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Don't write off gold in 2014

This article appeared in the February 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

There are sound reasons to ignore the doomsayers - and understand what really drives gold.

Photo of Gavin Wendt By Gavin Wendt, MineLife

The 2013 calendar year was a tough one for gold and silver - down 30 per cent and 36 per cent respectively (in US dollar prices) as Chart 1 below shows. Sentiment for the two precious metals is inextricably intertwined, so both endured sizeable falls as investors apparently became more confident in the future resilience of financial markets.

Chart 1: Gold and silver badly underperformed in 2013

Gold and silver performance line chart for 2013

Source: BigCharts.com

Time will tell if this confidence is misplaced, but there are certainly enough indicators around to suggest that gold remains an important component of an investor's portfolio, despite the hammering it is taking in the mainstream media. It has certainly been a case of kicking gold while it's down.

Financial gurus and media commentators can find all sorts of supposed reasons to justify gold's fall, but none of them really make a lot of sense when you take a step back and look at the bigger picture.

The reasons for my concern are the issues of sustainable growth and real wealth in the US, not what has simply been created through government stimulus and artificial price increases. Remember that this was exactly what fuelled the economic bubble in the US during the 2000s - the fact that households and individuals assumed they were wealthier than they actually were.

Over this same period there was also an explosion in the price of gold, from US$270 to more than US$1,800, as Chart 2 below shows. The smart money could see what was happening; the US and many other Western nations were on a credit-fuelled spending binge.

Chart 2: Gold's remarkable bull run, and recent correction

Gold price performance line chart for 2013
 
Source: Kitco

Of course, when the music stopped we saw the inevitable devastation wreaked by a lengthy period of economic excess. The problem is that the US Federal Reserve has more or less implemented the same "easy money", low-interest-rate policies as those that created the mess in the first place.

Those able to take advantage of the Fed's accommodative monetary policies have benefited from low-interest easy money they ploughed into shares, property, art and other collectibles - the prices of which have all outperformed - subsidised by the ordinary US taxpayer.

Of course, the ordinary citizen is missing out on this particular party. Stubbornly high unemployment levels, low labour force participation rates, high real rates of inflation, declining housing affordability and low returns for those on fixed incomes: these are all factors that have disproportionately affected ordinary citizens.

Deconstructing some myths about gold

Let us deconstruct some of the common arguments by sceptics for not owning gold.

First, it is argued that quantitative easing (QE is a form of monetary policy in the US designed to boost its economy) has not resulted in inflation. The major explanation in my view is the low velocity of money within the US economy, which implies that much of the loan funds are not being passed on to regular consumers, but instead being retained on bank balance sheets.

The reasons for this include: banks being unwilling to lend to people with poor credit; people being unwilling to take on loans that they cannot afford; and banks not passing on the entire low-interest benefits.

A Federal Reserve insider has even come forward and apologised, explaining how QE had only helped large banks earn more cash via speculation. Furthermore, the remaining available funds that are not being lent to ordinary people or small businesses are being loaned out to "safer" hedge funds and large corporations, further fuelling speculation.

QE has encouraged over-investment, over-consumption and over-speculation. In essence, when money created by QE is only used for speculative purposes - rather than for consumption or investment in the real economy - the results are strongly rising stock and house prices but very little inflation in real goods or in capital goods, which is exactly what we are seeing in the US today.

The second argument against owning gold is that the US is in recovery mode; hence there is no further need for a hedge against instability. The employment-to-population ratio in the US declined sharply during the last recession and is currently at its lowest level since the 1980s. This is despite all the talk of job creation and is contrary to most recessions, where a sustained recovery takes place soon afterwards.

What it demonstrates is that many people in the US have simply given up looking for work, which artificially makes the unemployment statistics look better, as the number of supposed jobless falls. What is also happening is that a higher number of people are being forced to accept casual jobs instead of gaining full-time employment.

Another key issue is home affordability. Despite all the media hype over a "housing recovery", the US home-ownership rate is at its lowest since 1997. Real income levels are another key pointer to genuine economic recovery, but the median income in the US has reached its lowest level since 1996.

The third argument against gold is that US stocks are at record highs, so there is no need for a relic like gold. Record highs in the sharemarket typically occur as a result of a recovering economy, but, as previously noted, one must be hugely cautious in accepting the current situation that a record high sharemarket indicates a recovering economy.

The US is essentially a market that has been pumped to the max with Fed-administered financial steroids. If you pump trillions of dollars into a financial system you will generate growth to some degree. But like the steroid-addicted athlete, exactly how sustainable is the performance and what are the unintended consequences?

The US has mortgaged its future by bringing forward future consumption in an attempt to stave off what could have been a deep and prolonged recession, and the financial taps have been left open for too long. The result is that the financial sector has become addicted to what was intended to be only a short-term quick fix, not a long-term remedy for the economy's ills.

Conclusion

I remain bullish on the longer-term prospects for gold and choose to ignore the supposed media and financial experts as they try to justify the irrelevance of gold in the current financial environment. Those savvy enough to look past the bullish rhetoric currently enveloping financial markets as the Dow soars to ever greater heights, can see an economy with major problems - which are being papered over by the Fed to the tune of $65 billion (now $75 billion) a month.

It has taken $5 of stimulus in the US to create each $1 of growth - hardly a sustainable situation and one that is creating major longer-term headaches for the US economy (and the US taxpayer).

The first half of 2014 could see further downside pressure on the gold price, as the media and speculators revel in an escalating Dow that is continuing to be assisted in its ascent to the tune of $75 billion every month. They will use this as further justification for gold's irrelevance, blindly ignoring the dangers lurking below the surface.

The reality, however, is that gold appears to have good support around US$1,200 an ounce and is unlikely to dip below this level for long. Gold investors, therefore, should remain patient and I retain every confidence we will see a recovery in gold prices over the course of the next 12 months. Prices above $1,400 are certainly possible as part of a renewed appreciation of gold's relevance in somewhat uncertain financial times.

About the author

Gavin Wendt is the founder of MineLife, a leading investment newsletter on the resources sector, and a noted mining and commodities analyst.

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