 70.3 %. Profits were squeezed as worker productivity fell at a 1.2 % rate and business unit labor costs rose at a 6.3 % rate during the first quarter, the fastest since the fourth quarter of 1990. Bankruptcy filings rose, and capital spending came down. Although the NASDAQ Composite Stock Index fell 68 %, valuations on the senior stock indices are still historically high.

The FOMC reversed its tight money policy and sharply lowered its target for the federal funds rate from 6.5% in January to 3.75 % in June to encourage a resumption of the credit expansion and economic growth and to avert the threat of recession. The current expectation is that the easy money policy will succeed in expanding credit and that business will rebound in the foreseeable future.

The present debt structure, however, may be unsustainable, and its correction could lead to a recession. The slowdown could be more than a self-correcting inventory correction. Excess capacity, excessive consumption and the nation's "balance sheet" might have to be corrected. Warning signs are developing as follows:

1. The NAPM manufacturing index contracted in June for the eleventh straight month.
2. The U.S. high yield bond spreads turned up again in early June showing rising financial risk.
3. The recession in the manufacturing sector may spread. Service sector employment fell in June and in the second quarter as a whole, the first quarterly decline since 1958.
4. Thirty year Treasury Bond yields rose from 5.57 % on June 22 to 5.76 % last week.
5. Consumers continued to spend in excess of their personal income in May in spite of job cuts. Their spending is supported by high borrowing. Household debt rose at an annual rate of 7.8 % or $ 560 billion a year during the first quarter of which approximately 70 % is home mortgage debt. During the first five months of the year Americans bought more homes than during any previous January-to-May period on record. The median price of an existing home has climbed 5.7 % from a year ago. A recent Harvard University report, however, warned that the recent strength of the housing market is pushing prices out of reach of some families and was a "significant problem". Perhaps consumer spending is peaking.
6. Household debt, a record 103 % of disposable income, may be vulnerable to a weakening economy because household budgets are stretched so thin. Debt-servicing costs as a percent of disposable income have grown close to 1986 peak levels. Low- and moderate-income household debt-to-income ratios have doubled from 1989 to 2000. These household are more exposed to shock than in the past.
7. If households were to reduce their spending in order to increase their personal savings from a negative .95 of 1 % of disposable income in May, a record low, to a more normal positive 4 to 5 % of disposable income, a recession probably could not be avoided.

Growth of Gold Investment Demand

If the economic and financial imbalances are more serious than expected and a recession begins, the Fed may fight it with ever lower short-term interest rates rather than allow free market forces to correct the imbalances quickly although painfully. The fight may well be prolonged. Thus, creditors may be punished over a longer period with negligible or negative real interest rates. This period has already begun (see our June 25 Update). Gold, historically, has been a refuge from such discrimination as creditors seek to preserve their wealth in real terms. The longer the period of negative real returns, the greater the possible gold investment demand.