In this article, we explore the gold market, and talk to Michael Pento, Chief Economist at Delta Global Advisors (with over $1.5 billion under management). We talk to Michael about the role of gold as the world’s reserve currency, the factors and economic theories affecting gold pricing, the ‘ financial crisis’, and the future of gold prices.
First, a little history, to set the scene. Gold, since the earliest days of humanity, has been an object of lustre, and a medium of storage and exchange of monetary value. From the advent of the "Shekel" in 1500 BC which gave the middle east a standardised medium of exchange for international trade, gold gained value, as Caesar used it to repay Rome's debts (58 BC) and eventually the Venetian Ducat and the British Florin, Crown and Guinea set the trend for the efficient monetisation of the "yellow metal". In c.18th, following Isaac Newton's setting of "the gold price" (which lasted 200 years) Gold's progress accelerated, with the USA Coinage act setting a currency equivalent for gold and silver, and the eventual adoption of the Gold standard for currencies in 1900 and Bretton Woods taking this concept global in 1944 as international gold exchange standards were set (and the IMF created). During this period, the world was changing rapidly, and as financial markets evolved and grew, with increasingly complex products emerging, gold lost its position as a leading asset class, becoming a mechanism of reserve, and with its lack of volatility, and function as a commodity and monetary unit, gold provided an excellent hedge against inflation and store of economic value.
According to the world gold council, annual demand for gold falls into three main categories, jewellery, industrial (mainly electronics), and investment. These sectors, across 5 years to 2006, averaged 69%, 12% and 19% of demand flows for gold. In recent years, as the world’s financial markets and economies have come under pressure, “retail” and industrial uses of gold have certainly reduced, but gold’s inherent quality of not being a liability of any government or corporation with, therefore, no default risk, has brought it back to the forefront of portfolio managers and investors screens to not only diversify their funds, but to provide a hedge against currency and inflation, and provide a stable ‘haven’ for money in uncertain times.
To learn more about gold’s resurgence and economic role, where gold prices will go in 2009-2010, and the realities of the recession, we spoke to Michael Pento, Chief Economist at Delta Global Advisors, with over 17years of experience in the market, and responsibility for overseeing over $1.5billion of investments.
Q: Why Invest in Gold?
[Michael Pento] “Gold is “real and genuine money” and is the best place holder for wealth and is a store of value for investors. The Gold supply cannot be increased in the same way that currencies can (by decree), it is the least economically cyclical of all metals, and is a hedge for investors when they see the supply of their currency superfluously increased which causes the purchasing power of their currency to diminish.
Gold demand is strictly monetary so even if economies collapse and provide severely negative GDP prints, gold would increase in demand as a currency as investors begin to take more physical delivery (whether in jewellery, bullion, or coins) this services the need for an alternate currency whose purchasing power cannot be attenuated by the decree of a secondary body (e.g. Bank of England, European Central Bank, etc)”
Q: What are the factors leading to a depreciating currency?
[Michael Pento] “Negative real interest rates! In a guaranteed investment such as a short term treasury bill, if that yield falls below inflation, then investors should buy gold which will always maintain its value against depreciating currencies and inflation. When analysing this phenomenon, the crux is to assess “the inflation rate of the US Dollar versus Gold supply” as the relative weakness in the dollar may not be as apparent when comparing currency to currency (it is more apparent when comparing to hard assets).”
Q: How is Gold Priced? And what is the role of Central Banks in the gold market?
[Michael Pento] “The gold fixing price is set twice daily by the five members of the London gold pool by their interpretation of the market, and used as a benchmark for the London Bullion market(s) and hence sets the pricing of all gold derivatives and pricing of gold on global exchanges. London has become the global hub of gold trading by volume and seniority relative to other exchanges. It is, though, free market determination which sets the spot price, which is influenced by investors.
Most central banks (with the exception of a few like China) have traditionally been sellers of Gold. When you sell gold, you temporarily depress the bullion price, and increase the value of the currency, which is a countervailing force. This is a short term negative with a long term positive as gold moves from one hand to many hands, from weak hands to strong hands, and ownership of gold becomes diffused across many investors rather than being controlled by a few central authorities.
