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Gold: Barbarous Relic Or Investment Superstar? Part 2

In part one of a three-part series on gold, I noted that the price of the metal has risen significantly in the past year, despite all the arguments leveled against gold by its detractors. Meanwhile, the metal looks to be headed for its seventh straight annual gain. Gold bulls point to the following as having a significant impact on its price in 2007:

U.S. Dollar Weakness- The U.S. currency is down four out of the last five years, and has dropped almost 11% so far this year based on the Federal Reserve’s U.S. Trade-Weighted Major Currency Index. This autumn it’s been at its weakest against the euro since the European currency started trading in 1999, the lowest against the Canadian dollar since it was floated in 1950, and at a 26-year low versus the British pound. The end of the U.S. housing boom, the subprime mortgage crisis, and a credit crunch, in conjunction with forecasts for a slowing U.S. economy, have weighed down the U.S. currency. The increased threats from dollar diversification by countries holding large numbers of greenbacks in their foreign currency reserves, sovereign wealth funds looking to exchange their dollars for other assets, and more nations looking to decouple their currencies from the U.S. dollar have only made matters worse for the world’s reserve currency. Assuming the existence of a strategic inverse relationship between gold and the greenback, investors have poured money into the precious metal and related investment vehicles. Validating such actions have been forecasts by legendary investors such as Warren Buffett, Jim Rogers, and George Soros, who all predict that the U.S. dollar is going lower. Back on October 25, Buffett was quoted by CNBC as saying, “We are still negative on the dollar. We bought stocks in companies that are earning their money in other currencies.” On November 15, Rogers told Bloomberg that, “If you have dollars, I urge you to get out. That’s not a currency to own.” Finally, on June 2, AME Info reported that Soros said, “A slowdown in the United States will be transmitted to the rest of the world via a weaker dollar.”

Geopolitical Risk- The continuing stalemate between the West and Iran over its nuclear program, political instability in Pakistan, and Turkey’s spat with Iraq are just some of the more recent geopolitical risks that have driven the price of gold higher. The ever-present danger from Al-Qaeda should not be forgotten either. Consider the following warning from Michael Scheuer, a 22-year veteran of the Central Intelligence Agency (CIA), where for 6 years he was in charge of the search for Al-Qaeda leader Osama bin Laden. When asked by Radio Free Europe/Radio Liberty earlier this year if he expected more attacks on the United States or in the West on the scale of September 11, 2001, Scheuer’s response was:

Oh, I think greater than 9/11. I don’t think it will happen in Europe, but I do think it will happen in the United States. Bin Laden has been very clear that each of Al-Qaeda’s attacks on America will be greater than the last, and I think the only reason we haven’t seen an attack so far is that he doesn’t have that attack prepared. But when he does, he will use it. And try to get us out of the way, which of course is his main goal.

Stephen Walker, director of global mining research at RBC Capital Markets, said last week that increasing geopolitical risk, combined with combined with rising economic uncertainty, “should continue to provide incentives for investors to increase their exposure to gold as a safe haven.”

Supply and Demand- Last Friday, the Telegraph (UK) announced:

The era of ‘peak gold’ has arrived. Try as they might, miners cannot find enough ore at viable costs to replace their fast-depleting reserves, even if they dig miles into the centre of the earth.

The global mine supply of gold peaked in 2002, and has fallen every year since. Last year alone, the mine supply of gold fell 15%. Also in 2006, South Africa, the world’s single-largest gold producer, produced its lowest amount of gold since 1922 with overall output down 72% since its 1970 peak. It should be noted that no major new mine production is expected in the near-term either.

On the demand side, RBC Capital Markets noted last Wednesday that demand is rising as consumption increases in China, India, and the Middle East. On Thursday, a study by precious metals consultant GFMS Ltd. showed that global gold demand in the third quarter rose 19% year-on-year on the back of robust inflows into bullion investment funds and improved jewelry consumption. The report revealed that the increase in investment demand replaced jewelry buying as the major source of growth for the third quarter. Demand grew sharply in India, China, Turkey, and the Middle East, while it slowed in the United States.

Outside of U.S. dollar weakness, geopolitical risk, and supply/demand factors, gold bulls say that some of the drawbacks which Bloomberg’s Michael Sesit spelled out in part one are actually advantages to owning the precious metal. Critics of gold like to point out that it “doesn’t earn a return.” Michael J. Kosares, President and Founder of Centennial Precious Metals, Inc., argued in his book The ABCs of Gold Investing, that:

Those who criticize gold because it fails to offer a return do not really understand gold’s position as the fixed North Star of asset value around which all other assets rotate. Gold is a stand-alone asset. It relies on no individual or institution for value. Gold investors prefer it this way. In the ultimate sense, this is what money is and what money should be.

Another criticism directed at gold, said Sesit, is “the world’s biggest holders of gold, major central banks, aren’t overly eager to keep owning it.” If so, gold bulls ask why central banks hesitate to unload the metal. In 2006, net central bank sales amounted to just 319 tons, less than half of the 659 tons recorded in the previous year.

Love it or hate it, bulls and bears, gold is here to stay. In the final part of this series, I will talk about where this precious metal may go from here.

(Part 3 will be posted on Wednesday)