The Fundamentals of Gold

Fundamental Reasons to Invest in Gold

The gold market, for years shunned by investors, has experienced a rash of interest over the last four years, undergoing a bull market and becoming one of the best performing assets; In this time, prices have risen from lows of $250 to its present level. In sterling terms that's a rise from around £184 per ounce to today's value. This is all the more remarkable, when compared to the backdrop of falling stock markets and bearish sentiment.

However, this leads to the question of whether gold has exhausted its gains, or whether it is set to continue its meteoric rise to its highs of the 1980s, and continue to be one of the best performing investment assets over the coming year? To answer this, it is necessary to look at the fundamentals underpinning gold and what is happening to them.

The Dollar has fundamental structural problems

The U.S. dollar is the world's reserve currency, and so naturally, gold is priced in dollars in the same way oil is. Towards the end of the 1990's, gold languished under the weight of a strong dollar, with the strength of the U.S. currency, depressing prices. Quite simply, the strength of the dollar has done much to keep gold prices low. However, the dollar is no longer the strong currency it was, and there are signs that it will only continue to get weaker in the foreseeable future. It is these that we will look at.

Firstly, the U.S. is suffering under a huge trade deficit, with the global superpower importing far more goods and services than its exporting. Current estimates for this deficit are put at a whopping 5% of GDP, with many economists and analysts agreeing that this is not sustainable. With America now a net oil importer, the current rising oil prices will only serve to exacerbate this problem.

Secondly, the current U.S. fiscal policy is also running huge deficits, creating further massive downward pressures on the dollar. The current policies of the U.S. administration have all seen massive increases in public spending. Wars are costly, as are many of the government's other policies and need to be paid for by someone. So who is footing the bill? Usually it would be taxpayers, but instead, this U.S. administration has cut taxes, so how is all the public spending being financed? The simple answer is borrowing. The U.S. government, with the help of the Federal Reserve, is issuing bonds to foreign investors, which is akin to flooding the market with dollars, creating further downward pressure on the currency.

Thirdly, as concerns mount as to the viability of a strong dollar, investors reduce their exposure to U.S. stocks and Treasuries (U.S. bonds), no longer wishing to hold such items in their portfolio. This also helps to add an extra downward pressure on the ailing dollar.
Overall, the fundamentals for the dollar do not look impressive. Should the dollar's decline be sustained, gold will benefit on two fronts. Being priced in dollars, the price of gold will tend to increase as the value of the dollar declines. Also, as the value of the dollar declines, foreign investment in U.S. stocks and bonds will decline adding to the negative momentum in those markets. This will then indirectly boost investment demand for gold.

Uncertainty in the Stock Market

Stock markets from London to New York to Tokyo have experienced declining fortunes since 2001. Despite a slight rally in 2003, sentiment amongst many analysts and advisors still remains bearish. Quite simply, there are still lingering questions about high stock valuations, indicating the market may have further to fall. Should this prove to be correct and there continues to be a downward trend in share prices, more and more investors will look for alternative assets, such as gold. Gold's correlation with stocks has historically ranged from nil to negative. It is for this reason that investors are turning to gold with investors looking for alternative assets to under-performing stock markets.

Inflation

Inflation is a problem affecting all economies. The low interest rates seen over the past few years have helped to create an inflationary climate, evident in most economies. Oil prices have quadrupled over the past 18 months and have recently greatly surpassed their all time highs in the oil crisis of 1980. Almost every commodity index has been on the rise as indicated by the huge increase in the CRB index or basket of commodities index. The combination of a tight labour market and rising raw materials prices has not occurred since the 1970s. If inflation continues to build, stocks and bonds will suffer. However, gold acts as a hedge against inflation, and will appreciate in value.

Demand Fundamentals

Demand for physical gold is at near-record highs around the world. It seems that the only aspect of gold demand, which has not reached record highs, is western investment demand, although it should be noted that this too is on the increase. Certainly, when macroeconomic conditions bring investors back to gold, they will find a very tight market.

These investors in the western world will be joined by significant increase in demand from large elements of the developing and semi-developed world, such as China, Russia, Brazil, Argentina, India, Indonesia and the Islamic world.

