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Gold: Falling off the cliff... again? - Outside View

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Gold: Falling off the cliff... again?
Jul 1, 2010

Lately, there has been increased volatility across all asset markets and traditional correlations aren't working the way they used to earlier. The global economies barely managed to keep their heads up, the debt crisis emanating from Europe blew things apart. Stocks were pricing a full blown recovery whereas the recent correction led to questioning of the underlying reality. Unfolding of all these have added to investor's confusion, with talks of a double dip (a double-dip recession refers to a recession followed by a short-lived recovery, followed by another recession - pictorially it would look like a "W") echoing across the globe. However, such opinions are now gathering credibility. Prominent experts provide different reasons for a dreadful slowdown. Austerity measures, fading of stimulus impact, unsustainable debt and large unfunded liabilities, high unemployment, falling money supply are amongst the prominent reasons cited to slide the economy towards a recession.

Here's what the experts have to say:

George Soros

"We have just entered Act II . . . . The collapse of the financial system as we know it is real and the crisis is far from over . . . 1930's style budget deficits are essential as counter-cyclical policies [to pull economies out of recession], yet many governments are now moving to reduce their budget deficits under pressure from financial markets. This is liable to push the global economy into a double-dip."

Paul Krugman

"Suddenly creating jobs is out, condemning deficits is in. Many economists, myself included, regard this turn to austerity as a huge mistake. It raises memories of 1937, when FDR's premature attempt to balance the budget plunged the recovering economy back into severe recession. . . . . Economic policy around the world has taken a major wrong turn and the odds of a prolonged economic slump are rising by the day."

Christopher Wood

A double dip recession is a real possibility. He cited the weakening outlook in Europe, the threat that outlook poses to financial markets, a cycle of tightening policy in China, along with the growing deflationary threat and the possibility of a wave of protectionist activity.

That's just a sampling of astute folks who are now calling Double dip a given possibility. Unfortunately, recent economic reports seem to justify their worries.

There was the very disappointing employment report for May for the US, and another report that highlighted the fact that retail sales unexpectedly fell 1.2% in May. Those are two critical areas for any economic recovery, jobs and consumer spending.

Sales at U.S. retailers unexpectedly dropped in May, signaling consumers boosted savings as employment slowed and stocks fell. Purchases decreased 1.2 percent, the biggest drop since September 2009, Demand plunged at building-material stores, reflecting the end of a government appliance rebate, and sales fell at auto dealers, in contrast to industry figures which showed a gain.

Mortgage applications are down a huge 40% since the home-buyer rebate plan expired in April. It was reported this week that new housing starts plunged 10% in May, with single family home starts plummeting 17%. And permits for future single family home starts fell 10%.

If you look around the globe, recessionary prospects are evident. Europe is in a really dire state. Increasing incidence of taxes accompanied by other austerity measures, high unemployment, will all ensure lower growth. In the U.S, upticks in different sectors were enforced by stimulus measures. We have seen increased car sales with cash for clunkers, improved housing activity with tax credits - impacts faded as stimulus was withdrawn. The other major economy, China is also consciously trying to slow things down.

Even, some of the leading indicators are pointing towards probability of slowdown.

ECRI weekly leading index Baltic dray index

Talk of the dreaded double dip recession is gaining credence.

Is all this pointing to the fact that the economy was on life support and now as the stimulus impact fades, the economy is sliding its way down?

On the Other Side
While confidence in the markets is everything, a realisation amongst the investment fraternity that all, in reality, is not set for burgeoning growth after all, will fuel a further dip in markets and the double dip scenario will be well and truly in place.

This could be a reason why many policy makers shrug off the idea of a double dip.

Many point to the below given study by the Newyork Fed which states a near zero probability of a recession as predicted by Treasury spread.

Note: The shading on these charts does not reflect the 12/1/2008 announcement by
the NBER that the last period of expanison ended in December 2007.(Updated June 7, 2010)
Source: New York Fed

Reaching Conclusion
There is clear evidence that the recovery was stimulus driven as the momentum failed to continue once the stimulus ended.

Also, it is likely that policymakers will be in action once the economy starts faltering again. Exit strategies are not talked about anymore. The Fed still maintains its tone of keeping rates near zero levels for an extended period of time. In case of a double dip, more money printing will be undertaken as has been the case to solve all economic problems ranging from economic stability to defaults. Currencies will be continued to be debased and purchasing power will continuously be eroded. Gold is the only real form of money that can't be debased and will likely continue to move higher as faith dwindles in paper currencies.

In all likelihood, there is high uncertainty on the future plight of the global economy. Whether there will be a double dip or will the central bankers act to flood systems with money be able to kick the can forward and postpone the eventuality? In such an environment of uncertainty, gold will be the much needed "Insurance" for your portfolio.

Assuming that policymakers succeed in pulling the world out of its current mess and there's no recession, then there is a high probability of inflationary prospects gathering steam. It is the direct result of all the monetary excesses that have entered the economic system. Gold has historically been an excellent inflation hedge and will likely do well to protect your purchasing power in event of an inflationary threat.

All in all, it sums up the necessity of having an allocation to gold and as events unfold, there might be more clarity on where the global economy is headed.

Disclaimer:
The Golden Truth is authored by Chirag Mehta. Chirag is Fund Manager - Commodities at Quantum Mutual Fund. Views expressed in this article are entirely those of the author and should not be regarded as views of Quantum Mutual Fund, Quantum Asset Management Company Private Limited and Equitymaster. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Equitymaster has not verified the facts contained in this column and it does not accept any responsibility for the same. Please read the detailed Terms of Use of the web site

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