Reasons Why Gold Will Rise In 2009

ECONOMY

How bad can things get? Former Secretary of the Treasury Paulson talks of the current crisis being potentially worse than the Great Depression. Alan Greenspan told Congress that the financial meltdown had left him in a “state of shocked disbelief.” Reputable economists are saying “this looks an awful lot like the beginning of the second Great Depression.” U.S. consumer confidence has fallen more sharply than in any period since records began in 1978. Since September 9, we have seen the nationalization of Fannie Mae, Freddie Mac and AIG; the socialization of the auto industry; the disappearance of the investment banking industry; a $700 billion Bailout with more to come; the bankruptcy of Lehman Brothers; the “breaking-of-the-buck” of the supposedly rock-solid money market funds; the largest bank failure in history; the implosion of global stock markets; the collapse of home values, retail sales and consumer sentiment; the biggest fall in industrial production in 34 years; and an unprecedented shattering of confidence in both commodities and financial assets.

FEAR

As the market does its daily job of balancing fear and greed, it becomes increasingly apparent that fear predominates. Individual investors are abandoning anything with the slightest hint of risk. Last year was the worst year for global equity markets since the Great Depression, with the Dow suffering its worst annual decline since 1931. Anything remotely risky or linked to the performance of the global economy was shunned. U.S. financial institutions are toppling like tenpins and confidence in those institutions has never been lower. Investors are pulling huge amounts of money from hedge funds, stock mutual funds and bond mutual funds in one of the biggest flights to safety the financial industry has ever seen.

DEMAND

The U.S. rate cut to virtually zero lowers the opportunity cost of buying gold and gold ETF holdings have exploded from 7 million ounces to over 30 million ounces in less than four years. Gold is different from other precious metals such as platinum, palladium and silver because the demand for these precious metals arises principally from their industrial applications. Gold’s value does not arise from its usefulness in industrial or consumable applications. It arises from its use and worldwide acceptance as a store of value and a safe haven. Other precious metals have also been classified as Defensive Assets, but have not performed as well as gold during this crisis. For example, investment accounts for about 90% of the demand for gold, while investment makes up only one-third of the total demand for platinum. Therefore, although gold has done well, platinum’s demand from industrial uses has fallen rapidly, particularly because of the high concentration of uses of platinum in new automobiles – an endangered species in an economy in which automakers are begging for funds from Washington just to keep them afloat.

REFLATION

Gold benefits from the cure for deflation, rather than from deflation itself. At some point, the market is going to get over its concerns about deflation and become concerned about inflation – that will be the real inflection point for gold. In the past twelve months, the Federal Reserve’s balance sheet grew by 146%, the European central banks’ by 58%, the Swiss national bank’s by 74%, and the Bank of England’s by 158%. Huge amounts of money supply growth are on the way. The Fed and central banks throughout the world are sending so much money sloshing through the system that they will eventually generate a bad case of inflation. While inflation isn’t apparent today, stimulus packages and bailouts mean much more money in the system, which is classically inflationary. Historically low U.S. interest rates, U.S. dollar weakness, and the longer term inflationary pressures of the Federal Reserve throwing trillions of dollars at the U.S. economy make the environment favorable for gold and other tangible assets. Of the major assets, only Treasuries and gold have escaped the selling panic that has gripped the markets. Gold rose 5.4% over 2008, ending the year above $850 a troy ounce. Gold bullion reached $1,030.80 in mid-March and Mints around the world ran out of popular gold coins and small gold bars after the collapse of Lehman Bros. in September. Because of the inflationary impact of the Bailouts, Merrill Lynch predicts that gold will hit $1500. Other analysts believe that $1500 is the floor, not the ceiling.

THE DOLLAR

The dollar has benefited from the global flight from risky assets, as well as the unwinding of bets made with borrowed dollars. That has come as a surprise to many who expected that increased government spending and a collapsing U.S economy would cripple the dollar. In the longer term, the dollar’s health remains dependent upon foreigners’ appetite for U.S. assets, which will decline as the economy falters and the government continues to inject additional liquidity. Dollar weakness, plentiful liquidity and policy reflation will be persistent themes over the next year or so. Massive fiscal and monetary stimulus have combined to weaken the dollar, but are expected to do so in an orderly fashion since no country wants a strong currency in a deflationary world.

GOLD PRICES

We expect to see an eventual breakout in gold prices once the dollar softens more decisively and once reflationary policies gain economic traction. We see a breakout above $1,000.00 per ounce as a sign that U.S. monetary and fiscal policy is finally getting ahead of the deflation curve. Liquidity conditions will be easier and easier as the year progresses as part of the fight to support the economy and reduce deflationary pressures. Such conditions are consistent with higher gold prices and we expect to see gold prices exceed their prior peak by summer and exceed $1,500 by year-end.