I post here a brief note I sent to former colleagues:
As we write about the performance of various assets in 2011, we do find that the US dollar has appreciated the most against Indian rupee and has gone down the most against Gold. The margin is around 15%(this number would be a bit lower now that gold had dropped a lot overnight). In spite of all the angst at the recent inability of gold to rally in the face of mounting risks globally, the fact remains that Gold has ended 2011 a lot higher than it was at the beginning of the year.
Many people think that Gold is a safe-haven against risks and these risks are mounting, the world over. However, as long as faith in paper money remains intact, gold will be one of the safe havens and not the only safe-haven. After all, it is a non-yielding asset. In a year when most fund managers – long, short, long/short – found it very difficult to make any money, it is tempting for them to sell gold where they might have good gains in 2011 and invest the money elsewhere for some quick gains in the last few months or weeks of the year.
Then, there is the forced liquidation of MF Global. We do not know exactly what kind of bets were taken, how much needs to be unwound and within what time-frame, etc. That might be having its own impact on the prices of commodities, incl. Gold.
Third, Indians who are the world’s biggest importers of Gold, have reduced their gold imports in the last two months. Their gold imports in the first nine months of the year were significantly higher than in 2010. But, as the Indian rupee declined rapidly in October and in November, Indian gold imports declined. At the margin, it is a negative but not a very significant factor.
Fourth, many European banks are actively deleveraging and selling off assets. They are not lending. They need to resize their balance-sheets and hence, their clients too. Gains in gold must be handy for many to re-liquefy themselves. In fact, this deleveraging is the most important driving force behind the last two days’ accelerated sell-off in gold.
I could think of the above four explanations as to why the recent performance of Gold has been disappointing.
Nonetheless, I would not despair. I would keep my faith in gold as a potential store of value, as an alternative to fiat money and as an insurance against the ‘end of the world as we knew it in the last thirty years’.
When we look ahead to 2012, we must include two other reasons that not only explain the recent lacklustre (pun intended) performance of Gold but also potentially point to a bright outlook for the metal:
(1) Recent US economic data have been on the stronger side and that has also put a gloss on the US dollar. At one stage, as the US economy appeared to disappoint in the summer months of July/August, the talk of an imminent round of quantitative easing (no. 3) by the Federal Reserve lifted the price of Gold. But, political opposition in the US was fierce and data improved too. Talk of another round of QE in the US has diminished considerably lately. That is another reason for the dollar to do well against Gold.
However, we do not think that the performance of the US economy or that of the US dollar to be sustainable. Indeed, as we approach the second quarter of 2012, the US economy is likely to begin to flounder again. Recent consumer spending strength is bound to be transitory. Both jobs growth and income growth are too anaemic to support US consumer spending on a sustained basis. Talk of a looser US monetary policy would be revived soon. That will cause dollar weakness (esp. vs. Gold) to resume in 2012.
(2) In the Eurozone, the European Central Bank (ECB) has, so far, set its face against unlimited and unrestricted support of the debt markets of Eurozone sovereigns. This is mostly semantics as ECB bond purchases have been helping to keep the bond yields of Italy and Spain from rising alarmingly high. Nonetheless, the market is looking for signs of unqualified ECB support. In the interests of preserving the single currency as it stands today, Eurozone leaders would go through the political process of granting rights (or, responsibilities) to the ECB to be a lender of last resort to Eurozone governments. That would open the doors for money printing by the ECB in 2012.
Thus, once we have economic weakness in the US and unqualified money printing by ECB, the next phase for gold gains would commence.
In the final analysis ,it is important to remember that gold is a portfolio insurance. If Western governments are willing to go through de-leveraging and deflation rather than resort to money printing, gold will lose its appeal because that would signal to the markets that western governments are not prepared to engage in fiat money debasement. If there is no fiat money debasement, then there is no case for gold.
In that environment, de-leveraging and deflation would be negative for all assets including Gold. But, such an attitude on the part of Western governments – if adopted – would preserve the long-term integrity of Western economic systems, capitalist societies and financial markets. If that scenario pans out, investors would have to abandon gold and buy on financial assets.
However, we think that such a scenario has a low probability and that governments would inflate their way out of debt. Neither the public nor governments in the West have the patience for hard work and the mental make-up for bearing pain.