A Brewing Storm
Gold Poised to Move in 2008
BY TONY ALLISON

Events are aligning to provide a bullish fundamental foundation that could push gold significantly higher in 2008. While volatility will likely remain a feature of the metals market, the price could begin to march higher as the markets react to gold’s strong fundamentals. The cable channel “experts” keep calling for a top in gold, much as they have for oil all the way from $20 per barrel on up. Once again it appears this is wishful thinking more than analysis based on the fundamentals.

The Dollar

The dollar has been battered severely about the head and shoulders the past few years and remains fundamentally weak. The Federal Reserve is under enormous pressure to keep cutting rates to keep the economy out of recession and bail out the real estate market collapse. Give the presidential election cycle, the odds favor more rate cutting. The dollar should spiral lower with continued interest rate cuts, benefiting gold. The continual money printing and liquidity expansion is not limited to the Fed. Central banks around the globe are printing money at much higher rates than GDP growth, and much higher than the rate of growth in gold production.

Ambrose Evans-Pritchard, writing for the Daily Telegraph in the UK, had some pertinent observations on currency devaluation versus gold.

“Tony Fell, chairman of RBC Capital Markets, said the world money supply has been growing by 5-10%, while the stock of mined gold has been rising by 1.6%, creating a mismatch that must be covered. Mr. Fell says the total debt burden in the US has exploded to 340% of GDP, in stark contrast to the steady levels of around 150% in the post-War era. It almost insures further dollar debasement. ‘We’re in the very early phases of a prolonged bull market,’ said Fell. RBC argues that the global dollar system known as Bretton Woods II is ‘coming apart at the seams’ as Asian, Middle East, and Latin American states start to break down their dollar links to avoid importing US inflation. The result is to resurrect gold, which is fast regaining its role as the world’s benchmark currency.”

As investors, institutions and central banks around the world watch the Fed continue to cut rates and flood the system with liquidity, they will likely continue moving toward the exit door, gradually dumping their dollars and looking to diversify into areas such as gold and other currencies. The process has thus far been orderly. For the sake of our dollar, let’s hope that there is not a sudden rush to squeeze through the exit door at once.

Inflation

As long as reported “core” inflation remains low, it gives the Fed room to keep lowering rates. However, with real world inflation likely much higher than the reported figure, the odds increase that continued Fed rate-cutting runs the risk of releasing the hyperinflation genie from the bottle. As the markets begin to sniff out growing inflation, gold will be the beneficiary.

Remember, gold is the time-honored asset to hedge against inflation. The inflation-adjusted 1980 high for gold is $2145 per ounce. The fundamentals point to much higher prices from here, especially if inflation once again becomes a clear and present danger to the average American.

Credit Market Chaos

The banking and credit crisis, which started in the US and is spreading world-wide, is helping create demand for gold as a safe haven. As investors and institutions remain wary of the uncertainty and potential damage to come, gold provides many investors with a prudent diversification for a portion of their assets. If there are any significant bank failures down the line, gold’s safe haven status, now subdued, may move to the front pages.

Peak Gold

The global demand for gold is clearly outstripping supply. Global gold production was down 3% in 2006 and is nearly flat this year. South Africa’s output is down to its lowest level since 1932. According to Barrick Gold CEO Gregory Wilkins, “There’s not much gold out there.” Barrick recently told industry analysts that gold production will fall 10-15% below market expectations over the next three to five years. There appears to be a growing price-inelasticity for gold, as higher prices are not bringing more gold to market. (In addition, any future de-hedging by hedged producers like Barrick will add to gold buying demand.)

Investors are beginning to understand that massive global money creation may just lead to massive currency depreciation. New gold demand is created as buyers are looking at gold as an alternative currency and a store of value. Yet the supply of gold continues to grow very slowly in relation to demand. This is precisely the mirror opposite of the fiat dollar. This supply/demand imbalance will underpin higher gold prices in 2008.

While it is true that western central banks could begin dumping gold onto the market, who would be the buyers? China, Russia, the Middle East, and India would likely be enthusiastic buyers to hedge against their large dollar reserve positions. Selling a scarce and appreciating asset to cap the price for a few months may not seem logical, but it’s happened before. And it may happen in 2008, but as in the past, the effects will be short-lived. The longer lasting effects may be on the western central banks as they sell their legacy of tangible wealth on the cheap once again.

