Reflation and Gold Loom on the Horizon

Back to Contents of Issue: March 2003

The equity bears and gold bugs may be moving in to stay in the new fiscal year.

by Darrel Whitten

DURING THE SECULAR BULL market in the US and similar bull markets in other developed nations (the major exception being Japan), bears and gold bugs were an endangered species, as were value investors. Following a monster rally that propelled the price of gold 8.5-fold in a mere four years between 1976 and 1980, gold had been in a major secular bear market, one that took the price of gold down 70 percent over the next 20-plus years from a peak of $850 per ounce to around $256.

As the gold market was crashing, a major secular bull market emerged in US equities from 1982. It was a bull market of historical proportions, lasting for the next 18 years to early 2000 despite a short-lived but nasty correction on "Black Tuesday" in 1987 that many erroneously heralded as the end of the bull market.

It takes decades to work off the excesses of bull markets of such historical proportions. Technically, the price of gold has only recently risen after a massive 22-year falling wedge pattern, the breakout point being somewhere above $330 per ounce. Conversely, the Dow Jones industrial average is showing a massive head-and-shoulders secular bear formation. While the market has declined for three consecutive years, the bear market is far from over.

The US equity market had logged its third straight year of losses at the end of 2002, the first time this has happened since 1941. Yet market pundits, in delving into the equity market's prospects for 2003, are far from sure that this year will be a slam-dunk in terms of market gains. The last time that the Dow Jones and the S&P 500 recorded four-year declines was 1929-1932. Following the peak in the Dow in early 2000, equity investors have waited in vain for stock markets to come back. While more value-oriented investors had been suggesting that the US (particularly Nasdaq and the tech, media and telecom offerings, known as TMT stocks) was way over-priced and due for a tumble long before the major secular peak was confirmed, they were much less willing to suggest that once the US market peaked and a bear market began, it would take all major equity markets down with it. However, that is exactly what happened. Over the past three years, the MSCI World index is down by 36 percent, and the level of decline is essentially unchanged even if we factor out the US.

Nikkei blues
Strategists also suggested that Japan would fare better than the US because the Nikkei 225, which had been in the throes of a bear market since 1990, was supposed to have presented less downside risk than the US market, ostensibly because it had fallen so much already in the prior decade. However, the Nikkei 225 actually has fallen more than the S&P 500 during the last three years, according to data compiled by Trust Net.

For most equity investors, 2002 was a year they could not wait to be done with. According to Lipper, a Reuters company, rallies late in the year did little to ameliorate the damage: Science and technology funds had tanked 42.3 percent, telecommunications funds had fallen 40.2 percent, and health/biotechnology funds had lost 29.7 percent. All were on track to exceed the record losses of 2001. Even the so-called "defensive" utility funds had also been hammered 24.2 percent thanks to Enron and other scandals. The utility-fund losses in 2002 were headed for their second-worst year on record -- only the 29.9 percent fall in 1973 was worse.

Gold rally not a fluke
Meanwhile, gold funds have been recording record gains. The HSBC Global Gold and the FT Gold Mines indexes both rose more than 50 percent during 2002, while three-year gains were well over 40 percent. Moreover, gold's spot price went beyond the "breakout area" of $325 to $340 per ounce at the turn of 2003. This was an important range in 1991-93 and 1985-86. It also marked the peaks of the October 1999 spike. After starting 2002 at $270 an ounce, gold's price was up 27 percent well into December, and was trading between $360 and $370 in early February.

Ostensibly, gold's rally is linked to a host of events: a weak stock market, terrorism fears, a looming supply shortage if central banks and commercial banks try to recover the bullion they have lent to third parties, and gold producer efforts to reduce their hedge books. Since the secular bull market in global equities cracked early in 2000 with the Nasdaq crash, global investors have warily been eyeing the US dollar as an over-priced asset.

With growing signs of deflationary pressures even in China, policy makers around the world are moving to anti-deflation stances, as opposed to their traditional role as inflation fighters. Recent speeches by central bank officials in the US, UK and Japan raise the possibility of global reflation. At the US Federal Reserve, Ben Bernanke was quoted as saying: "The US government has a printing press that allows it to purchase as many dollars as it wishes at essentially no cost." From Alan Greenspan: "There is virtually no meaningful limit to what we could inject were that necessary." Any reflation, ostensibly in the name of global economic revival, strongly implies a structural weakening of the dollar, which also happens to be the world's largest reserve currency.

