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Thank you Mr.
Chairman for that flattering introduction and thank you to the conference
organizers who have made it possible for us to exchange information and insights
into the future of gold here in China and in the global marketplace.
You should know
that my presentation today will be posted on my website, NicholsOnGold.com,
so you can easily check back in a few days, or a month, or a year – to
review my analysis and my expectations for gold.
A few weeks ago,
I mentioned to a Chinese acquaintance in New York that I would be traveling
to Shanghai. He said, with some excitement that his family was
originally from Shanghai and that he still had relatives here. Then he
told me about a friend of his grandmother . . . a very old lady who is a
fortuneteller of great repute. He said, in all seriousness, that I must
visit her before speaking here today on the outlook for gold, just to be
sure, and volunteered that his cousin would accompany me and translate.
So yesterday
afternoon, we visited the old lady in her new apartment. We were
offered tea and sat down together to talk. Finally, I asked: “So
where do you see the price of gold next year?” To which the old
lady replied: “Well, young man, we’ll just have to wait and
see.”
Jeff
Nichols addresses China Gold Summit
What the old
fortuneteller really meant was this: Global asset markets have jumped
into another dimension – a non-linear “Alice in Wonderland”
universe – where the irrational and unpredictable have suddenly become
the most likely.
Indeed, writing a
forward-looking speech – at this moment of unprecedented worldwide
economic crisis and uncertainty – has been like trying to hit a
fast-moving target. Today, the price of gold has less to do with
ordinary supply and demand fundamentals . . . and much more to do with
fear-driven investment and speculative demand at the margin.
Every country is
now affected by the spreading recession. From day to day, the business
news worsens, bankruptcies and unemployment mount, one central bank after
another cuts interest rates, new fiscal initiatives and other policies are
undertaken – some of them seem wise, others may prove to be less so
– and the United States, still by far the world’s largest economy
and dominant political force, is in the midst of changing Presidents and
changing directions in Washington.
Where We Are . .
. Where We’ve Been
The International Monetary Fund is now
forecasting that 2009 will bring the first aggregate
decline in global economic activity since World War Two. It will also
be the first synchronized slump with the United States, Europe, and Japan all
in the same sinking boat.
Economists and
policymakers are at sea in unchartered waters. Since they don’t
know how deep and long-lasting the recession might be, they don’t know
how extreme their actions to combat the slump should be.
So far, in one
country to the next, economists and policymakers have been slow to recognize
the severity of the recession and slow to react.
At this time of
extreme global economic crisis and financial risk, we might expect to see the
price of gold moving sharply higher.
But apart from
the brief period earlier this year (coinciding with the collapse of the
American investment bank Bear Stearns) — when gold shot up to a new
all-time high just over $1030 an ounce — the yellow metal has not
performed true to course.
Instead, the
first quarter advance proved to be a bubble with large-scale institutional
speculators driving the price first sharply higher . . . and then sharply lower
over the next seven months.
Looking at the
numbers, gold began the year at just under $850 an ounce. Since then,
it soared like an eagle to over $1030, fell back to a recent low briefly
under $700 an ounce, rallied to $820 last week, and has since fallen partway
back to trade around $770 in the past few days.
In spite the lack
of direction and day-to-day price volatility in the gold market this year, at
least we can say that no other asset class has held its value quite so well.
Negatives for
Gold
In my view,
gold’s decline in recent months has been a direct consequence of the
unfolding global economic situation. In a sense, gold has been an
innocent bystander to the financial hurricane hitting Wall Street and
financial markets around the world.
Gold’s own
positive fundamentals – and even its role as a safe haven in turbulent
financial seas – have simply been overwhelmed by massive selling of
virtually all securities, commodities, and other investment assets and a
flight to cash and near-cash alternatives in the form of U.S. Treasury debt.
Let’s take
a look at the main factors and forces that have conspired to push gold lower
in the past half-year:
Much of
gold’s weakness in recent months can be blamed on indiscriminate
shedding of long commodities positions by hedge funds and other institutional
players in order to raise cash, increase liquidity, cover big losses in
equity and other asset markets, or simply wind down and return cash to their
investors.
Often these
sellers were not holding individual commodities but baskets or indexes that
included gold – so gold got dumped along with everything else. In
other words, gold was sold not because it was singled out as an unworthy
holding but simply because it was a component in the indexed baskets of
commodities held by many hedge funds and institutional traders.