The gold market was recently liberalised in China. For the first time in 50 years Chinese individuals can buy, save and invest in gold. Couple this with the large and growing demand for gold jewellery, and it is evident that Chinese gold demand is set to grow.

The Russian Central Bank, like many Central Banks worldwide, is attempting to diversify its assets out of dollar holdings, into euros and gold. They are therefore actively selling their dollar reserves and replacing them by buying euros and gold.

India is the world's largest importer and consumer of gold. Its economy is booming and the rupee is becoming much stronger facilitating even greater imports of gold.

In much of the Islamic World, there is growing resentment at Western foreign and economic influence, with many individuals blaming the 1994 Asian Financial Crisis on Western institutions and currency speculation. In response, the idea has been mooted for a greater diversification into gold.

Supply Fundamentals

As said before, the physical gold market is very tight. The low gold prices over the past few years have only contributed to this situation. As the gold price fell, it no longer became viable to mine in many parts of the world. As a result, numerous mines closed, and exploration slowed. However, opening and finding mines is not like turning on a tap. It takes time to do this. Thus, rising gold prices cannot result in a sudden dramatic surge of supply. This, alongside curtailed central bank sales, will not help physical gold supply.

Rising Commodity Prices

Commodity prices have been on the rise for months. Base metals, raw materials and energy prices are all up. Gold prices have not kept pace, lagging slightly. History has shown that a wide disparity between commodity prices and gold does not persist for long, with a noticeable correlation between gold prices and oil prices. It is no surprise to see historically that the two major upward moves of oil in the 1970s were accompanied by increases in the price of gold. Recently, the price of oil has tripled over the past year and a half, surpassing the highs of 1980s, and is likely to continue to exert an upward pull on gold prices. An oil price rise also tends to increase inflation.

World Tensions

The uncertainty, instability and international terrorism that currently exist are not an ideal climate for investors. In this atmosphere, it is natural for investors to seek a safe haven asset. Gold is this asset, being virtually indestructible, and acting as an asset that investors can trust. The threat of another major terrorist strike has serious implications for the markets and investors, and so consequently the geo-political climate needs to be viewed almost as much as traditional market indicators. The constant menace of Al Qaeda, coupled with the turmoil in Iraq and attacks on oil installations in both Iraq and Saudi Arabia, have taken their toll on consumer and investor confidence. These threats have not gone away. Furthermore, there is also the spectre of Iran's nuclear ambitions, and potential instability in the oil rich region of the Caspian, on the horizon. Equally important, the 'War on Terror' and 'Homeland Security' policies lead to the creation of long term government deficits. Either way, it points to potential instability with gold acting as a safe haven asset.

America's Growing Consumer, Corporate, State and National Debt

America's debt levels are reaching all-time highs; perhaps unsustainable highs. Consumer (credit card) debt is at record highs. Home equity is actually down, despite the rise in home ownership. Nearly 48% of American families spend more than they earn each year. The average household carries more than $19,000 in debt - excluding mortgages. U.S. government debt will hit $521bn in 2004. All of this debt has to be financed somehow, having serious implications for the global economy.

America's Burgeoning Trade Deficit

Mentioned earlier, the U.S. has an often overlooked, serious and troubling trade deficit. The gap between America's imports and exports is running at more than $500billion per year. This trade deficit is approaching unsustainable levels and no one knows for sure what the effects might be. This deficit could potentially lead to a US protectionist backlash and consequently, foreign, particularly Chinese, dumping of U.S. Treasury Bonds and consequent raise in interest rates, foreign dumping of other U.S. securities, and or a sharp decline in the dollar. Gold would perform as a hedge against any of these three scenarios.

The fundamentals

Many analysts are extremely bullish on the prospects of gold. Certainly, the fundamentals seem to back-up this viewpoint, with many investors adjusting their portfolio to include gold. Crucially, the critical issue will be the strength of the dollar over the coming year. Certainly, many financial advisors advocate holding gold as a part of one's investment portfolio. They understand the advantages of holding gold.