Fears of Renewed Global Financial Turmoil

Jeffrey Nichols, Senior Economic Advisor to Rosland Capital

Managing Director of American Precious Metals Advisors

We should have seen it coming. On Thursday, when Americans were celebrating Thanksgiving, the potential multi-billion dollar debt default by a Dubai state-owned development conglomerate triggered fears of renewed global financial turmoil. Dubai had borrowed some $80 billion to finance infrastructure construction and real estate development aimed at transforming its economy to an international tourist destination and financial center – but the global business slump has put these projects in financial jeopardy and the emirate state can no longer make payments due its creditors.

Reacting to this news, world equity markets sold off sharply on Thursday, as did U.S. stock markets on their Friday opening . . . and the dollar rallied sharply as, once again, many investors and traders saw it as a safe haven, just as they did at the time of the Bear Sterns and Lehman crises. This rush into the U.S. currency and the decline in world stock markets triggered a swift correction in gold, a correction that was, in any event, overdue, given the speed and magnitude of the metal’s recent advance.

Through mid-week, before the Dubai debacle hit home, the yellow metal had risen about 16 percent since the beginning of November, with demand fuelled by expectations of further central bank reserve diversification, growing pessimism about the sickly U.S. dollar, and increasing fears among some market participants about inflation in the next year or two.

Gold’s swift ascent early last week to successive historic highs had gathered momentum as the dollar dropped through key technical levels against the euro, yen, and a widely followed basket of currencies . . . and on news of additional central bank buying. First came a report that India might buy more gold from the International Monetary Fund, following its purchase of 200 tons earlier this month. Later came news the IMF had recently sold 10 tons of gold to the Central Bank of Sri Lanka and Russia’s central bank purchase of 15.6 tons from domestic mine production.

Last week’s price action is an important reminder that even long-term bull markets do not go straight up. While the focus has been on central banks, hedge funds, and retail investors in the West supporting the rising gold market, we have been hearing reports that demand in India and other price-sensitive markets was softening at prices over $1,100 an ounce. Moreover, the technical picture was already looking worrisome with some indicators suggesting a sudden, swift sell-off of $50 to $100 might be in the cards. Perhaps the market’s “Thanksgiving Day” drop was the expected correction . . . or perhaps not.

Here are more details and other timely Talking Points:

• Even a much deeper price decline would not change our expectation that the yellow metal will be going much higher in the next few years. In the short run, there are eager buyers – central banks, sovereign wealth funds, and hedge funds – as well as a multitude of small-scale retail investors – all looking for attractive price points to buy gold.

• China is – and will be – a growing influence in the world of gold and on the metal’s future price. According to the China Gold Association, the country’s gold demand may be more than 450 tons this year, up from 395.6 tons in 2008 (a 54.4 ton increase), and output may climb to 310 tons, compared with 282 tons a year earlier (a 28 ton increase). Clearly Chinese demand is growing more quickly than domestic mine supply – and the central bank is probably continuing to buy from local production as well. The gap is filled by imports, leaving less gold available in the world market. With these trends expected to continue, China’s net position will be a continuing positive force for gold prices for years to come.

• Longer term, more sovereign debt problems are likely to be a plus for gold. Dubai is just one of several countries facing possible bankruptcy. Others include Greece, Spain, Hungary, and Latvia. The real problem is that country debt defaults threaten the balance sheets of the lending banks and a contraction in credit available to otherwise healthy businesses and institutions.

• The four pillars of gold-price strength remain in place: (1) inflation-fueling U.S. monetary and fiscal policies, (2) central bank reserve diversification with the official sector being a taker rather than a supplier of gold, (3) expanding retail and institutional investor participation, and (4) declining world gold-mine production.

• As we have said repeatedly over the past year, announcements of official gold purchases by one or another central bank are quite likely. The IMF still has some 190 tons to sell . . . and, it seems the only question is which central banks are at the head of the line. Additionally, some gold-producing countries – like China, Russia, Peru, Venezuela, the Philippines, Indonesia, etc. – could purchase domestic production. Each announcement will promote additional private-sector gold demand and add support to the continuing rise in the metal’s price.