There's no business like show business, but there are several
businesses like accounting.
-David Letterman
Over the last few years, gold and oil prices have tended to move
together, as the chart shows (
click here to view). Prices have moved in a
similar fashion, both directionally and in relative magnitude, from
2002 through last fall, and a longer-term chart would show the same
sort of pattern since the mid-1970s. Since last fall, however,
their paths have diverged significantly. Between September 23, 2008
and February 20, 2009, crude oil prices have fallen by 63 percent,
while gold has rallied by 13 percent. This year alone, gold is up
around 12 percent, while oil is lower by 13 percent.
In the past, economic slowdowns depressed demand for both
commodities and caused prices to fall, while inflation and a weak
dollar caused prices to go up. The last few months have seen a
noticeable slowdown in global growth, a relatively strong dollar
and deflation is viewed as a far greater near-term threat in the
developed world than is inflation. All of that is consistent with
lower prices and, therefore, oil prices appear to be behaving more
"rationally". Does that mean gold prices are in bubble territory?
Deflation (or the threat of deflation) might actually be boosting
gold prices in the near term. Deflation is viewed as a negative for
the financial industry today, as it will keep housing prices
depressed and, hence, the prices of many of the toxic assets held
by financial institutions. Gold is viewed as a hedge for financial
instability and uncertainty in general. In that context, the recent
rise of protectionist sentiment in the U.S. and the prospect of
mounting bank failures in Eastern Europe raise the level of fear
and uncertainty and add to its allure as well. Gold is a
non-earning asset, but with short-term rates just about everywhere
falling towards zero, the opportunity cost of holding gold is as
low as it has ever been. There are two "safe" assets today: gold
and U.S. Treasuries. Both yield about zero, but gold truly has zero
default risk and no risk of ratings downgrades. There is also the
demand-supply equation to consider. Global production is down
around four or five percent on the year, while retail demand
remains robust for the reasons above even though industrial demand
has slipped. Finally, despite the recent rally, gold trades at less
than half its 1980 inflation adjusted value and has lagged many
other commodities and the S&P 500 in recent years. Some are
calling for a rally to $2000/ounce or higher.
Turning to oil, the majority of energy price declines are probably
behind us and in recent months OPEC appears to be more successful
in ensuring quota compliance amongst it members, which is also a
positive. However, the future demand-supply picture is less
constructive, as reserves are approaching record levels, industrial
demand is low and as the end of winter in the Northern Hemisphere
approaches, demand for heating oil will fall as well. Oil has a
closer correlation to global GDP growth than gold does, suggesting
that demand for oil will keep falling or stagnate for quite awhile.
Markets appear to view deflation as the more likely near-term
problem over the next year or two. However, they are also concerned
that longer-term inflation will rise as a result of soaring
deficits, surging money supply and a fall in the dollar. Gold is
benefiting from short-term deflation concerns and longer-term
inflation concerns as well. The pace of the run up, the increased
flows into gold ETFs (exchange traded funds) and the twin benefits
from deflation and inflation concerns improve the odds that prices
will correct once markets recover and its safe haven allure
diminishes.
I believe the dollar will lose value and inflation will be somewhat
troublesome a couple of years down the road, which works in favor
of both commodities. In my opinion, the recent divergence has more
to do with fear (positive for gold) and a sharp decline in global
investment and consumption demand (negative for oil). That would
suggest gold could continue to outperform in the near term, but oil
could play catch up once the global economy recovers and fear
subsides.
Looking Ahead
Despite a late short-covering rally last Friday, the euro remains
under pressure, buffeted by fears about a widening financial crisis
in Eastern Europe that threatens the future of Europe's banks.
Markets expect the ECB to cut rates from 2 percent to 1.5 percent
on March 5, with the prospect of another cut thereafter. There has
also been discussion about the future of the single currency, as
individual countries are said to favor currency devaluation as a
way of boosting their economies. In the current climate, the
Eurozone appears to offer the worst of both worlds - a lack of
currency and monetary flexibility because of the unified framework,
but wildly differing borrowing rates for each member country.
The JPY finally weakened as terrible economic numbers took their
toll. JPY weakness and growing risk aversion led to pronounced
weakness in the KRW and other Asian currencies and more of the same
is expected this week.
Once again, the USD is benefiting from risk aversion, a flight to
Treasuries, a perception that we are closer to the bottom and that
the Fed has been more proactive. Our numbers don't tell that story
- it remains to be seen how perception and reality are reconciled
in the weeks and months ahead. While there is the very real
possibility of a further drop in the EUR and perhaps even the JPY,
the dollar is no longer cheap, especially vs. Asian and Latin
American currencies. The conservative approach is to hedge all
known exposures, but increasingly, the greater risk in my opinion
is to leave Asian currency payables unhedged.