Investec Precious Metals Insight
Commentary by Daniel Sacks, Co-Portfolio Manager, Global Gold and Precious Metals, Investec Asset Management
Inflation or Deflation in 2009: which will be positive for gold?
We believe that quantitative easing will result in one of two probable scenarios, both of which should be positive for gold.
Scenario 1: Quantitative easing works, the world stabilises, and inflation returns: This scenario should be positive for gold.
• Gold has historically done well during periods of rising inflation and negative real interest rates. Traditionally thought of as a hedge against inflation, the spectacular rise in gold prices during the inflationary 1970s cemented conventional
wisdom about the strong positive link between rising inflation and gold prices.
• Can this relationship explain the substantial rise in gold prices over the past four months? Expected inflation (as measured by the spread between the yield on US 10 year Treasuries and 10-year TIPS) has risen by over 2% since late November last year and over 1% since late October. Recent record inflows into gold ETFs could support this view.
Scenario 2: Quantitative easing does not work, and we enter a deep recession/depression accompanied by a period of falling prices. This scenario should also be positive for gold.
• Contrary to the consensus view, we believe that the opposite of inflation is in fact positive for the gold price.
• Past periods of rising deflationary risk have been associated with households hoarding cash and cash-equivalents such as short-term US Treasury debt, bank deposits, and money-market instruments. Gold and other precious metals are also seen as cash equivalents, yet also as a diversifier - a form of borderless non politicised currency - and perhaps as better stores of value, particularly when policy measures and the validity of the cash issuer are called into question. (The most significant period of falling prices took place from 1929 to 1932, at the start of the Great Depression, during which gold retained its value as the prices of many other commodities fell sharply.)
• Gold could also be seen as preferable to currencies as concerns mount surrounding the credit quality of the issuer of paper currency. The recent breakdown in the strong historical relationship between gold prices and the euro/US dollar exchange rate - over the past few months we have seen both a stronger dollar and a rise in gold prices - could be explained by the global nature of financial distress and the large-scale transfer of financial risk to governments. The increasing correlation between gold prices and measures of sovereign and financial risk default suggests that gold could be considered the currency of last resort.
• Finally, the opportunity cost of holding gold is low in times of deflation as central banks are likely to maintain very low interest rates. In other words, an investor in gold is unlikely to lose out significantly by holding non-interest-bearing gold during low rate environments.
Gold appears to be benefiting both from being the traditional hedge for inflation hawks (some of whom are now beginning to worry about the risk of hyperinflation) and from the mistrust of some investors towards cash assets and government obligations during the current financial crisis. It would probably only require a minority of investors to believe that they need to continue to allocate more towards gold to have a significant price impact. Even though inflation risks remain low in our view, we believe that these forces are likely to continue to support gold prices.
