Golden Years

Back in 2003 I used to bicycle down to Hatton Garden every payday and use a quarter of my salary to buy Krugerrands. I kept buying until gold broke through $400/oz.

This week I sold my first tranche back. I also went short gold last week in the fund – to the tune of 40% of NAV.

In short, I think we’re at a major turning point for the commodities here, and I think gold is in trouble. Gold is the talisman of the commodity complex – and my bet is that where gold goes, the rest will follow.

But before I start, it’s worth stating my basic view on gold. It’s not a hedge against inflation. It’s not a defence against doom. It behaves as an index of reflation. My view – reflation is over. From here on in it’s either disinflation or deflation.

The very big picture call is that the US non-oil current account is collapsing. It’s fallen from 5.5% of GDP in 2006 to 2.5% now. It’s heading for zero, or beyond, in my view. That is yanking deposits from foreign banks, who are anyway cutting back their banking multipliers. That kind of pressure goes beyond disinflation and into deflation.

The first way this affects the gold market is that foreign central bank reserves will stop growing as fast, and then stop growing at all. As part of that reserve accumulation was going into gold, that will strip away some demand at the margin.

The second effect is from the dollar. If the dollar rises in response to the deflationary forces described above, and my bet is that it does, then gold production gets cheaper, and consumption more expensive.

Another way deflationary pressure affects gold is via the production function. Deflationary pressure is going to push down utilisation rates in a lot of places. I think recessions are due across Europe, in Australia, New Zealand, Pakistan, Vietnam, Iceland, in the UK and in the US in 2009. I’m expecting deep cyclical downturns in China and India. And I’m anticipating outright collapse in Hungary and several other Eastern European reflator states. Over the next year, that’s going to take the pressure off production globally. Shortages will become less frequent, and bottlenecks will loosen. In a roundabout way this will ease production constraints across the whole commodity complex. Gold will be no exception.

And then we have the crowding out of consumption from higher food prices. We’re seeing that across the emerging economies. Indian gold imports fell 50% YoY in May. The same stresses on emerging market consumers is causing a large increase in scrap supply, as people sell back their coins and jewellery to help make ends meet. Scrap supply hit 300t in Q1, from 200t in Q307.

And finally we are drawing to the end of dis-hedging. Back in the 1990s, when producers sold forward, it involved, via a convoluted mechanism, a spot sale of gold out of reserves. When the producers started to buy back those hedges in the early 2000s, it effected a repurchase of gold back into reserves. That’s added around 300t, or around 8%, to global demand in the last year. But there aren’t many hedges left to dis-hedge. Over the next year we’ll see that demand fade away.

Now, the likely outlook for mine supply over the next year is for a 2-3% fall – given the problems in South Africa. But the bounce in scrap supply will likely bring that number back to zero. And if you look at net sales from Central Bank reserves – that will likely increase – not because of greater sales, but just because of fewer purchases.

But if we look at demand, my guess is we’re facing something like a 10-15% decline. Gold should be at $600/oz, not $945/oz. In a year or two, I think it will be.

Tomorrow I’m heading to Kinsale, Ireland for a week with the family. So the next blog will come out early the week after next. It’s always a tough call what to do with the portfolio when you’re away. I’ve got a high conviction call on, so I’m not inclined to pare my positions. What I’m doing instead is to put stops in place that will guard me against the worst possible event – and for the current portfolio that would be an Israeli attack on Iran, and a full scale disruption of shipping through the Straits of Hormuz. If that happens I’ll be stopped out 7% down from here, and I’ll be drowning my sorrows in an ice cold pint of Magners.