On April 20, I recommended the iShares SPDR Gold Trust ETF (NYSE: GLD). Since then, it has surged more than 10%. And while the price of gold may experience some short-term pullbacks, the U.S. government’s overly expansive fiscal policy could lead to a sharp inflationary spike that makes this exchange-traded fund a must-have investment.
Given the “green shoots” of economic growth that have appeared over the past few months, it looks as though the economy has managed to avoid a very dangerous deflationary spiral.
Indeed, last year's financial turmoil wiped out major financial institutions, left the housing market in shambles, and sucked all of the air out of an outsized commodities bubble. U.S. Federal Reserve Chairman Ben S. Bernanke was right to fear deflation.
A deflationary spiral like the one that nearly took root the U.S. economy is the worst nightmare of central bankers, because once you fall into it, you can bring your interest rates down to zero and people won’t put money to work by spending or investing in projects at risk. Investors realize that by simply sitting on their cash they are actually becoming "richer" since their money buys them more and more goods.
Central bankers and governments need to react aggressively and preemptively or else they risk losing 10 years of growth, like Japan did when its real estate and stock market bubbles popped in the 1990s.
That it is precisely why the Fed pursued such aggressive monetary policy. Of course, prescribing inflationary measures as a remedy for deflation has its own risks, namely inflation. Now, since the problem of inflation seems easier to contain than that of deflation, the great temptation is to put the pedal to the metal with both monetary and fiscal policies in order to ensure that the economy responds vigorously. But then the trick is trying to coax the inflationary genie back in the lamp, so that the recovery is self-sustained.
Weaning the economy off of fiscal stimulus too fast might kill the recovery, but injecting too much stimulus into the economy will entrench inflationary expectations in the economy. In the latter case, it would require higher-than-needed interest rates for a longer period of time, curbing output.
So, where are we now?
Interest rates are down to are range of 0%-0.25% and the Fed has implemented a number of inflationary programs, such as the Term Asset-Backed Securities Loan Facility (TALF), to make credit once more available and get the economy moving. In addition, since the Fed Chairman Bernanke cannot reduce rates any more, he has resorted to a policy of quantitative easing.
Quantitative easing essentially is the practice of issuing money in order to buy assets. With these programs, the Fed has bought commercial paper, mortgages, and Treasuries. These programs are all simulative, and thus designed to prevent the deflationary bubble.
Other central banks around the world have taken similar measures to stimulate economic activity. Throughout the industrialized world, there are different degrees of fiscal stimulus being deployed. In the United States, Japan, and Europe, governments are saddled with decades of entitlements that cannot be sustained. And, as Milton Friedman reminded us: "Inflation is a monetary phenomenon."
In addition to the huge weight of entitlements and negative population growth, governments around the world are facing the temptation of resorting to "competitive devaluations." This is a situation in which a government deliberately undermines its own currency in order to make the relative prices of its economy more competitive globally.
A country essentially "borrows" growth from its trading partners with the hidden subsidy of an undervalued exchange rate that fosters exports and taxes imports. But competitive devaluations do not work long term, because they create local inflation and inflation eventually eats away the competitive advantages obtained. That is, unless structural reforms to solve the underlying economic problems that led to the collapse are taken.
Hence, we have the three advanced economic blocks with fiscal and economic trouble incentivizing their economies with lax fiscal and monetary stimulus, and they all secretly would like their currency to fall against that of their trading partners, but cannot say it publicly. We indeed have a covert "race to be last" between the U.S. dollar, the Japanese yen and the euro. There’s also Chinese yuan, which Beijing has kept artificially low for about a decade.
To add fuel to the fire, the Chinese and the Russians have been criticizing the U.S. Dollar and calling for some change or competition in its status as the world's primary reserve currency. Good luck. The reality is that the flexibility of the U.S. economy allows it to readjust very quickly in a way that no other economy can.
U.S. Treasury Secretary Timothy Geithner has reassured the Chinese about his intentions to withdraw stimulus from the economy as the recovery builds momentum. And Federal Reserve Chairman Bernanke has testified before Congress that he is determined to reduce the long-term fiscal deficits.
While I do not for a second doubt their intentions, the reality is that U.S. and global policymakers are navigating unchartered waters, and economies do not change over night. It takes months for monetary and fiscal measures to take full effect. By the time inflation becomes apparent, it may be too late to change course.
This is why investors must hedge their bets with gold.
Gold meets all the criteria to serve well as a currency: It is a reliable store of value, a medium of exchange, and a unit of measurement.
Gold is an asset that protects from financial meltdowns. Witness its performance in 2008, when it was up 5%, while the U.S. stock market was down almost 40%. And this is without any traces of inflation, but deflation, rather.
In the last few years, with the creation of the gold exchange traded funds, it has become even easier to buy gold, since the small management fee and instant liquidity of the ETF avoids the typical high custodial fees and trading costs associated with physical gold.
The market capitalization of the iShares SPDR Gold Trust ETF is hitting record highs. And with the probability that something could go wrong in the global financial system and the risk that some inflation does indeed creep into expectations before policymakers act, investors need to have gold in a portfolio as a diversification tool.
The main reason, again is to cover ourselves from the unexpected global geopolitical risks, and at the same time ensure that we are prepared if inflation rears its ugly head.
The main risk to our investment is the International Monetary Fund's (IMF) commitment to sell gold out of its reserves. In fact, the IMF has already made the small concession to China and the Group 20: The IMF will sell 403 metric tons of gold to "provide $6 billion additional concessional and flexible finance for the poorest countries over the next two to three years."
These sales will keep a lid on prices for some time and actually create some downward pressure. But that will be precisely the opportunity needed to buy in at a discount.
The Gold Trust ETF has appreciated some 10% in past three weeks, but ideally we need to see some more consolidation, down to perhaps the $900 levels before we continue to purchase up to our maximum of 5% or 10% of the portfolio, depending on your risk aversion.
Recommendation: Hold existing gold positions in the iShares SPDR Gold Trust ETF (NYSE: GLD) and add to a maximum of 5% or 10% of the portfolio if we see gold-price retrenchment down to the $900 level (**).
(**) – Special Note of Disclosure: Horacio Marquez holds no interest in iShares SPDR Gold Trust ETF.
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Term Asset-Backed Securities Loan Facility (TALF)
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