Some of you have been a little dismayed by the performance of gold in the last two months, against the background of falling stock markets. The sterling price of gold has fallen by over 12% in those two months. Some of this is due to the fall in the dollar price of gold, and some of it reflects the dollar’s fall against the pound. Why has this happened? Isn’t gold meant to offer safe haven properties when other asset markets are in disarray? After all, the gold price fell by two-thirds between 1980 and 2000, while the FTSE All Share index increased 12-fold over the same period. So why isn’t gold bouncing back, now that stock markets are in free-fall? The reality is that gold is a safe haven against some contingencies, but not against all.
The events that have pulled the gold price down
There are some short-term reasons why gold and the equity markets are heading in the same downwards direction. The gold price fell by $20 in the final week of July, registering its steepest weekly decline since August 1993. The main culprit was the widespread liquidation of gold holdings by US funds and companies. Some funds were believed to be raising cash to offset their losses on the equity markets.
Also, some companies were thought to be boosting their cash holdings ahead of the Securities and Exchange Commission’s deadline for US company account recertification on 14th August. These influences are both short-term and should unwind in time.
But there is a longer-term negative influence, namely the mounting fear of a double-dip recession. Gold is not well suited as a safe haven asset in a recession, where low inflation or falling prices are the norm. Japan provides us with a recent example. The Japanese endured a protracted slump throughout the 1990s, yet they did not stampede into gold in the face of falling asset prices and economic stagnation. The dollar price of gold fell by 30% during the decade and the yen price by 45%. The reality was that the Japanese preferred cash as a safe haven instrument.
US weakness will help the gold price
So what sort of economic and political conditions are conducive to a sustainable rally in the gold price? A look back at the last bull market in gold is interesting. Gold’s most spectacular decade was in the 1970s, a period characterised by two oil shocks, rampant inflation, rising budget deficits and political uncertainty.
In 1971, President Nixon suspended the convertibility of the dollar to gold at $35/ounce, as the US administration resorted to printing dollars to finance — amongst other things — the Vietnam War. Throughout the decade gold’s rally snowballed to reach a high of over $800/ounce in 1980. The last stages of the rally had all the characteristics of a speculative bubble. Nevertheless, the economic and political background remained supportive for gold.
America was a land of trouble. Inflation raged. Entire cities faced bankruptcy. The US administration under Jimmy Carter was considered very weak and inept. It was powerless to stop the Soviet Union invading Afghanistan and it bungled its attempt to rescue US hostages held by Iranians at the US embassy in Tehran.
So we have a pretty good idea what sort of developments ought to be supportive for the gold price. Here are a couple of possibilities for the future. Ever eager to resort to easy money to finance military adventures and bail out a debt-laden economy, the US administration finds itself with rising inflation and a falling dollar. A botched invasion of Iraq undermines American prestige and precipitates a sustained jump in oil prices.
Hang on to your gold
If you think these contingencies are likely, then it might be worth exposing your portfolio to the prospects of a sustained rally in the gold price. You can do this either by buying gold bullion, investing in krugerrands or buying gold mining shares. However, sterling-based investors should be aware that if the rise in the gold price entirely reflects a fall in the dollar, then you will be no better off. Larger investors in gold may wish to consider hedging their dollar exposure. You should be aware that hedging strategies have risks and implications of their own, so please take individual advice from your broker or independent financial adviser.
The last two months have not been easy for unhedged holders of gold. But you can take heart that some of the bearish influences may be transitory and that the threat of a double-dip recession is, we believe, overstated by the markets (see FSL 2143, 3rd August 2002). Inflation could be the surprise development in the next couple of years, so gold holders should sit tight, be patient and take the long view. Remember, as Warren Buffet has point ed out: it’s no t enough to predict rain; it’s building the ark that counts.
BRIAN DURRANT