Gold mining shares should profit from higher gold prices, but higher mining costs, estimated at 15% annually, have taken a toll the last few years. But as gold continues to climb, the quality producers will likely enjoy substantial leverage over the price of gold. Another group to look at would be the gold and silver royalty companies, which have no exposure to higher mining costs or liabilities.

Price of Oil

Historically gold tracks the price of oil. Gold has tended to trade at 10 times the price of oil over most two-month periods. Since oil is over $90 per barrel, the odds are that either oil will pull back sharply soon, or gold will advance toward $900 per ounce in the coming months. Unless global growth nosedives in 2008, driving down oil prices, the odds certainly favor gold catching up to oil next year.

Sovereign Wealth Funds

According to analyst Stephen Jen of Morgan Stanley, Sovereign Wealth Funds currently have approximately $2.5 trillion available to invest. Jen estimates, conservatively, that the total for all SWF’s will reach $5 trillion before 2010 and hit $12 trillion by 2015. That is some serious wealth. 

The implications are enormous. The massive shift of hundreds of billions and perhaps trillions of dollars from sovereign bond markets into other assets will have profound effects. Even if the SWF’s decide not to sell their Treasury bonds (and they might), but just cap new purchases, the effects will be harsh for the US treasury markets, and ultimately the US dollar. To feed our insatiable and endless appetite for borrowed foreign currency, the US will be forced to raise rates significantly to attract foreign capital. Or perhaps the Fed will just print the money and buy the bonds. Either path will lead to higher inflation.

These huge holders of US dollar reserves are already looking for diversification out of dollars and into commodities and tangible assets. It would seem logical that gold will be a beneficiary of these funds. Even a small fraction of the trillions of dollars available to invest would drive the relatively small cap gold stocks much higher.

India Demand

India, with a long history of coveting gold, is currently 22% of world gold demand. With India rapidly industrializing and growing at nearly 10% annually, the demand for gold should continue to grow rapidly as well. In addition to the traditional gold jewelry demand for the wedding season, Indian investors may buy more gold as a store of value as India continues to rapidly inflate its currency.

Geo-politics

The list of trouble spots and issues is long and daunting. A short list would include problems in Iraq and Afghanistan, confrontation over nukes in Iran, oil supply disruptions in the Niger delta, trouble between Israel and its neighbors (including Iran), conflict with China over trade, with Russia over defense shields, with the Middle East over petro-dollar standards, etc, etc. This pervasive background of uncertainty and conflict adds to the safe haven status of gold.

The path to $1000 gold (and higher) will not be straight up. It never is. We could see $750 gold before climbing to $900 and beyond. Look out over the horizon. Study the fundamentals. Don’t be shaken and stirred by wild short term swings in volatility. The road ahead for gold is bright, but like all epic journeys, it will likely be a wild, bumpy ride.

Today’s Markets

U.S. stocks declined in volatile trading Monday, as continuing woes in the financial sector offset early signs that holiday shoppers weren't as deflated as some had feared. There was also profit-taking from a big rally on Friday, when stocks rallied in a shortened session as traders had bet on upbeat holiday sales.

The Dow Jones Industrial Average fell 237.44 to close at 12,743.44. The S&P 500 Index closed down 33.48 to close at 1,407.22. The Nasdaq also closed lower, ending at 2,540.99, down 55.61.

Preliminary data showed Black Friday sales were up 8.3%, according to an estimate from ShopperTrak RCT. A separate study from the National Retail Federation calculated that the average shopper spent 3.5% less than last year between Thanksgiving Day and Sunday, though 4.8% more customers shopped.

Crude-oil futures fell modestly from the previous session's record high, ending below $98 a barrel, as traders pondered a possible production increase from the Organization of Petroleum Exporting Countries and the effect of a sliding dollar on oil prices.

Gold for December delivery gained $1.80 to finish at $826.50 an ounce on the New York Mercantile Exchange. On Friday, gold futures finished with strong gains, rallying $26 to $824.70 an ounce.

Wishing you a good evening,

Tony Allison