Dollars and Gold
 The new gold rush
“Invest in gold” ads are as ubiquitous today as day- trading ads in the late Nineties and “flip-this-house” type TV shows earlier this decade. The gold push rationale goes like this: deficits caused by big government spending are causing inflation, devaluing the dollar, threatening its reserve currency status, thus making gold the best investment money can buy.
While such argument may seem convincing enough, let us remember that the rationale invoked for the rise of dot.com stocks also sounded compelling at the time. The internet would shift all business paradigms to new levels. Traditional valuation methods would be completely irrelevant in such brave new world.
When dot.com stocks collapsed, it became clear that “real estate” was the place to be, because it was, well…”real”. After all… home prices never go down. Or do they?
Now that the real estate market collapsed as well, paralyzing the world’s financial system in the process, gold seems to be the new answer. Will late comers to the gold party suffer the same fate as those who came late to the dot.com and real estate parties? We believe there is a significant risk of history repeating itself for late comers to any party.
What could slow the march of Gold?
“PIGS” could. The US dollar’s recent rally has been triggered by unexpected relative weakness in certain European countries. After rising to new highs, both the Euro and gold began to retreat.
The culprits are the “PIGS”. “PIGS” is an acronym given to a group of European countries most affected by the financial crisis: Portugal, Ireland, Greece and Spain. The acronym may not only sound unflattering, but also unfair given these countries’ rich cultural heritage and overall contribution in the development of the western world. From a current fiscal discipline perspective however, the acronym is rather clever.
Perhaps because of an abundance of breathtaking ocean views, these countries have experienced massive real estate bubbles back when markets were awash with cash. The boom was followed by a violent contraction and a deep economic recession.
The governments of PIGS are now loaded with debt. Since joining the Euro, they also no longer have a currency of their own that they could devalue when the going gets tough. Today, the governments of PIGS count on a free ride by piggy backing (couldn't’t resist) on the European Central Bank as a lender of last resort, rather than impose unpopular austerity programs at home.
Greece’s sovereign debt was recently downgraded and Spain’s is on the cusp. The downgrades weakened the Euro and strengthen the US dollar - at least temporarily.
The strengthening in the US dollar is a strong reminder that investors should not ignore the significant risks associated with speculating in gold. Investors around the world have become increasingly confident in the dollar’s continuous decline and in gold’s strength. When such confidence turns to overconfidence, the short-term risk for a possibly violent correction goes up. Dubai’s recent debt crisis has sounded the alarm. Greece and Spain downgrades may well be the confirmation.
Recent dollar strength: a hiccup or a trend?
It is both unlikely and undesirable for recent the US dollar strength to become a longer-term trend.
In the years leading to the financial crisis, US economic growth was fueled by strong consumer spending. The spending was turbocharged by borrowed money backed by appreciated property values. The goodies we purchased increasingly seemed to have all been made in China. On the other side of the globe, producing these goodies made the Chinese economy grow by leaps and bounds. It all worked fine for a while.
It only became clear that consumers have overspent when the value of their loan collateral (home values) collapsed. Excessive spending eventually drove US debt to unsustainable levels. On the other side, Chinese over-production drove that country’s savings to unprecedented highs.
The massive global imbalance thus created needs some time to correct. A stronger dollar would hurt the process rather than help. A stronger dollar translates to relatively cheaper imported goods thus an incentive to spend not to save. To close the gap, the US needs to save more and China needs to spend more, not the other way around.
Yearning for a stronger dollar is in essence an attempt to reignite the economic growth model of borrowing and spending, by making imports cheaper. As we are all now painfully aware, such model cannot be sustained forever. Additionally, in a world of 10% unemployment and banks that are stingy with their loans, Americans’ appetite for borrowing and spending is likely to stay low.
To correct the global imbalances in place, US economic growth drivers need to shift from consumption. New growth drivers are likely to be found in reinvigorating innovation, new technologies, domestic production, modernizing an aging infrastructure and exports. To that end a weaker dollar will help, not hurt. Your investment portfolios at Fragasso Financial Advisors will increasingly reflect such trends.
Does a weaker dollar mean a loss of its reserve currency status?
One of the main arguments for gold is the danger that the US dollar would lose its reserve currency status. If the dollar were to lose its reserve currency status it would lose it to another currency, not to gold.
Gold only represents 3 to 4% of world central bank reserves and cannot satisfy the liquidity and depth demanded by today’s financial markets. Additionally, gold is an arbitrary storage of value since it does not represent the economic production power of any nation. Gold is more of a vote of no confidence if you wish. As soon as confidence returns, gold will lose its current luster.
It is possible that over the very long run the US dollar’s dominance as reserve will be challenged by other currencies that will be growing in importance over time. For now any such fears are vastly exaggerated as there is no viable alternative to the US dollar.
The Euro comes closest, but the Eurozone suffers from the similar economic problems as the US. Unlike the US, Europe does not have the benefit of a central fiscal authority; therefore it is exposed to increased political instability. The British pound has lost its currency reserve status to the dollar in the past and has not exactly grown in relevance since. While the Japanese Yen is considered a safe heaven in times of crisis, Japan is still nursing a two decade long hangover after its own real estate bubble party. The emerging nations of China, India, Brazil and Russia do not even have directly convertible currencies at this point.
Is current big government spending and a weak dollar a sure way to hyper-inflation?
Doomsayers pushing gold would have us all believe the US is on its way to its very own version of Germany’s Weimar Republic or Mugabe’s Zimbabwe.
Aside from being a sensationalist story, the hyper inflation theory has no merit. The biggest threat to the US economy is currently deflation not inflation. Asset prices have fallen, wages are stagnant, unemployment is high and retailers are pressuring suppliers to lower prices so they can sell their products to unwilling consumers.
Higher energy and food prices are examples often given as evidence of inflationary pressures caused by a weaker dollar. True, the cost of imported commodities has risen but
in the absence of rising wages to match those higher prices, an inflationary spiral is not possible.
If anything, the higher cost of imported commodities is most likely to result in a slew of desirable outcomes: development of new technologies and domestic alternative sources of energy, as well as local farming and food production. I have personally never been a big fan of container ripened tomatoes that taste like potatoes coming from far away lands.
We look forward to a new year of working diligently on growing and protecting your investment assets.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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