Gold gives a precious insight into economy

By Tom Stevenson
The Telegraph, London
Saturday, October 24, 2009

http://www.telegraph.co.uk/finance/comment/tom-stevenson/6424245/Gold-gi...

What a strange and fascinating commodity gold is -- a store of value that is no one's liability, which cannot be printed or debauched by governments but which, with no income stream, has no objective value. A simultaneous hedge against both deflationary slump and inflationary spiral, it is little wonder gold should be the investment of choice for the Armageddon crowd.

Gold attracts conspiracy theories like no other asset. Google "Yamashita's Gold" and enter into a half-plausible thriller of Japanese wartime loot and abandoned bullion in the Philippines. It is the stuff of an airport page-turner but what can it tell us about the real world?

Some serious people think that the recent rally in the gold price really is different this time. It's not like the safe-haven spikes that have pushed the yellow metal through $1,000 an ounce on a handful of recent occasions but each time failed to hold the gain. Traders are pointing to the shallowness of recent pull-backs and the volume of bets buying speculators the right to purchase gold at between $1,100 and $1,200 an ounce.

One long-term market player said this week that he'd been trading gold for 18 years, the first 13 of which no one wanted to talk to him. Today he's fighting off questions about what's going on in the market.

What's happening is that gold is pushing higher in the face of things that history says should push it lower. Gold rises with inflation but it has strengthened in recent months despite easing price pressures and lower inflation expectations. The other tail risk that investors use gold to hedge against -- rising defaults and deflation -- has also faded into the background.

If gold is telling us anything today it is that governments -- principally America's and our own -- are about to make a mess of the exit from their economic stimulus programmes. Either they are going to tighten too soon, plunging the world into a deflationary ice age, or, more likely, they are going to hang back too long until we are swept away by hyperinflation.

Take a look at the Fed Funds rate -- according to Credit Suisse, the most important driver of the gold price. Despite rising economic activity, the rate is falling. That's because the market has cottoned on to the fact that the US government is not going to take any risks with the recovery. Rates are going to stay too low for too long and the excess bank reserves that are the aviation fuel of the inflationary firestorm to come are going to keep on rising.

Ben Bernanke, chairman of the Federal Reserve, has spent his life studying the economic causes of the Great Depression. He simply isn't going to make that mistake again. Historically, the Fed raises rates 19 months after unemployment peaks so, with the job queues still lengthening, the exit is not imminent. Cheap money is casting its dark spells all over again.

Arguably, governments have no viable alternative. Drowning in debt they could default, but it is scarcely conceivable that this is being considered in either Washington or London. The only honest way out is the slow grind of tax hikes and spending cuts but anything that is remotely acceptable politically will be totally inadequate fiscally. The required cuts in the US -- perhaps a quarter of government spending -- are even more implausible.

Printing money remains the time-honoured way out -- and it will end as messily as it always has. Hard assets, the king of which is gold, and the shares of companies that produce them are a must for anyone looking to survive this institutionalised generational theft.

Meanwhile, central banks are seriously underweight when it comes to gold, with China and Japan keeping a tiny fraction of their reserves in gold. Just shifting 10 percent of their reserves into gold (Europe's weighting is 70 percent) would involve the purchase of gold equivalent to nearly four times the amount currently held in exchange-traded funds. This would be massively destabilising for the gold market.

Gold shares are currently valued at roughly the same multiple of earnings and assets as they were in 2003 despite the gold price being three times higher. Even at today's nominal high, the real inflation-adjusted price of gold is 40 percent below its all-time high 20 years ago.

Gold is not the only way to protect yourself against the policy errors that politics and psychology make a racing certainty. Index-linked bonds look good value. But my favourite alternative is platinum. It shares some of gold's precious metal appeal with the added kicker of sharply rising global demand for catalytic converters and a price that was shot to pieces during the industrial collapse a year ago. As far as I am aware there is no secret platinum stash in the mountains of the Philippines but if there is, I am sure someone will tell me.

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Tom Stevenson is a market and investment commentator at Fidelity International. The views expressed are his own.

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