Tuesday, November 22, 2005

As the Global Economy Crumbles (Part I)

It seems that the signs are becoming more obvious that the global economy is headed for a serious downturn. One of the key indicators here is sentiment regarding gold. For decades now, gold has been marginalised as an investment strategy and indeed derided as an "ancient relic" that no longer has any real place in the advancing neo-liberal economy of the Brave New World. However, certain groups of commentators that one might circumscribe as the "alternative financial media" have been keeping an observant eye on gold, and have an entirely different opinion.

For instance, there are the friendly folks at the Gold Anti-Trust Action committee, who also have a hand in running gold investment advice website Le Metropole Cafe. James Turk, founder of GoldMoney, a kind of "Paypal with Gold", also provides some interesting gold commentary. In Australia, Bill Buckler of The Privateer is also a notable gold advocate, providing excellent weekly market commentary.

So what is the general opinion of the alternative financial media on gold? To put it in a nutshell, it's that gold is incredibly undervalued, to the tune of possible thousands of US dollars per troy ounce. Why is it so undervalued? Well, that's a very large can of worms right there. It appears that there has been a systemic, global effort on behalf of powerful Central Banks to devalue gold as part of maintaining massive credit expansions in Western economies. You won't hear a peep of this in the mainstream media of course, but it's up to you to research for youself and decide whether this is a viable hypothesis.

What is NOT hypothetical are recent leaps in the gold price in US$. As of the time of writing this entry, gold is sitting at $491 US / $667 AUD. Gold first approached its Dec '04 high of US$456 on Sept 9 when it reached $450. It set new highs of US$477 on October 11. Since early 2002, gold has appreciated in the order of approximately 60%, despite repeated commentary in the mainstream media about gold being consistently overvalued. Although a historical chart over 2005 to date will show that the gold price in $US is quite volatile, the general trend is up, and I believe it will continue going up in fits and starts in the near term, although more non-linear events such as a global economic downturn could cause an exponential increase in demand that will send the price soaring.

Another fact is that the mainstream media can only ignore a huge story for so long, and there are signs that a "gold rush" is becoming the tentative idea du jour of the more daring commentators. For instance, observe this article by Alan Kohler in the Sydney Morning Herald:
Gold's switch in the past few months from being the inverse of the US dollar to going up with it is a sign of some big forces at work in global markets and economies. It may be "Pink sky in the morning" (the shepherd's warning).

In the first half of this year the US dollar went up 12 per cent on the back of an interest-rate arbitrage play as it became clear the Federal Reserve Board in the US would keep raising cash rates until they were "neutral" (probably 4.5 per cent). At the same time gold fell 6 per cent, which was in keeping with its long-term position as an alternative "currency" to the greenback.

By the way, the mysterious appeal of gold, despite paying no yield, is based on its character as an asset that is no one's liability, unlike all other financial assets. Liabilities can default or become devalued; gold is just gold.

Between November 2003 and January 2004, gold rose 10 per cent and the dollar fell 9 per cent; over the following four months those moves were reversed; in the second half of 2004 gold bounced 20 per cent while the dollar fell 12 per cent, and in the first half of 2005 the dollar regained the 12 per cent and gold fell 6 per cent.

Since September gold has risen 9 per cent to an 18-year high as the dollar has risen 7 per cent - which is virtually unprecedented. It has happened because oil revenues are being recycled as much into gold and domestic investments as petrodollars (remember them?), while Asia continues to recycle trade surpluses into US treasury bonds (and thus dollars).

So what's the problem? It's that the US dollar is overvalued and the country's competitiveness has eroded to the point where the cash rate arbitrage will be pitifully inadequate to hold the currency. This has occurred because Asian central banks, led by China, have been buying US bonds at ridiculously low interest rates in order to keep their own currencies and improve their own competitive position.

US consumers and businesses have been buying their goods from - and outsourcing their services to - cheap currency countries, which has stopped what would have otherwise been a natural depreciation of the dollar. As a result, the US current account deficit is now pushing $US800 billion ($1086 billion), $US300 billion higher than when, as research house Bridgewater Associates puts it, "private sector capital gave up on the dollar in 2002". It is also the biggest financing task the world has ever known.

Meanwhile, Asian current account surpluses are declining and those of oil-exporting countries are rising. According to the ANZ Bank's Saul Eslake, current account surpluses of the Middle East have quadrupled in two years to more than $US200 billion. Russia's surplus is up to $US120 billion and even Latin America is running a surplus now because of oil from Venezuela. In fact, Australia is about the only commodity exporting nation still running a deficit (because we are bigger consumers).

