Monday, July 6, 2009

Gold: still more downside ahead

Gold is frequently being sold as outperforming during both, inflationary as well as deflationary periods. So irrespective of where we are headed, gold will be doing well. Additionally, it is being stated that while gold has maintained its purchasing power in real terms over long periods of time, paper money has not. The USD for example has lost approx. 95% of its purchasing power over the last 100years. I am not denying any of these statements. However, I think that this is not all there is and I remain unconvinced in the gold story.
1) Inflation targetting central banks nowadays have an explicit or implicit inflation target which is usually close to 2%. At 2%, money loses 50% of its purchasing power every 35 years. This is planned and generally accepted (furthermore, it is also known). More importantly, it is also incorporated into prices (most notably inflation expectations and therefore yields).
2) Additionally, I am not forced to hold my money in cash, in fact, most people hold only a very small part of their wealth in cash and invest most of their wealth in one form or another. On these investments you earn a yield. Even with short-dated US government bonds you have earned a substantial positive return over the past 100 years. On the other side, gold as an investment does not pay any coupon or dividends, the change in the price of gold is already your total return. Therefore, if people compare the change in the price of gold (a total return) with the change in the purchasing power of cash (without compounding via the help of a short-term interest rate), then the comparison is not done on equal grounds. This is especially relevant if done for longer horizons.
3) The volatility in the price of gold is very substantial: Gold reached a high in the early 1980s and it took approx. 25 years before this price was reached again in nominal terms. However, in real terms, the current price is still far off the levels reached almost 30 years ago.
4) End demand for gold is falling. Gold is also used as a durable consumer good (in the form of jewelry) and is used in medicine/electronics. However, amid the drop in GDP growth across the globe, demand for such usages are falling.

I personally think that across the large majority of countries in the so-called 'developed' economies, a scenario of currency crisis/sovereign default can be averted. Furthermore, as stated frequently, I am not a believer that high inflation rates are around the corner. Rather nominal GDP growth will be low for a multi-year period. Low nominal growth without wars/currency debasements is exactly NOT the environment where gold is likely to do well. Having a small share of ones wealth invested in Gold as an insurance makes sense from an asset allocation perspective, however, I continue to see more performance potential for government and high grade corporate bonds in the major currencies than for gold (be it in USD or EUR). As inflation fears are currently easing, I expect gold to fall further over the summer.

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