The Flight to Gold

In early August, the market sell-off was worse than at any time since fall 2008. As the triple-A pressures are escalating from the United States to the Eurozone, the gold price is climbing in bursts.

Despite records, growth fears will continue to drive gold higher. It is still far from the real record high.

When markets are in turmoil, everything that looks precious is precious. However, when confidence returns, precious stones do not look so precious.

Today, the gloomy fundamentals in the United States, Western Europe and Japan suggest that slow growth, stagnation, or Japan-like lost years have come to stay. But what will happen to gold? Is gold’s upward trajectory sustainable?

In fact, the shift toward global stagnation heralds a new gold-en era.

Gold Still Far from Real Record Highs

After a rollercoaster week in risk-averse markets, world stocks are looking cheap and last Friday some investors began to pile back in.

Valuations have fallen steeply worldwide. Most importantly, the benchmark MSCI world equity index hit 11-month lows, losing 15 percent in a fortnight. After its three-year high in May, the Index has dropped more than 20 percent. The shift in the market capitalizations of the world’s major exchanges tells the same story. Since April, their aggregate market cap has plunged some $3 trillion from $59.2 trillion – almost 5 percent.

On Tuesday, the much-touted meeting between French President Nicolas Sarkozy and German Chancellor Angela Merkel ended with a lingering whimper rather than a big bang. Prior to the meeting, markets had hoped for a big announcement about the possible creation of Eurobonds or a boost to the stability mechanism.

Instead, the investors got promises of “economic government” and new piecemeal approaches that would take more time and resources without solving the underlying problem. Asian investors were the first to let their disappointment show. They were soon followed by market decline in Europe. Now investors in the United States are following in the footsteps.

Set against this backdrop, the flight to gold is only understandable. Of all the precious metals, it is the most popular as an investment. It is seen as the ultimate proxy against risk. It is the anti-equity par excellence.

But how far can gold go?

The Golden Era of the New Normal?

Typically, investors buy gold as a hedge against economic, political, or social crises. It has been the paramount investment vehicle against market declines, burgeoning national debt, currency failure, inflation, war and social unrest. But no investment vehicle is fully safe. The gold market is subject to speculation as are other markets, especially through the use of futures contracts and derivatives.

As gold topped a record $1,800 last week, even traders that are long on gold began to get nervous. As gold is now climbing even higher, the question is: Does gold have momentum left at record prices?

In March 2008 and February 2009, the gold price temporarily broke the $1,000 barrier, only to regress soon thereafter. Later in 2009, gold achieved new highs. As the $14.3 trillion debt ceiling was exceeded in the United States in mid-May and a still another bailout of Greece pushed the Eurozone into a new turmoil, gold began to climb again, reaching a high of $1,550 in London and $1,795 on August 10.

In real terms (adjusted for inflation), however, gold remains significantly off its all-time high of around $2,400 set in 1980.

It would be naïve to think that gold cannot go higher. Resuming the upward trajectory is not a matter of principle – just a matter of time.

The new normal could well be a golden era, with all puns intended.

What Is Driving Gold?

Historically, the greatest driver of the gold price has been uncertainty. And as the multi-year deleveraging has barely been initiated in the leading advanced economies, the era of uncertainty is only beginning.

In the coming months, concerns over global growth are likely only to increase, given the magnitude and impending escalation of economic problems in the United States and the Eurozone, Japan’s continuing triple crisis, the deepening turmoil in North Africa and the Middle East, as well as the accelerating struggle against overheating, inflation and potential asset bubbles in the large emerging economies, or the BRICs.

In the aftermath of the energy crises of 1974 and 1979, inflation took off dramatically, pushing the gold price to its real record high. That era is not just history; it is about to make something of a comeback.

Moreover, due to economic stagnation in the leading advanced economies, it is quite likely that certain G-7 nations will resort to still new rounds of quantitative easing and, thus, asset inflation. Conversely, that means a push for the gold price.

Then, there is the role of the central banks. With rising fears stemming from U.S. and European debt, retail investors are running after precious metals, while central banks around the world are fleeing fiat currencies for hard assets, especially gold.

Furthermore, gold price increases are not just about supply, but also about the demand side. Reportedly, physical sales to India for fabrication and jewelry are 25 percent higher year-to-date than in 2010. Meanwhile, China has become more seasonal than India, with turnover on the Shanghai gold exchange easing off in the summer months and picking up again in September.

There was a scramble for physical gold during 2011’s Chinese New Year. And next month, Indian wedding season, along with holidays there and in China, will boost physical demand for gold.

Taste of the Future

Certainly, the gold price could also be affected adversely, especially if new market fears would trigger the large hedge funds to raise money by unloading gold. In such a scenario, the ensuing panic might cause a rapid and substantial plunge of the gold price.

Nonetheless, given the continued concern over the U.S., Eurozone and Japanese economies, along with a potential hard landing in some of the largest emerging economies, and the turmoil in North Africa and the Middle East, the dramatic price increases of gold are not an anomaly or a matter of history, but just a taste of the future.

With gold price, both supply and demand drivers are accelerating. In the new normal of economic stagnation, extraordinary uncertainty and historical market volatility, gold, along with certain other precious commodities, is likely to remain the anti-equity proxy of choice.

Nonetheless, gold is no panacea. It should not have a disproportionate role in the portfolio of the future; the latter will be significantly more multipolar, in comparison to current portfolios with their US/Eurozone-centered biases.

Gold and many other commodities have an important role in hedging, but neither can diversify risk away.

The flight to gold does not reflect a collapse of portfolio allocation rules. However, it may reflect an impending shift in allocations that will leave an impact on most portfolios.