The Federal Reserve banks role, much like others around the world, is ostensibly to maintain maximum employment and price stability. It’s interesting to note that we already had something which maintained price stability, the gold standard. The central bank(s) were created to increase bankers profits, they are the “bankers banks”, and are entities where banks go to increase the money by decree which should be derived from savings (deferred consumption, which is then loaned out). In 1913, U.S. bankers got together (partly as a result of the 1907 crisis) stating that they needed more funds, to loan out more money. This was an effort to usurp power over the money supply from free market forces, it then freed them from the strictures of a gold standard.”
Q: What is the impact of the current economic crisis and inflation on gold?
[Michael Pento] “Economic growth or the lack thereof, has NOTHING to do with inflation. Take the example of Zimbabwe, with negative GDP growth, 85% unemployment, but inflation in the millions of percent per annum. Also take the example of Weimar in Germany where they also saw collapsing growth and huge inflation.
Higher prices occur when the supply of money is greater than the amount of goods and services available for purchase in the economy, thus causing prices to rise. It’s the relative amount of money in circulation, not goods and services, which cause recessions. Central banks raise and decrease the supply of money, in the latter case, causing supply to contract and causing a reduction in goods and services.
I believe inflation will be an insidious problem.
MZM (money of Zero Maturity) is up 14% YoY and is growing 32% annually. M2 (money & close substitutes) has grown 10% YoY and 24% annually with M3 (M2+Large Time Deposits) growing 11% YoY. The Monetary base (a measure of the most liquid forms of money) is up 105% YoY and is growing 183% annually, it is now close to $2trn, which can be loaned into existence more than ten times its nominal level, potentially doubling the entire M2 money stock. US national debt is over $10.6 trillion, with a $2.0 + projected 2009 trillion deficit, and a fed funds target rate of 0-0.25bps. Add that to an attack on free market capitalism and you get a perfect formula for intractable inflation!
What we have seen in recent years is a “credit crisis” as the private sector choked on onerous debt levels, and impaired bank balance sheets caused the economy to slow. Can the fed take back their rate cuts? Of course they can, but they will not be able to take it back with impunity, as they will take the entire economy down with them as debt levels have reached the point where without artificially low interest rates, the economy will implode. So can you have slow growth and massive inflation? Absolutely! History says yes. They can both exist together, and this is my prediction for what will happen in the US.
Artificially low interest rates (that must exist in perpetuity to service the unreal debt levels) will create a downward spiral of stagflation. There is no way I can see to exit this spiral without extreme levels of economic duress, i.e.: a depression.”
Q: What are your views on the gold price through 09/10?
[Michael Pento] “I have been on record for the past month or so on Bloomberg and CNBC as saying gold will get to USD1250-1500 per ounce over the period. We have seen that gold has risen remarkably, and recently has again got over USD 900/oz, a very positive move. Gold is rising in all currencies, just slower currently against the USD.”
Gold is the most liquid commodity market other than crude oil and is as sophisticated as any other financial instrument, with Over the Counter (OTC) transactions in spot, forwards, options, exotic derivatives, futures and options providing investors with a range of methods of trading and investing, and giving industrial and retail customers the ability to not only satisfy their core demands, but to efficiently hedge against the volatility of gold as a proxy for currencies and economic climate.
As economies recover, and the world moves into its next phase of financial evolution, these investment roles will not diminish and as technology advances rapidly (requiring gold for its components) and emerging markets grow, the demand on physical gold will grow too, bolstered by a more risk averse world, requiring ever larger physical reserves. All these factors combine with the relatively static supply of gold to the market (which is unlikely to keep pace with growth); further bolstering sentiment that underlying prices will rise.
Many analysts and economists argue and debate the true value of gold, but the facts remain, as summed up by Gerald Loeb that, “The desire for gold is the most universal and deeply rooted commercial instinct of the human race.”
For more information: Delta Global Advisors - World Gold Council - Gold News (Bloomberg)