Large-scale
bullion speculators have also sent gold reeling over and over again by
selling the metal short on futures exchanges at moments of technical
vulnerability.
This selling by
funds and institutional speculators was amplified and accelerated by the lack
of market liquidity, automatic program trading, and the continuing
reassessment of global economic prospects suggesting further deep declines in
demand for one commodity after another.
Moreover, some
wealthy private investors and private family funds were reportedly
liquidating gold and silver holdings to raise cash and cover their losses on
equities, real estate, and other investments.
In addition, the
decline in inflation and inflation expectations due to the fall in oil and
other commodities prices and the increasingly gloomy economic outlook
dampened demand for gold among some who look to the metal as an inflation
hedge.
Golden Spring
Does this mean
that gold is suddenly no longer a safe haven in turbulent times . . . or a
hedge against inflation . . . or a useful portfolio diversifier? Of
course not — but it does demonstrate that at times of panic even the
yellow metal can fall victim to developments in other asset markets.
Now, not
withstanding the latest price retreat, it looks like the intensity of
commodity disinvestment is diminishing. Quite possibly, the commodity
holdings of hedge funds and other large-scale players are nearing depletion .
. . so there’s not much remaining to sell. The vaults are nearly empty,
so to speak — and, to the extent that these were actual physical
positions, the gold has presumably moved to stronger hands.
Recent data on COMEX, TOCOM (the Tokyo Commodity Exchange), and Exchange
Traded Funds suggest that the October-November wave
of sustained liquidation of long gold futures positions has abated and may be
nearing an end with the emergence of some fresh buying and a decline in short
selling.
Golden Dichotomy
Perhaps the most
positive leading indicator of gold’s future price is the continuing strength
of individual investor interest in the yellow metal in contrast to the
institutional selling I mentioned earlier.
Household
investment in gold – as a safe haven, inflation hedge, and portfolio
diversifier – is booming in most markets. Although the major
mints of the world are working flat out, coin retailers continue to report
shortages of the popular gold bullion coins – the American Eagle, Canadian Maple Leaf, the South African Krugerrand, and the Austrian Philharmonic. And,
similarly, bar fabricators report strong demand, high price premiums, and
long delivery times for small bars heading to the Middle East and Asian markets.
In recent months,
we’ve seen strong physical demand from ordinary investors and savers
driven by fear, rushing for the safety and protection historically offered by
gold.
Importantly,
these buyers are not traders looking for quick gains but scared people
seeking to protect their wealth, their savings, and their retirement nest
eggs.
And this strong
household demand is global – not limited geographically to any country,
region, class, or station. People everywhere are buying gold as an
insurance policy against the unknown.
Somehow, I
don’t think they are all wrong and the wizards of Wall Street who are
selling gold are all right! Rather, this wave of gold interest is a
harbinger of gold’s ultimate ascent.
Official Sector
– Stealth Buyers
I’d like to
say a few words about the official sector – central banks and sovereign
wealth funds – since these players may have a big impact on the gold
market in the years ahead.
On average, the
central banks of the world hold around 10 percent of their international reserves in gold.
However, the
percentage of gold in total reserves varies greatly among central banks and
from region to region. The major Euro-zone nations together hold about
58 percent of their assets in gold. In contrast, the Asian nations as a
group hold only about 2 percent of their reserves in gold.
China,
America’s biggest creditor – with some $1.4 trillion invested in
U.S. Treasury securities – has only one percent of its reserves in
gold. Japan has only 2.1 percent of its reserves in gold, and Taiwan
has about 3.8 percent of its reserve assets in gold.
Another big
holder of U.S. debt is Russia with about $330 billion in reserve assets, of
which only 2.1 percent is in gold.
If I were
advising the central banks of China, India, Japan, Russia and other nations
with a low percentage of reserves in gold, I’d be saying buy, buy, buy
whenever the market presents an opportunity.
One can imagine,
especially with today’s world economic and political situation, the
central banks of these countries with large U.S. dollar holdings might like
to diversify, if only to reduce risk.
Unfortunately,
any attempt to purchase in the open market significant quantities of gold
relative to the size of their international reserves would be terribly
disruptive and self-defeating.
But, China and
Russia could gradually add to their gold holdings by taking up the output of
their domestic gold mines.
