Precious metals have been the best performing asset class of the past 10 years. Gold hit $1,800 mark recently. Gold is up over 32% compared to April 2010 and 470% compared to April 2001. At $44.8 per ounce, silver is up 149% from April 2010 and an unbelievable 911% from April 2001. At today's prices, many investors ask themselves if this precious metals rally is nearing its peak. As you will see, there are many reasons for it to last for some more time.
Basically, a high gold price is the reflection of how bad things are or are about to become. Any force that creates uncertainty and negatively impacts major asset classes such as currencies, stocks or bonds tends to increase the investment demand for gold. Hence, we need to identify such negative future forces in order to confirm the positive price outlook for gold. There are plenty of them. Find them presented below, divided into short-, mid- and long-term clusters.
Yes, the following list is a conscious indulgence in the pleasure of confirmation bias. Yes, perhaps a follow-up article should try to confirm the opposite thesis. Yes, a few hints sketching the opposite view will be provided. But for now, enjoy the exercise and don't say you weren't warned!
Short term (2-3 years)
The euro: Greece, Ireland, Portugal – who's next? The fear of further bailouts that could become bottomless pits is not subsiding. The heated political discussion, the wide spectrum of possible solutions, the veto threats from member countries and the ECB's unpredictability – they all create additional uncertainty. Will the political decisions come fast enough to prevent blows to the eurozone's credibility? How many more euros is the ECB going to print while buying up the maturing debt of the default candidates? There are some rough times ahead for the euro. The lack of reliable currency alternatives feeds the investment demand for gold.
The dollar: Same story, but worse. The Fed has been buying up outstanding US debt with freshly printed dollars, only on a much grander scale. This real-time dilution of the dollar demonstrates itself in the dollar continuously falling against most major currencies, commodities and precious metals. Look at any of the relevant indexes (DXY, CRBQ) over the past 10 years. They speak a thousand words. Any businessman who expects future dollar payments asks higher prices, reflecting on dollar's ongoing inflation. This is a self-feeding spiral and the Fed has not made any effort to stop it.
The Middle East & Northern Africa: The military conflict in Libya and further potentially contagious unrests in the Middle East (Bahrain, Yemen, Algeria, Syria, Jordan) continue. The outcome and long-term effects on the oil price are yet unclear. High oil prices would dampen economic growth, reverse the fragile economic recovery and negatively impact the stock markets. Unpromising and turbulent stock markets force investors to flee to safe heavens such as gold.
Japan: The earthquake/tsunami/nuclear disaster will result in a long-lasting drag on the Japanese economy and the Yen. Those who argue that the rebuilding processes will actually boost Japan's economy need to familiarize themselves with the Broken Window Fallacy. More importantly: Japan, being one of the top three lenders to the United States, may need to redirect outbound financial resources towards rebuilding its own infrastructure. This would further negatively impact the U.S. and the dollar, thus increasing the attractiveness of gold.
Mid term (+-5 years)
Central banks: Fearing devaluation of their forex reserves, central banks around the world have been lately increasing their gold purchases (becoming net buyers in 2010, after 21 years of net gold sales).
China: Has been looking for ways to diversify itself away from the dollar without causing too much damage to its dollar reserves. One of the ways is to motivate savers to invest in gold. China has a yearly savings rate up to 40%(!) of income and its government actively encourages citizens to put 5% of savings in gold.
The abandonment of the dollar: Investors and countries are evidently moving away from the weakening U.S. dollar. China abandoned the dollar in its trade with Russia in 2010 and has been working on a similar deal with Brazil. These BR(I)C countries now settle a notable part of their trades in their own currencies. Could the OPEC follow? Some sources indicate that talks with this subject have been taking place. Also, some prominent investors and entities took similar bets against the dollar: John Paulson made a fortune during the 2007-2008 crisis while most investors lost money. Today, the GLD ETF accounts for 14.93%, and the gold-mining conglomerate AngloGold Ashanti for 6.89% of his portfolio. A few days ago, The University of Texas put $1 billion or 5% of its $20 billion endowment into gold bars stored in a New York vault. You can expect many more stories like this as the weakening dollar forces countries, investors and institutions to look for alternatives.
US debt: Historical benchmarks suggest that the US debt as well as the debts of many European countries are now past the point of no return. In other words, any way politicians tweak the system (taxes, stimuli, laws), this debt is now too high to be paid back – virtually no country managed to recover from such high debt levels in the past without destroying its currency or its economy or both in the process. This destructive process is already under way – quantitative easing, government purchases of toxic assets, liquidity injections, etc. are just fancy names for money printing and the last desperate attempt to create the impression that these debts are being paid back – alas, with soon to be worth-less fresh paper money.
Long term (5-20 years)
Baby boomers: Because most countries have no savings (rather, they have massive debts), in order to pay the promised pensions (at least on paper) to retiring baby boomers, they will have no other option than to print large amounts of money and debase their currencies. Gold, being the closest tangible yet liquid alternative to currencies will benefit from this development.
Military conflicts: From the historical perspective, the gold price tends to rise in times of heightened military activity. While the reserves of natural resources are shrinking, the global population is growing at a rate never seen before. Because a country's standard of living depends directly on cheap access to natural resources, fights over the remaining reserves are not unlikely—we have seen a few just lately (Middle East, Afghanistan), and new areas of tension are already on the map: Russia has newly started voicing its claims in the untouched and resources-rich Arctic continent, but so have Denmark, Canada and the United States; the Chinese are heavily investing in exploration in Africa, just to name a few.
Peak oil: Oil production reached its peak in 2006, which was admitted by the International Energy Agency (IAE) in November 2010 (in the preceding years and decades, the IAE would repeatedly deny such scenario). Now it is official that we cannot increase oil production above today's levels with the current and new technology available in foreseeable future. Demand for oil, however, is projected to rise sharply. For the first time in history, oil production will not fully satisfy the demand. As a result, the oil price may start increasing rapidly. Increasing oil prices will create inflation, dampen economic growth, decrease tax revenue and further amplify the need for printing money (which in turn creates more inflation) and force people to look for alternatives to cash savings – gold will be one of them.
Now, what may be the opposite forces that could drive the gold price down? Let's address the most obvious:
Trust (in the dollar) is powerful, and theoretically, it could last forever. Is it likely? You decide.
The power of the West to convince the rest of the world and its own citizens that everything will somehow be alright. Never underestimate it!
Solid, sustained recovery: Such recovery would reverse the current trend in the gold price. However, this type of recovery doesn't set in overnight – solid foundations take years to build. Right now, no foundations for a new period of prosperity are being laid. The focus is on the preservation of the (fairly rotten) status-quo. The recovery is either fragile, or purely nominal (due to inflation), or not present at all. Therefore, there is no need to fear a genuine reversal in the next years.
Speculation, gold price manipulation and high volatility: Yes, (sharp) corrections or whatever you choose to call them are possible in the short term – and they will shake out gold from weak hands. However, the dominant mid- and long-term trends should eventually prevail.
Deflation: Don't worry about gold. Deflation means a lot of uncertainty, which is one of the key drivers for gold. Gold was in such high demand during the deflationary 1930s, that the U.S. tried to prevent a depletion of its gold reserves by the Executive order 6102.
The altogether positive perspective for gold and silver doesn't mean that everybody should jump to them or put all their eggs in one basket. In the short run, the precious metals markets could become very volatile (silver more than gold). But still these commodities always do well when the economy turns sour.
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