Wednesday, July 21, 2010

Roubini on Gold

For the better part of 10 years running, all that glitters has, in fact, been gold. Since 2001, the precious metal has outperformed all of the core asset classes, gaining an average 15.3% per year in dollar terms since January 2001.

Gold is back in vogue for several reasons. Investors view it as an alternative to fiat money, as a hedge against extreme economic risks—which now include both high inflation and deflation—and as a measure of protection against financial meltdown. Given the intensity of the economic storm that has broken out over the past three years, in which all three fears have been invoked, gold and its fellow precious metals have spiked in price. RGE’s forecasts for these metals, and for all the commodities we cover, are outlined in our fresh-off-the-presses Q3 Commodities Outlook, available exclusively for clients.

The concerns propelling the price of gold specifically are very real and should not be ignored. But is now the time for investors to jump the gold bandwagon? We wouldn’t encourage it. Our logic and our precise investment recommendations are spelled out in a recent RGE Strategy View, “All That Glitters is Not Gold,” which was released to clients early last week.

Why aren’t we giddy about gold? In short, our core economic forecast scenario does not entail any of the extreme events that could result in a major gold price spike—and given the fact that the metal has already surged in price, we see several potential downside risks.

In the abstract, gold is most attractive as a hedge in one of three extreme scenarios: high inflation, persistent deflation, or when the risk of global financial meltdown is large.

We think high inflation in the near-term is unlikely, given lingering slack in advanced economies. For prices to rise, there must be buyers, and weak employment in the U.S. and Europe, coupled with murky economic prospects, has led consumers to retrench and tighten their purse-strings.

Should inflation eventually surface, it will do so only after balance sheets have been repaired. Unsterilized Fed intervention will have long since eased, and the Fed will be managing the money supply with respect to a rising money multiplier or by selling assets. In other words, an increasing money supply is not de facto currency debasement. The demand for money also matters.

Deflation risk remains, but Ben Bernanke has signaled in the past that the U.S. could pull out all stops—by printing more money—to prevent this dangerous outcome from materializing. For now, the U.S. dollar remains the preeminent safe-haven in times of severe stress—and a dip toward inflation would happen in such a time—so very much in line with Bernanke’s comments, the U.S. appears to have policy options at its disposal to stave off a period of sustained deflation.

Our core scenario is thus that once national balance sheets are repaired through a protracted and gradual deleveraging of household and public sectors (following the relatively rapid deleveraging of the financial sector, particularly in the United States), excessive deflation and inflation fears will subside.

In periods when the risk of global financial meltdown rises, the dollar exchange rate may appreciate against other currencies, but there also tends to be a flight to safety and gold prices appreciate even more. Gold prices tend to rise during periods of financial stress, up until the peak of market concerns—and then fall when the stress is resolved via bailouts or measures that restore market confidence.

There are certainly financial storm clouds to worry about—not least because of sovereign debt concerns in the Eurozone. Given this, we think it is possible that gold could continue to trend upward for a period. We still are not recommending it, however, due to what we see as significant downside risks.

These risks were succinctly outlined in a paper by our chairman, Nouriel Roubini, back in December 2009. They include: the possibility that the dollar-funded carry trade could unravel, popping asset prices—including that of gold—that have been bolstered by cheap borrowing in dollars; the concern that central banks will end quantitative easing and raise interest rates, again decreasing demand for risky investments like gold; and most basically the fear that gold prices have been driven up by herding behavior that could quickly turn the other way, prompting swift losses.

Similarly, even as gold spot prices rise due to demand for physical gold in times of severe financial distress, futures contracts and ETFs—the tools many investors now use to invest in gold—could suffer due to increased fears of counterparty risk.

Investors should thus take note—while gold and financialized gold products have posted consistent returns over the past decade, there are no guarantees that this golden goose will continue to lay eggs.

Source Roubini

Subscribe to All American Investor
Enter Your Email Address

Original content Bob DeMarco, All American Investor