Today, a number
of countries are employing sovereign wealth funds to invest in a
variety of assets ranging from equities and corporate bonds to real estate
and gold. Unlike central banks, these funds typically operate
anonymously and secretly with no international reporting requirements –
and can diversify their countries’ wealth out of dollars with fewer
international political consequences and less disruption or influence on the
marketplace.
Sovereign wealth
funds have been around since 1953 with the establishment of the Kuwait
Investment Authority. More recently, in September of 2007, China
established a major sovereign wealth fund – the China Investment
Corporation (or CIC) – with an initial capital endowment of $200
billion.
Other big
sovereign wealth funds include Abu Dhabi (with more than half a trillion
dollars in investments), Singapore (with $200 billion to $400 billion
invested, Norway (about $300 billion), and Russia (more than $100 billion).
Sovereign wealth
funds now control huge resources – by some estimates as much as $3
trillion . . . and if current trends continue these sovereign wealth funds
could total as much as $10 trillion in the next five or six years.
One more
thing: I think some of the sovereign wealth funds of countries with
large and growing foreign exchange reserves already may be
“stealth” buyers of gold on behalf of their governments wishing
to diversify, if only a little, out of U.S. dollar-denominated assets.
Although there is
no hard evidence, it is easy to imagine that some of these funds have
accumulated gold and other non-dollar investments – and some analysts
have suggested the China Investment Corporation may soon will be among the
gold buyers.
Deflation in the
Air
I want to return
now to the unfolding economic situation.
With deflation in
the air, gold bulls are separating into two camps — inflationists who
see gold as a hedge against future inflation and a decline in the U.S.
dollar’s purchasing power . . . and deflationists who see gold as a
deflation hedge as money seeks safe harbor in cash and cash equivalents like
gold.
These days,
everyone knows about inflation having experienced first hand in recent
decades . . . but few of us have experienced deflation or understand its
causes and effects.
Deflation is a
persistent ongoing month-after-month reduction in the general price level,
usually characterized not only by falling prices for goods and services but
also falling prices for most commodities, real estate, equities, and other
assets.
It is caused by
declining demand and an unwillingness on the part of consumers to
spend. As household spending contracts, industrial capacity utilization
falls and business capital investment grinds down.
Deflation is as much a mass psychological phenomenon as it is economic event.
In anticipation
of declining prices, consumers and businesses have an incentive to postpone
purchases. In turn, this depresses overall economic activity,
employment, personal incomes, and the level of demand across the
economy. And, with falling demand comes still lower prices – in
short, a deflationary spiral.
Most people who
think about these things assume that gold prices must fall during periods of
deflation. After all, deflation is the opposite of inflation –
and since gold rises during periods of inflation, shouldn’t it fall
during periods of deflation?
But,
paradoxically, gold is both an inflation hedge and a deflation hedge.
It is during periods of relative price stability and low inflation rates that
gold is least attractive.
Here’s why
gold is a deflation hedge:
During periods of
deflation, we postpone spending in anticipation of lower prices.
Instead, households hoard cash and cash-equivalents such as short-term U.S.
Treasury debt, bank deposits, and money-market instruments. Gold is
also a cash-equivalent . . . and some will choose to hold more of their
savings in the yellow metal, particularly during times of economic stress and
uncertainty when gold just feels safer.
Moreover,
deflations are also characterized by very low interest rates. Rates are
low because the demand for credit is depressed, savings are high, and the
Federal Reserve and other central banks will pursue low reflationary
interest-rate policies to encourage economic recovery.
As a result, the
opportunity cost of holding gold – that is, the income forgone by
holding these metals rather than interest-bearing assets – is also
extremely low, further encouraging some investors to favor the precious metal
over alternatives because of its other attractions and attributes.
Inflation or
Deflation
To shore up the
banks and other financial institutions, to get credit flowing, and to revive
the economy, central banks everywhere are pushing additional liquidity into
the global banking system. Even the People’s Bank of China is
cutting lending rates and lowering reserve requirements to support business
activity, shore up financial and real-estate markets, and encourage consumers
to go shopping.
In announcing
it’s latest policy initiatives to jumpstart bank lending to consumers
and businesses, the Federal Reserve said the money would come from an
increase in its reserves — in other words, “quantitative easing.”
Quantitative easing describes central bank actions to directly increase the
money supply by depositing funds with the banks or lending to non-bank
enterprises. Quantitative easing is equivalent to printing money
– and, in the long run, inflationary.
Most economists
— in and out of government and across the political spectrum —
believe these emergency measures (and possibly more to come) are necessary to
revive the failing economy and prevent a spiraling decline into deflation and
depression.
