The year 2009 is behind us. For gold investors this was a year of decent returns. Yet the 24.8% increase in dollar-denominated gold price pales in comparison to more volatile commodities, with lead, sugar and copper all gaining over 140% year on year. The last-minute dash by the dollar/euro in December also put to sleep the argument commonly repeated among English speaking observers that the gold price is a tributary of dollar’s weakness. In December gold may have steadied somewhat, but the year-on-year increase in EUR/USD exchange rate of mere 3% bears little resemblance to gold’s annual performance. Indeed, if the dollar has lost some of its trade-weighted value, the loss has been registered mostly against commodity currencies, rather than the Euro, with the collateral damage registered by some of the gold mining companies whose margins are often at the mercy on the strength of the Rand, Aussie dollar or Brazilian Real.
But, as we are entering the new decade, the old paradigms may require a revision. The received wisdom of perpetual Chinese growth, the permanently hobbled Japan, the happily overleveraged US and the haplessly uncompetitive Eurozone may need to be rewritten sooner than many expect. After a consistently rewarding decade for gold investors, longer-term questions mount for them as well.
On December 16, FOMC announced that as of February 1 this year, liquidity swap arrangements will be discontinued. The market briefly reacted pushing up the dollar against Euro, but with little immediate effect on dollar-denominated commodity prices. Indeed, the Euro’s slide may have owed more to the nervousness surrounding the Greek situation. Still, outright defaults are not a near-term option for Eurozone members. Rather, the global investors’ environment will more likely range between robust growth (in Brazil or Indonesia), continued balance sheet recession and deleveraging (with potential bouts of deflation, as in Japan), asset bubbles (which are notoriously difficult to spot, but near-certain in Shanghai and Beijing property markets today) and increased inflationary pressures in some less developed markets (especially if food prices accelerate again this year).
Of the five sets of economic conditions listed above, the most relevant for the developed world’s investors is the third (continued deleveraging), and possibly fear of the first (sovereign bond market stress, rather than actual defaults). The latter has been highlighted this week by the decision of several large bond funds to reduce exposure to US and UK paper. In future we will return to this topic and its significance for gold investors. In the meantime, let us review potential gold price scenarios in the former scenario (balance sheet recession). To do so, it is illustrative to dwell for a moment on Japan’s plight of the last two decades.
Balance sheet recession takes place when there is a shortage of aggregate demand and surplus of funds to lend. Such a borrower-less economy suffers from near zero interest rates, large-scale deleveraging and lack of spreads for banks to recapitalize. The most important lesson from the experience of Japanese investors over the last 20 years is that deleveraging is bad for corporate returns and dismal for the stock market. Since 1989 Nikkei 225 has lost nearly 67%, or the annualized 5% per annum, permanently forcing many investors from the market. Meanwhile, the gold investment, as denominated in the local currency (the Japanese Yen) has gone through several stages, with remarkable reversals in terms of its correlation to the FX market.
As the Yen initially weakened to 160 vs dollar in 1990, the gold price in Yen terms increased, but then fell as the Japanese currency gathered strength (hitting an all-time high of 80 Yen to the dollar in the Spring of 1995, with gold as low as Y35000/oz). Importantly however, when the currency intervention saw the Yen swing back down to nearly 145 per dollar, the gold prices remained flat in Yen terms until 2000. Then, in another reversal of fortunes between 2002 and 2004, a stronger Yen was accompanied by a steadily strengthening gold price (in Yen terms). Later, the weakness of the Japanese currency may have contributed to an even faster upswing in Yen-gold prices between 2005 and 2007. Finally, in the most recent period, gold-Yen outperformed the Yen-Dollar.
The above history of the (dubious and unstable) correlations between the currency of a balance-sheet recession-plagued economy and the performance of gold prices in the same currency shows that there is nothing deterministic about the gold price behavior in a deflation-prone, deleveraging environment. However, preliminary conclusions can be drawn from normalized returns during the 20 years of Japan’s unhappy experience with the financial markets. Over this period (using monthly returns):
- The Yen has gained 54% to the dollar
- Gold in Yen terms has gained 77%
- Nikkei 225 has lost 66%.
In light of the above, in deflation cash may well be the king, but gold is the emperor! By comparison, over the same 20 year period:
- The trade-weighted dollar has lost 16.5%
- Gold in dollar terms has gained 173%
- SPX index has gained 215%
Arguably, the experience of the Western economies is somewhat different from Japan’s balance sheet recession. For one, unlike in Japan, it is mostly not the corporations, but rather households that are in dire need of repairing their balance sheets. Unfortunately, the slow pace of deleveraging (around 6% between 2008-2009 in the United States) would indicate that the sluggish credit growth may remain the defining feature of the markets once the Central Banks deliver on their recent announcements and limit the liquidity mechanisms. Such premature, anti-inflationary measures are not per se a reason to shy away from gold. But they could become a good enough reason to run away from inflated equity valuations.
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