Saturday, May 26, 2012

Could a China hard landing end gold's bull run?

Gold has been one of the best performing asset classes for a decade now but recent price declines (it's about 15% down from last year's high) have led some to call the top of the market.

Are they right?  Is there any value left in buying into gold at this stage?  Are the many owners of gold and gold investments like ETFs headed for a fall?

Almost certainly not is the answer but there is a very apparent danger in the short term from a hard landing in China.

To understand why gold will remain in a bull market, consider what has driven gold this far.  Some people crudely characterise gold as an inflation hedge but it's more a form of insurance against monetary collapse and chaos which often leads to inflation.

When governments abuse their currencies and lose fiscal discipline like they did in the 70s it is very difficult to find safe places to put your money. With falling bond and share prices and negative real interest rates at the bank, gold offers a last chance at preserving wealth.

Before the 2008 crash investors bought gold because they saw Central Banks stoking a monetary  bubble which portended some 70s style chaos.  Since the crash worsening government finances and extreme monetary policy have exacerbated these fears and so we have had 10 years of gold price rises without much of the inflation that it is supposed to protect against.

Crucially, on top of gold's appeal to investors as insurance, we have had very low interest rates, often negative in real terms. This negates one of the drawbacks of owning gold - it doesn't earn anything.

Indeed if you want to know when gold is going to peak then the measure to watch is real, inflation-adjusted interest rates particularly dollar interest rates.  If there were any hint that the Fed were going to normalise interest rates at a level a percent or so above CPI then gold would fall a long way in a short time.

But this is not going to happen for a while and the Fed have publicly stated that rates will stay low until 2014.  That will put a floor under the gold price, probably not much lower than where it is now.

The Eurozone crisis makes more money printing likely and is just the sort of thing that gold as an insurance policy is made for, even if in the short term the Euro's weakness is a negative for the US$ gold price (the dollar has been at its highest level for years versus the sickly Euro).

The one cuckoo in the nest could be China. Private sector Chinese demand for gold, like its demand for just about everything else in the last decade, has been relentless and is still growing rapidly.  But a lot of the Chinese economic growth since 2008 has been artificially stimulated by its government, is ill-balanced and unsustainable.

The slowdown this year has been marked and I am sceptical of the soft landing claims.  The papers have been carrying stories like this one about Chinese buyers refusing to take delivery of iron ore and honour commodities contracts - Chinese steel mills defer iron ore shipments.

It is easy to see Chinese demand turning from a positive to a negative for the gold price.  Indian demand, usually a mainstay, has already fallen sharply this year as the economy slows.  But with the financial crisis dragging on with no (happy) ending in sight the overall case for gold is as good as ever.

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