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Will Gold Crash in a Recession? |
By Bud Conrad and David Galland, Editors
BIG GOLD from Casey Research
From the 1990s until today, Americans have
maintained their life style by borrowing. As the American consumer is
about to find out, the bill for that life style is coming due.
So where will that lead the U.S. economy?
Simply stated, surveying the landscape of current events, many of which
are a direct consequence of excessive debt and an inevitable slowdown in
consumer spending, we expect stagflation ahead. Loosely defined, that
term refers to a general economic slowdown – a recession – but coupled
with rising prices triggered by massive infusions of liquidity into the
market.
That liquidity can come from governments –
witness the billions upon billions now being thrown into the fray by the
world’s central banks – or it can come from, say, some percentage of the
6+ trillion in U.S. dollars held by foreigners coming home to roost. On
that latter point, in recent weeks there has been almost daily news
about foreign corporations and sovereign wealth funds unloading their
greenbacks in exchange for shares in some of America’s largest financial
institutions. Doug Casey has correctly pointed out that it is when the
trade deficit starts to shrink, which it recently has, that you need to
look for cover... because, among other things, it means the tide of U.S.
dollars is beginning to wash back up on U.S. shores.
Our view that the stagflationary scenario is
the most likely is supported by a steady stream of data. For instance,
despite an obvious slowdown in 2007 holiday season shopping, the Bureau
of Labor Statistics reports that producer prices in November increased
at the fastest rate in 16 years.
Rising prices make a stagflationary
environment positive for gold, if for no other reason than that
investors reallocate depreciating paper-backed investments into
tangibles with a demonstrated ability to float as the intangibles sink.
So, our view remains that we are headed for a
stagflation. But what if we are wrong?
What happens if the global economic crisis
gets so bad that it trumps any and all inflationary influences and we
enter a straight-up deflationary recession?
That is, we are sure, a question on the minds
of many gold investors.
Some quick thoughts...
Gold in a Recession
Traditionally, gold has been a safety net
against inflation. Inflation is good for gold, a case we don’t need to
make again here.
But, in a typical recession, the demand for
everything slows and the prices of many things fall. The knee-jerk
reaction of most casual market observers, therefore, might be that if
inflation is always good for gold, then the opposite is always bad.
Historically, however, that is not the case.
The chart below shows the price of gold overlaid against official
periods of recession as defined by the National Bureau of Economic
Research. As you can see, about half the time gold actually rises in a
recession.
(Note: this chart uses monthly averages, so
you can see that current prices are, in nominal terms, higher than the
1980 high, based on those averages.)
Simply, there isn’t a specific historical
precedent that demonstrates that gold will fall during a recession.
But could we have a general deflation, one
that might tip gold into one of the down cycles? Of course.
The developing recession, based as it is on a
global contraction in credit, looks to be especially long and deep.
Almost daily now we learn of multi-billion-dollar debt defaults. Those,
in turn, trigger both a freeze-up in easy credit and a flight from risk.
In response, the government has responded with
its predictable "fix-it" tools – stimulus and bailouts. The tools of
government stimulus are lowering the Fed funds interest rate, and
potential new large-scale bailouts like the Resolution Trust Corporation
(RTC) that was put into action to straighten out the Savings and Loan
crisis of the 1980s, to the tune of $200 billion. While the Europeans
have just unleashed an amazing $500 billion in new liquidity, so far,
U.S. Treasury Secretary Paulson and Fed Chairman Bernanke and friends
have been surprisingly slow to act. They started with denial and have
moved to inadequate band-aids.
In the absence of any concentrated and
well-funded program – such as the RTC – to try and keep the wheels on
(and, at this point, it is not clear that any imaginable measure will
suffice), the deflationary pressures of the housing collapse are
winning.
But there is an important, longer-cycle
pressure that is not talked about much, although it is increasingly
obvious to the American consumer: the dollars they're spending are
buying less. They see gasoline and heating prices rise, but don’t think
much about the dollar itself as the underlying source of price
inflation.
This decline in the purchasing power of the
dollar is extremely important for the price of gold. That’s because the
pressures on the dollar seem overwhelming when aggregated: huge budget
and trade deficits, wars and retirement demands of baby boomers,
unprecedented foreign holdings of U.S. dollars. Watching the prices of
internationally traded goods, including oil at $90 per barrel and wheat
at a record $10 per bushel, it is hard to imagine a situation of serious
deflation emerging.
Looking for Alternatives
The flight to quality by investors who no
longer trust packages of mortgage loans, or anything that is not
strictly labeled as government backed, is unprecedented. The interest
rate on government-issued two-year Treasuries dropped to 3%, reflecting
the demand for safety. Concurrently, other interest rates have risen in
response to increasing mistrust and uncertainty.
Gold, of course, provides a different form of
safe harbor alternative – an asset that is not only readily liquid but,
unlike government paper, positively correlated with the very same
inflation that will erode the purchasing power of paper assets.
Right now, gold is not on the front burner,
but this is only to be expected because of the state of flux of global
financial markets. Like observers of a war of Titans, the market is
confounded by the sheer magnitude of all that is going on, from the
devastation being wreaked on the world’s best-known and most established
financial institutions, to the unleashing of billions upon billions in
experimental new liquidity measures by central banks.
As the fog of war begins to clear and it
becomes obvious that not only will economic growth be severely curbed,
but that the fiat currencies are going to be sacrificed in the fight,
some percentage of the funds now sitting on the sidelines – much of it
in U.S. Treasuries – will begin to move into gold and other tangibles.
In the face of limited gold supplies, this surge in demand should create
strong upward pressure on the price of gold and, for leverage, gold
shares.
In sum, even though the relatively sluggish
and inept responses from the U.S. government in the face of the current
credit crisis could produce a severely slowing economy, creating periods
of deflationary fears that put stress on the price of gold, we continue
to believe that the most likely case is for massive inflationary
bailouts that support a positive outlook for gold.
Bud Conrad and David Galland
are, respectively, the chief economist and managing editor with Casey
Research, publishers of
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