GOLD ANALYSIS

Four pillars of gold price strength remain intact

Despite the recent setback in the gold price, the principal drivers of gold's recent strength remain in play and don't be surprised to see $1,500 gold next year.

Author: Jeffrey Nichols
Posted: Monday , 14 Dec 2009

NEW YORK (Rosland Capital) - 

Friday seems to be gold's unlucky day.  This past Friday, December 11th, gold tumbled as better-than-expected retail sales figures suggested that U.S. economic growth is rebounding.  Retail sales for November rose 1.3 percent, much better than the 0.7 percent rise economists and markets were anticipating.  Reflexively, the U.S. dollar strengthened and gold promptly tumbled from just over $1,140 to under $1,110 - a decline of more than $30 or about 2.6 percent.. 

A week earlier, on Friday, December 4th, gold reacted even more sharply to the unexpected fall in the U.S. unemployment rate when the yellow metal fell from its all-time high near $1,226 the day before to as low as $1,139 the following Monday morning - a decline of $87 or about seven percent. 

Group Think Wrong

In both cases, markets were re-evaluating prospects for the U.S. economy - and the Federal Reserve's interest rate policies.  The popular wisdom seems to be that a sharper recovery in U.S. economic growth will lead the Fed to tighten policy and begin raising interest rates sooner rather than later.  Higher interest rates in the United States relative to interest rates in Europe, Japan, and other countries suggests a stronger U.S. dollar exchange rate, which in turn is thought to dampen investor interest in gold. 

We think all of this "group think" about the U.S. economic outlook, the prospects for monetary and fiscal policies, and the impact on the greenback and gold is illogical and downright irrational. 

What now governs monetary and fiscal policy is not the monthly data on industrial production, or retail sales, or even the reported unemployment rate.  What counts to economic policymakers are labor-market conditions and the pain felt by American households.  This is what will determine the outcome of America's next mid-term elections and President Obama's chances two years later. 

Policymakers Looking First at Labor Markets

Federal Reserve Board Chairman Ben Bernanke has said over and over that interest rates will remain on hold (with the Fed funds rate near zero) for as long as it takes to assure a sustainable recovery with declining unemployment . . . and other Fed officials have echoed this week after week.  And, President Obama, along with assorted members of his economic team have said, again most recently this past weekend, that job creation is more important than reducing the Federal deficit. 

The U.S. unemployment rate has fallen, not because of improving labor market conditions, but because millions of Americans have quit looking for work and are no longer counted in the jobless rate.  Moreover, 25 million part-time workers are counted as fully employed even though they want and need full-time jobs.  The "real unemployment rate" counting discouraged workers who have dropped out of the labor force and part-timers who would prefer to work full-time was 17.2 percent in November, better than the prior month's 17.5 percent, but still indicative of serious financial pain and suffering across the country.  Reflecting the number of unemployed or underemployed, some seven million families are behind on their mortgages and at risk of foreclosure.  These are not the economic conditions that will lead to an early tightening of monetary or fiscal policies.

Misleading Retail Sales

What about last week's retail sales figures?  These, too, are a misleading indicator of the economy's health.  To some extent, the stronger November sales resulted from many retailers beginning Christmas promotions earlier this year, advancing some sales that would otherwise have been booked in December.  In fact, retailers are reporting much slower sales so far this month.

It also reflects much more aggressive discounting, so better sales won't necessarily translate into bigger profits for some retailers.  And, lest we forget, much of the merchandise bought by American consumers (especially the typical Christmas gifts) is manufactured abroad, benefitting foreign workers rather than Americans.  

No Change in Fed Policy- Good for Gold

All in all, we don't see any change in Fed policy for some long time.  A rising dollar buoyed by misguided perceptions and expectations will float only so long - and the long-term decline in the U.S. currency will soon resume. 

In fact, U.S. monetary policies will likely become still more reflationary - and, ultimately, more inflationary and dollar debasing.  With U.S Federal debt now over $12 trillion and this year's deficit in excess of $1.5 trillion, and with interest rates artificially suppressed, the Fed will be forced to monetize a growing portion of the Federal deficit by buying government debt and growing it's own balance sheet.  Fundamentally, the dollar is a declining currency because the Fed is printing too many of them! 

Don't Ignore China

While gold traders and investors are focusing on U.S. economic data, they're missing the just-as-important statistics from China. 

Recent indicators point to a "V" shaped recovery.  Chinese industrial production accelerated in November to its fastest rate this year - up over 19 percent from a year earlier.  I can tell you first hand from my recent visit to Shanghai that China's largest city is booming with new construction - roads, bridges, office towers, and apartment blocks - rising everywhere, streets crowded with shoppers, and auto sales so strong that many buyers wait months for delivery. 

Meanwhile, and importantly for gold, after nearly a year of falling consumer prices, China's consumer price index registered a 0.6 percent year-over-year increase in November.  Importantly, gasoline prices are up about 50 percent so far this year - and counting taxes are now higher than here in the United States.  Though so far still mild, the increase in consumer prices along with rising commodity, fuel, and gasoline prices, is aggravating inflation expectations and contributing to the growth of investor interest in gold. 

We've written and spoken about the importance of China to the world's gold market and price outlook.  It is now the world's largest gold-consuming market, surpassing India this year.  It is also the world's biggest mine producer of gold.  And the People's Bank of China, the central bank, has been a significant buyer of gold from domestic mine production for the past three or four years. 

Since the legalization of private gold investment about two years ago, a well-developed gold investment infrastructure has quickly developed with gold investment products now available at banks, gold retail outlets, jewelry retailers, and department stores across the country. 

We think China's private-sector investment purchases this year may total between 85 to as much as 100 tons (2.7 million to 3.2 million ounces) - and could double next year as rising incomes and rising inflationary expectations give people the means and motivation to invest in the metal.  In addition, jewelry purchases may total another 350 tons (11.3 million ounces) this year - and considerably more in 2010.  Chinese gold jewelry is very high karatage - usually 24 karats or pure gold - and is bought both for adornment and as an investment. 

The Four Pillars of Gold-Price Strength

Notwithstanding the recent correction - and the possibility that gold may yet fall further before bargain hunters and other buyers (including central banks) reappear - the four pillars of gold-price strength remain intact.  We've spoken and written about these often - but they are worth repeating. 

These are:

(1) Inflation-fueling U.S. monetary and fiscal policies;

(2) Central bank reserve diversification with the official sector being a taker rather than a supplier of gold in 2009 and the next few years;

(3) Expanding retail and institutional investor participation in the United States, China, and around the world;

 (4) Declining world gold-mine production. 

We have consistently warned (and continue to do so) that gold's advance would be marked by high volatility and occasional sharp reversals that would lead some to believe the long bull market in gold has ended - and we will continue to hold this view even if the metal falls back yet another $100 an ounce. 

Looking ahead to 2010, don't be surprised to see gold at $1,500 or higher by the end of next year!

Jeffrey Nichols is Senior Economic Advisor to Rosland Capital and Managing Director of American Precious Metals Advisors