Total trade surpluses of commodity exporting nations are about $US400 billion. Asian surpluses, meanwhile, have declined from $US370 billion a year to $US300 billion, so the most important financiers of America's consumption addiction are no longer the Asian countries supplying the finished goods and services acting out of self interest - what Eslake calls the greatest vendor financing scheme in history. Commodity exporters, especially oil, are taking over, and they have an entirely different set of motivations.

Morgan Stanley's chief economist, Steve Roach, is in the middle of a spin through Asia and the Middle East, and filed an interesting piece for his website from the Emirates Palace Hotel in Abu Dhabi. He quotes a friend of his who "shared what I believe is a very important insight on the recycling of the huge surge in oil revenues that has once again flowed into the region's coffers - estimated at around $US300 billion over the past year by many accounts".

"Unlike the oil shocks of the past, which gave rise to the concept of the petrodollar - a recycling of windfall oil revenues into dollar-denominated assets - the current windfall accrues to a Middle East that is much better prepared for inward re-investment.

"Take a look at year-to-date returns in the stockmarkets of the region's major oil producers - Saudi Arabia (+96 per cent), UAE (+179 per cent in Dubai and +85 per cent in Abu Dhabi), Kuwait (+84 per cent), Qatar (+77 per cent), and Bahrain (+32 per cent). Also take a look at the urban construction boom - Dubai is starting to look Singaporean in scale."

And they are investing in the other asset that is no one else's liability - gold. Certainly the Arabs are less inclined to finance American consumers than the Chinese and are more worried, as investors, about the sustainability of the US current account deficit.

The US dollar is rising at present - along with gold - because of a short-term arbitrage on cash rates as the Fed continues to push them towards 4.5 per cent, whence chairman Ben Bernanke is likely to stop and sit on the sidelines for a while. Bond yields have also been rising gradually because global growth is surprising on the upside (not because of inflation expectations, which are not rising).

This situation cannot last. American financial assets will have to be repriced eventually, either directly or through a depreciation of the currency, or both.

And while there is little doubt that we are in the midst of a "Santa Claus rally" on Wall Street or that Australian stocks are generally not expensive, the timing and force of the American reckoning will be the key to investment markets in 2006.
This article draws some interesting connections between gold and the coming collapse of the US economy, and adds weight to certain rumours in the alternative financial media of subtle, calculated gold accumulation by not ONLY Arab nations, but also China. Then, we also have the following interesting comments by Russia's President Vladamir Putin:
I support the proposal that the Central Bank pay greater attention to precious metals in forming our gold and foreign exchange reserves," Putin said, Interfax reported. Putin was speaking during a stopover in Magadan, the capital of Russia's gold mining industry, after a visit to Japan and South Korea.

Last week, the Central Bank said it was planning to raise the share of gold in its reserves from 5 percent to 10 percent. In reaction to the announcement, world gold prices reached an 18-year high on Monday.
Considering the actions of European Central Banks over recent years and their habits of announcing gold sales, despite the steadily upward pricing trends, this suggests that Russia is possibly attempting to "get ahead of the game" in terms of protecting itself from the worst excesses of any global depression. Also of interest is the German Bundesbank's recent :
FRANKFURT (AFX) - Bundesbank president Axel Weber indicated yesterday that the central bank will not give in to political pressure to sell part of its gold reserves, according to Frankfurter Allgemeine Zeitung.

Incoming finance minister Peer Steinbrueck said he hopes to convince the Bundesbank to sell 120 tonnes of gold to finance a 'future fund' that will promote research and education projects.

Steinbrueck said he will seek close contact with the Bundesbank to discuss the possible sale of gold reserves.

But Weber referred to a German law that puts all decision-making on gold reserves in the hands of the Bundesbank.

'I assume that we can agree to respect each other's responsibilities,' Weber said, while adding he welcomes Steinbrueck's interest in the central bank's policies.
Ouch! Reading between the lines, it seems that Mr Steinbrueck is being told to keep his nose out of it, in no uncertain terms. Do these stories hint at a renewed interest in gold reserves by the Central Banks? If so, why?

As mentioned in the SMH article:
By the way, the mysterious appeal of gold, despite paying no yield, is based on its character as an asset that is no one's liability, unlike all other financial assets. Liabilities can default or become devalued; gold is just gold.
Although Mr Kohler might interpret this as a "mysterious appeal", in times when a massive revaluation of US currency could lead to an economic depression, the appeal is not so much "mysterious" as it is based on solid common sense. During the crash of Argentina's economy, people were able to trade gold coins and jewellery for food on so-called "black markets" which were nothing more than people reasserting their right to trade free from government taxing and interference.

As I believe we are entering a critical phase of indicators for the collapse of the global economy, I have decided to make this blog entry first in a series to observe and document some of these indicators. Let's see what happens.


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