Overnight Report 25 May, 2005
Goldfinger
Tim Drayson
ABN AMRO Equities UK Limited
27 May, 2005
Last week I suggested an overweight
cash position. Both bonds and equities have since rallied. Rule
one: do not listen to economists for short-term trading tips.
With this risk warning, I am now going to discuss gold and particularly
gold mining equities leveraged to the gold price.
Gold is a lousy investment,
but a good insurance policy which you hope you don't need. It
pays no income or dividends and over the last 25 years it has
failed to keep pace with inflation. (Though it has over a longer
time period). Under normal circumstances I would stay well clear.
But as we set out in 'warning flares' on 2 May, today's environment
is more like the 1970s. Once freed from the shackles of a fixed
price, gold rose from $35 in 1970 to over $800 in early 1980,
as investors shunned equities and paper assets in favour of a
store of value.
Currently, gold has lost its
investment status. It behaves like a commodity. But unlike other
metals, mine supply is contracting and demand is fairly non-cyclical.
Its price is set globally, but quoted in dollars. So movements
in the trade-weighted dollar index tend to be reflected in the
gold price (R2 = 0.93 since 1 Jan 2002). Gold is a hedge against
inflation, as a weaker dollar tends to signal higher global inflation
as the rest of the world is forced to reflate. Conversely, the
recent flattening of the US yield curve is a deflationary signal
and negative for gold. In dollar terms the gold price has risen
50% since 1 Jan 2002, but for European investors the return has
been a mere 6%. So buying physical gold has been fairly pointless
unless you are a US citizen or your currency is linked to the
dollar. But if you bought gold mining equities leveraged to the
gold price, then it has been possible to make a good return.
The types of companies one could look for are those with unhedged
future gold sales and with their cost base in US dollars or similarly
weak currencies.
The case for medium term dollar
weakness is overwhelming. A benign rebalancing of the US current
account deficit will require a further substantial fall in the
dollar. This should be supportive for the gold price and gold
equities. But I think we are heading for a disruptive adjustment
and serious dollar weakness with the Fed printing money to prevent
an asset price collapse. In this environment gold could perform
spectacularly. Since my job is closely linked with the stock
market performance, I have already taken out my insurance against
armageddon!
Going for gold
click on images to see the charts - - - >
The 1970s are best forgotten,
but the bull market in gold was memorable. It culminated with
the spectacular quadrupling of gold prices in the year to January
1980. Since then it has been downhill most of the way. The bear
market ended during 2001 and gold prices have recovered to over
$400 an ounce today. Yet this is still only around half the record
high. In real terms (deflating using US CPI) the performance
has been dismal. Gold has failed to be a good store of value.
Though over longer time periods it has kept pace with inflation.
But 25 years of macroeconomic
stability are now under threat and gold could benefit. The weakness
of the dollar has driven the rally in gold prices since the start
of 2002. The gold bugs hope that gold will eventually decouple
from the dollar. This would make holding physical gold rewarding.
But for this to happen I think it would require a financial crisis.
Something I certainly don't rule out. But the investment case
for gold stocks does not require a financial meltdown. The dollar
is likely to decline over the medium term as this is a vital
part of the adjustment of the US currentaccount deficit. Without
a change in exchange rates and in the absence of a serious US
slowdown, the currentaccount deficit and external debt are both
on an unsustainable path.
But in the
short term, our equity strategists warn of potential dollar strength
if the carry trade continues to unwind and short dollar positions
are covered. So further turbulence for leveraged funds could
put more downward pressure on gold stocks. The XAU index (a market
cap weighted index of nine gold and silver mining companies)
has under performed the gold price in the last few weeks. Previously,
the XAU index has always reverted to the gold price. But the
general commodity price boom has pushed up wages in the mining
sector and the rising cost of oil has also undermined profitability.
My final chart shows that over
the last 10 years, US gold and silver equities have generally
been negatively correlated with US equities. It is only since
2003 that both indices have risen together. When dollar weakness
causes the long end of the US yield curve to rise, it is likely
the negative correlation will resume again.
Tim Drayson
ABN AMRO Equities UK
Limited
+44 20 7678 7339
email: tim.drayson@uk.abnamro.com
website: www.abnamroresearch.com
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