Capital Growth to Capital Preservation: Gold Hoarding Is a Real Possiblity

February 23, 2009 | By: AtonRa Partners

Credit quality deterioration and a shift to capital preservation are hallmarks of deflationary periods. At such times, individuals tend to hoard cash. They usually have a choice between paper currency and gold. As Sovereign States' credit quality is affected, hoarders move toward gold.

History proves that the loss of confidence in the issuer of paper currency is one of the main reasons for individuals to prefer Gold: unlike currency paper, Gold has no liabilities attached to it.

One good indicator of oversold to overbought conditions could be the S&P to Gold ratio which stands today at 0.7 and was as high as 7 in the early '80s and as low as 0.2 in the year 2000.

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We maintain our view that is necessary to have at least some exposure into physical Gold or Gold Equities.

Looking at fund managers' portfolio models we see that Gold exposure is dangerously low or non-existent.

Regarding the Gold miners we would favour exposure to companies that have the following characteristics:

• Mostly exposed to Gold and Silver mining and not to other "industrial" metals such as Copper, Platinum and Zinc whose demand is plummeting.
• Companies that are least hedged to rising metal prices.
• Companies that face the least operational risks in term of mining operations such as power constraints and country-specific risk.
• Companies with growing production.

Investment case

Deteriorating Sovereign credit quality is the key to Gold in deflationary times

The contraction in economic activity is still ongoing on a worldwide basis as the housing and credit bubble that preceded it were of rare dimensions. Confidence deteriorated even further than previously estimated and credit quality not only worsened for households and corporations but also for Sovereign States now (e.g. the latest downgrades on Greece, Portugal, Spain, Ireland and this list is likely to get longer by the day).

Credit quality deterioration and a shift to capital preservation and hoarding are all hallmarks of deflationary periods.

Individuals have a choice between paper currency and/or gold as a hoarding vehicle.

Even if almost all countries now guarantee deposits to a certain amount, we are not sure that individuals can keep faith in the perspectives of paper currency issuers as they see confidence plummeting every day a bit more.

History proves that the loss of confidence in the issuer of paper currency is one of the main reasons for individuals to choose Gold over paper currency. Unlike currency paper, Gold has no liabilities attached to it.

Gold, as a hoarding vehicle directly competing with paper currencies and other cash-substitutes, ultimately owes its attractiveness to relative credit quality.

It is the deteriorating credit quality of the currency issuers (the Sovereign States) that is key in understanding gold's behaviour under deflation.

The more countries descend into dire financial conditions, the more Gold will be hoarded compared to currency paper.

In the US, Gold hoarding will only start when Main Street perceptions about fiscal and economic stimulus policies and budget deficits undermine the credit quality of the US government (which happened in 1932, following Roosevelt's election, when rumours of dollar devaluation were inadvertently leaked to the public).

Deflation is currently a global problem, therefore foreign currencies as well as the US dollar are impacted by deteriorating credit quality, making the case for hoarding Gold a compelling one (had it been only a one-country problem, we would have actually shorted gold in dollar-terms). Asians and Europeans tend to hoard gold much earlier in a deflationary spiral, leaving American investors behind (as we started to see last week with EUR/USD down, USD/CHF up and Gold/USD up at the same time).

Gold is usually seen as the "inflation hedge" as investors still recall the spectacular gold rise of the '70s with inflation rates skyrocketing at the time and the subsequent fall during the '80s together with falling inflation rates (at the time Paul Volcker was instrumental in the collapse of Bretton Woods, the gold convertibility and the subsequent rise in the Fed Funds rate to 21.5% in 1981 in order to combat inflation).

The return of Paul Volcker

Mr. Volcker is well-known for proactively searching for solutions and not waiting until it's too late. Could it be that he will reverse what he was doing during the '70s? We have absolutely no doubts that this would indeed be the case should the crisis and deflation deepen.

The decisions he took during his tenure in the '70s had the desired effect of lowering inflation but the consequences were one of the biggest recession (in the early '80s) and unemployment levels not seen since the "Great Depression" in the US.

This was one of the main reasons he was not nominated for a 3rd term as Chairman of the Fed (in June 1987, under Ronald Reagan) in favour of Mr. Alan Greenspan.

Mr. Greenspan was instrumental in the current crises as he "deregulated" the financial system starting with the banking industry and enacting "easy money" policies resulting in the credit bubble. Mr. Volcker had always resisted calls for a full banking and financial deregulation.

In this scenario, Mr. Volcker could be elevated (again) to national hero if he proves able to "reflate" the economy.

To prevent a Japanese scenario in the US, Mr. Volcker is likely to take unconventional and unpopular decisions (as in the '70s) that would be followed by Barack Obama and his economic team such as a possible dollar devaluation and maybe the birth of a new "world currency".

The longer-term advantages of such a choice are likely to outweigh the short-term pain incurred by a possible financial loss incurred by countries that held US dollar-denominated debt-instruments and a loss of purchasing power by individuals. Debt structures would be lowered to a point where debt creation would once again be needed. In a sense it's the same as writing-off a big chunk of debt in order to make the lending machine work again.

While today's real interest rates are still negative in many countries (see our November 19th Weekly Barometer report) policymakers understand that the deflationary spiral needs to be stopped quickly before it can threaten International Trade. In Japan during the '90s, an increasing demand for cash, weak domestic demand, and high real interest rates created a surge in the Japanese yen as a hoarding vehicle in the early stages of deflation, which further compounded the deflationary loop as a decline in competitiveness inflicted damages on Japan's internal export-producing sector.

As Japanese policymakers capitulated to inflationary policies in early 1995 (at the height of the yen bubble) in order to stimulate domestic demand and to devalue the yen, domestic hoarding stopped.

When is massive gold hoarding likely to take place?

If we consider that since the '80s, wealth creation in financial assets was among the greatest ever in history and that we have come back to 1997 levels in only one year in many financial assets, we think that massive gold hoarding could take place if the public feels that the current levels could not hold on the main Indexes and that the credit crunch could go on for some more time and further impact the credit ratings of sovereign states (including the US).

There are many instruments that compete with cash for hoarding purposes such as Treasury Bills, Municipal Bonds, Commercial Paper, Money-Market mutual funds but we would put land, real estate and any real tangible asset (such as food) as primary hoarding vehicles.

Many investors already lost faith in Mutual Funds as two of them last year "broke the buck" or simply were trading at below their "guaranteed" $1 net asset value and despite the US Treasury Department announcement on September 19th 2008 insuring the holdings of any money market fund, this covers only funds invested before that date.

If we were to experience another wave of panic like September-October 2008, people would suddenly realize that there are not many safe-havens around.

The time has come already for gold hoarding in many countries and the US are likely to be the last one to jump on the gold wagon. This development would likely push gold prices to levels that we can't imagine today.

What could make the upward move in gold even more powerful is on one side the plummeting demand for jewellery across the world (India, which is the biggest importer of gold, saw imports for January 2009 down 90% Y/Y and many people are reported net sellers of jewellery items in order to face a lack of liquidity), and on the other side many short-sellers and sceptics that are keeping their short positions as they see gold as another asset to sell in this deflationary spiral.

We think those are the main two reasons why gold was not trading higher in 2008. But one should ask what will happen should those two selling forces suddenly disappear from the scene: on one side we have individuals that need money and are forced to sell any asset in order to meet debt service requirements, while on the other side we have individuals that have money but are losing trust in their respective currencies.

Stock position: None.

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