The prime cause of the increasing unease and debate over the prospect of deflation in the US is the growing worry about the inability to service debt. You can see the worry in the Fed's insistence that a deflationary collapse cannot happen. In other words, it is very concerned about the implications of deflation and rightly so. Greenspan, Bernanke and other policy makers have let it be known that they can and will create all the dollars "necessary" to forestall this development, which means that, right now, the most vulnerable "asset" in the US is the dollar itself. Efforts to reflate will push down the value of the dollar, while at the same time pushing up the value of gold.

The current gold rally is not simply an issue of dollar depreciation, however. From the lows seen in early 2001, gold has had a dramatic rally. In the past year alone, it surged about 34 percent. Given the surging price of gold, the aggregate market capitalization of the word's gold and silver equities at the end of 2002 was worth some $70 billion, up by 75 percent over the previous year's levels. Average market capitalization values in 2002 were worth just less than 6,000 tons, or over two times annual production. But comparatively speaking, market capitalization of the sector is tiny. For example, the market capitalization of Toyota Motors in Japan alone is $92.4 billion.

Gold and the Nikkei 225
The Nikkei 225 has on occasion tracked well with gold prices, but this is merely because both react positively to a weaker dollar. Until 1990, the Nikkei 225 (in dollars and yen) was leaving the price of gold in the dust, but it has since completely erased the gains it made versus the price of gold since 1985, while gold is just recently moving above where it was in January 1985. As Japan is in much more dire need of a major reflation than is the US, the reflation argument for a weaker currency (and therefore better relative performance of gold and gold shares) is arguably stronger for the Japanese yen than for the US dollar.

On the other hand, the yen has so far been supported against the dollar and major trading currencies by:

a) continued growth in net foreign assets that have made Japan the world's largest creditor;

b) the fact that Japan's balance of payments surpluses are now largely driven by income from foreign investments; and

c) a surplus in the social security system that significantly mitigates the much-publicized gross government debt and festering nonperforming loans in the banking sector, helping to create the apparent paradox of a strong currency amidst serious fiscal and financial-sector problems.

For the first half of fiscal 2002, income from overseas investments accounted for 59 percent of the current balance of payments surplus, and the trade/income surplus of JPY 10.1 trillion was largely being recycled into direct and portfolio investments of JPY 8.6 trillion. Japan's international investment position as of the end of 2001 was JPY 179.3 trillion, up 34.7 percent from the previous year and a record high. Some 40.4 percent of the reported increase was attributable to outward investments being funded by the current account surplus, while 60.2 percent was due to the yen's depreciation.

In addition, liabilities decreased JPY 23.1 trillion simply because the value of equities held by foreigners depreciated as a result of falling Japanese stock prices. Moreover, a weaker yen also made the foreign direct investment and portfolio investments in foreign currencies appear larger when quoted in yen.

While Japan's international investment position continues to increase, the country is recycling the bulk of this back overseas, and the weak yen makes the increase in the surplus look much larger than it actually is. Thus, the major factor driving the price of gold -- a secular breakdown in the value of the dollar -- does not necessarily make gold and gold shares less attractive to Japanese investors. Indeed, gold and gold shares are cropping up in the discussions of strategists and economists of major investment banks and asset managers. A veteran fund manager at one of Japan's larger asset management companies says, "The Japanese economy is facing extraordinary circumstances, and it would therefore be prudent to allocate a certain portion of assets to physical assets such as gold."

If it were merely a question of a falling dollar, investing in the euro or the yen would suffice. But the fact that gold is appreciating against all major currencies, including the gold-backed Swiss franc, suggests deteriorating trust in paper assets, ostensibly because of the sustained bear market in equities and the structural debt overhang, and a long-term bottom in general commodity prices.

Under such circumstances, Japanese equities and, indeed, all financial assets are in the same boat as US equities and the dollar. They're all facing a new era where equity bears, gold bugs and commodity players have their day in court, following a 20-year hiatus. @

Darrel Whitten writes MoneyWatch, a free email newsletter, for J@pan Inc.

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