If there is one lesson I derive from history, it is that things that have never happened before do occur.  Extrapolation or intrapolation from past trends has led many an investor onto the manure heap of wasted capital.  Looking back at the last decade, there are at least several themes which seem to be enjoying a “stronger for longer” mantra: the emerging market growth, the commodity boom and the (ever more enigmatic) gold story.  But while the emerging markets have seen tangible wealth generation, sound macroeconomic stewardship and a productive combination of savings and investment (pulling, not surprisingly the commodity trade along), the gold fundamentals are poorly understood in this context.  Little attention has been paid to the mechanism of the progressive wealth shift which has underpinned the gold demand through reinforcing feedback loops, with several positive effects on the way.

Let us start with the US market and the introduction of the Greenspan put, recognized sometime after his seminal 1996 speech.  With the exception of 2004, when interest rates were hiked some time after the long-term yield rose (and gold still returned a creditable 6%) the US economy enjoyed a prolonged low-interest rate environment.  This famously fed into the construction boom and supported non-yielding assets, not least gold, whose lease rate (below Libor) is negatively correlated to prices.  But this low interest rate environment also unleashed a hunt for yield.  The emerging markets were among the beneficiaries of those flows, barely 3-4 years after the most recent (“Asian”) crisis.  This time however, the flows were not dominated purely by US-dollar denominated credit, and included capital from equity funds.  Importantly, the growth in wealth affected several economies whose consumers had historically been “positively inclined” towards ownership of gold.  For all the near-universal ubiquity of gold as ornament and as a store of value, the enrichment of Middle Eastern, South Asian and East Asian consumer/investor has had a stronger impact on gold sales than wealth preservation of baby boomers.

Yet much of the capital inflows also triggered a defensive posture by the monetary authorities in the emerging markets, many of which remembered all too painfully the lessons of the Asian crisis.  Beijing consensus began to emerge, with the religion of an open capital account more commonly questioned.  This created a strong upward pressure on the currencies of the economies running a current account surplus over and above the capital inflows.  In extreme cases, sterilization was required to reduce the domestic component of the monetary base.  Elsewhere, the liquidity conditions allowed for a construction boom which appeared commodity-friendly.  Although gold did not participate in this process directly (as metallurgical coal, iron ore and copper did), it has benefited from it indirectly, via commodity indices, where the yellow metal was bought along with the energy and industrial metals.

But the net capital inflow into current account-surplus countries has also led to a massive accumulation of foreign reserves.  Over a decade, the foreign reserves increased from 1.9 trillion dollars to 6.8 trillion dollars, dominated by growth in four Asian countries: China, Japan, India and Taiwan.  Given that the current account surpluses were generated by trade surpluses (with the exception of Japan, where the surplus was more related to income from overseas investments), it is not surprising that most of the inflows were in US dollars.  Understandably, they were also deployed in US dollar vehicles – Treasuries, agency debt and corporate debt.  But this accumulation did generate expectations that after a decade of post-Cold War net selling by (Western) central banks, globally the monetary authorities would now move into a net neutral, or even net positive purchase mode.  Although it is not in the interest of dollar holders to make dollar-bearish statements, there are indications that central banks have indeed shifted away from a strongly negative attitude to gold.

The other gold-friendly element, which has long been occulted by the foreign reserve accumulation, relates to the role of the Euro.  The foreign reserve growth has seen the progressive erosion of the role of the dollar as a reserve currency, though not yet as a currency denominating the global trade (occasional renminbi swaps notwithstanding).  In the effect, some of the accumulated dollar positions have been exchanged into the Euro – whose global role increased significantly over the last decade.  For most of the decade, gold traded with a positive correlation to Euro / dollar pair, a phenomenon disrupted in the first quarter of 2009 and again most recently.  But for the most part, inflows into the Euro were viewed as “bullish gold”.

However strong, the demand for Euro from the monetary authorities has been dwarfed by the overseas demand for US Treasuries, 33% of which are held outside of the United States.  This, seemingly perennial demand has helped the US authorities to keep yields low, fuelling the credit boom until 2007.  But as already noted before, low (real) interest rates are gold’s most trusted friend.

As we can see, this large loop of global capital flows has benefited gold at several junctures – through the interest rates, capital inflows into gold-consuming nations, the commodity boom and resulting index investments, the growth of forex reserves with the potential increase of the role of gold as a reserve asset, and finally through the increased role of the Euro – which has been mostly positively correlated to gold prices.  Which of these factors are here to stay and which are to go away?

The emerging market side of the equation may last longer – despite the current fears surrounding inflationary pressures and higher interest rates (indeed, the related capital outflows could first affect Latin America, rather than Asia).  The Euro story will depend on whether the multiple public deficits are treated via strict – and ultimately deflationary – austerity measures (a near-term negative for gold) or through monetization.  And the US interest rates?  Here’s a tough one.  According to Bernanke, they are low for a “foreseeable future”, and indeed, as long as they trail inflation, gold will benefit.  But does “future” mean 2011?  This is when Bush’s tax cuts (1.6% of GDP) will expire.  The US economy is too brittle to survive an interest rate hike and a tax raise.  Are Washington politicians are as suicidal as Ryutaro Hashimoto was in 1997?  Although it is highly unlikely that Republicans ever vote a tax increase, expiration of old tax cuts is a different story.  Deficit bashers are aplenty today, jockeying now for November elections.  But a tighter monetary policy, coupled with fiscal fundamentalism will smother the US economy and its exports, which will struggle under a stronger dollar.

Would this happen early this decade, gold will suffer, offering spectacular new entry points.  Why?  Because this exercise in macro-economic amnesia will not last.  Nor did Hashimoto.

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Tags: capital inflows into emerging markets, commodity index investments, interest rates, taxes