A few economists
— myself included — and a larger number of ordinary folks are,
nevertheless, worried about the mounting financial cost that has already
reached several trillion dollars . . . and the long-term economic
consequences of central bank monetary creation, the expansion of
government-sector deficits around the world, and the likely inability to pay
the piper through increased taxation.
I believe we will
see a longer, deeper decline in business activity than most, not just in the
United States, but also in Europe, here in China, and around the world.
Unlike most past
recessions in the United States, this one was not caused by tight monetary
policies and rising interest rates or a downturn in a few industries.
Instead it
started with easy money, excessive borrowing and spending by households and
business, followed by a housing bust that quickly metastasized into a
spreading credit crisis and failure of the financial markets to keep the
economic engine lubricated. As previous financial crashes in other
countries, Japan for example, illustrate, recover can take many years.
In the United
States, more than a few companies will go bankrupt. Unemployment will
shoot up. Commercial real estate values will drop. Credit card
defaults will rise. Big government will be forced to bail out more big
business. There will be new stimulus packages and tax cuts next year
– totaling hundreds of billions of dollars –to boost private
spending and consumption.
At the same time,
we are likely to experience some form of deflation –particularly in
commodities, food, autos, and a variety of consumer goods. To be
honest, deflation has already hit home — first in real estate, then on
world stock markets, more recently in oil and commodities, and, as anyone
shopping for the holidays will soon notice, in many retail stores.
But as the
economy revives — as it must with massive and unprecedented government
stimulus in the United States, Europe, here in China and in most other
countries — the prices for many goods and services will shift from
reverse to forward . . . and inflation will replace deflation as all those
trillions of dollars come home to roost.
Monetary
Reflation Today, Price Inflation Tomorrow
I remain bullish
on gold because — even as the global economic recession deepens —
governments will find the only way out of this mess is to print more
money. In other words, to inflate.
The United States
Treasury and the Federal Reserve have already thrown a few trillion dollars,
more or less, into the banking system and are now also lending directly to
businesses and households. And, there’s surely much more to come
when the next Administration moves into Washington.
It’s not
only the U.S. monetary authorities pumping up the money supply. Their
counterparts in every major economy – including the United Kingdom and
the Euro zone, China, Russia, Japan and on and on – are doing likewise.
We have never in
the history of money seen such an expansion in its supply without, after a
period of time, a rapid deterioration in its value – in other words,
without a rapid increase in the overall price level. More than any
other factor influencing the gold market, it is the inevitable devaluation of
money and the corresponding rise in price inflation that will propel gold
skyward in the next few years.
As sure as day
follows night, reflationary monetary policies — however necessary
— have long-term implications for global inflation. Typically,
monetary creation affects price inflation with a lag of six months to a
couple of years – and in the current environment, the lag could be
still longer . . . so it may be some time before inflation is recognized as a
serious problem. But gold prices have shorter lags and could begin
moving up before rising inflation becomes apparent or worrisome.
Longer term,
gold-price prospects remain as bright as ever — and I firmly believe we
will see record high prices in the next few years with gold back over $1000
an ounce in the coming year.
With the right
confluence of economic and geopolitical developments we should see gold break
through $1500, then $2000, and possibly still higher round numbers in the
next few years – particularly if we get the type of buying frenzy or
mania that often occurs late in the price cycles of financial and commodity
markets.
This is hardly an
audacious forecast when looked at relative to the upward march in consumer
prices over the past 28 years. After all, the previous high of $875 an
ounce in January 1980, when adjusted for inflation since then, is today
equivalent to more than $2200.
Let me end with a
warning about the days and weeks ahead. In the short term, gold remains
volatile and vulnerable, if only because market psychology is nervous,
anxious, and fearful. In this environment, we could still get a quick
sell-off that would bring us back to the recent lows. But, day by day,
I think that becomes less likely and, day by day, I think the base is
building for a lasting longer-term recovery.
Jeffrey Nichols
NicholsonGold.com
Read
all the other articles published by Jeffrey Nichols
Jeffrey Nichols,
Managing Director of American Precious Metals Advisors, has been a leading
gold and precious metals economist for over 25 years. His clients have
included central banks, mining companies, national mints, investment funds,
trading firms, jewelry manufacturers and others with an interest in precious
metals markets. Please check his website and register to his free newsletter
by clicking here.
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