Golden Wall of Worry

By Scott Silva

Editor,  The Gold Speculator

1-10-12

It is often said that gold climbs the wall of worry. What the old saw means is that the price of gold tends to rise in the face of economic uncertainty or peril. History shows that for the most part, this has been true of gold, and to a lesser degree, silver. In 2011, gold shot up to test the $2000/oz mark and silver topped $50/oz. 2011 was certainly a volatile year for world economies.

Political unrest in northern Africa and the Middle East toppled governments in Egypt and Libya, and the sovereign debt crisis in Europe came to head, forcing out Prime Ministers in Greece and Italy, threatening the survival of the Euro as a currency. In the US, the $15 Trillion US debt and continued deficit spending threatened to bring the government to a halt more than once, as ideologues in Washington played politics. The government did not shut down, but the nation’s sovereign credit rating was downgraded for the first time in its history.

Economic uncertainty continues into the New Year. The sovereign debt crisis has not been solved in Europe or the US. The EU now has a plan for new fiscal regime, but it is far from implementing a workable solution. Now there are signs that the plan could collapse over terms of the Greek bailout. Investors are balking over the earlier 50% haircut on Greek notes and a new revised plan in which bondholders receive only 35% of capital stretched out to 30 years. Closing the deal is an essential part of the 130-billion-euro ($165 billion) bailout package from European partners and the International Monetary Fund (IMF). Without an agreement from bondholders, which include hedge funds, Athens faces the threat of a debt default in March.

Italy and Spain are vulnerable and could fall if the Greece defaults. The bond market is giving us the sign. Italy's 10-year government bond is yielding 7.13%, 5.25 points over the German bund. Italy is planning to sell €440 billion ($561.67 billion) in government bonds and Treasury bills in 2012, but higher borrowing costs will stress its fiancés beyond the breaking point.  The ECB has stepped in to purchase some Italian bonds, but the central bank cannot bail out Italy’s $1.9 Trillion in outstanding liabilities.

Italy has passed balanced budget legislation and is now implementing several austerity measures, but austerity can be a double edged sword. Austerity, combined with massive debt, tends to stifle economic growth. Investors shun credit risk, which drives yields up. In addition to cutting spending, the government raises taxes to close budget gaps.  Higher taxes drive off investment capital, the engine of private sector growth.

Recession across the Eurozone may be here already. The Greek economy is now in its fifth straight year of contraction. EU data released Friday showed that unemployment in the Eurozone hit a new high and consumer spending declined in November. In Germany, the largest producer in the Eurozone, industrial orders fell 4.8% in November, nearly reversing October's 5% gain.  Some industry estimates show that Eurozone gross domestic product fell by 1.75% in the last three months of 2011, at an annualized rate. The EU will publish official numbers in February, but forecasters expect continued contraction in the first quarter of 2012. Economists traditionally define recession as two consecutive quarters of economic contraction.

The Markit PMI index measures manufacturing output for the Eurozone. The index shows that manufacturing output in the Eurozone contracted in December, but at a slightly lower rate than the November 2011 contraction.The purchasing managers index for the 17-nation euro zone's manufacturing sector rose in December from a 28-month low the previous month but still signaled a further contraction in activity, The Markit manufacturing PMI rose to 46.9 in December from 46.4 in November, confirming an earlier, preliminary estimate. A reading of less than 50 indicates a contraction in activity, while a figure of more than 50 signals expansion.

A Eurozone recession would make it more difficult for vulnerable countries to recover from their debt problems. Also, a recession in the Eurozone would impact the US recovery. The EU and the US economies account together for about half the entire world GDP and for nearly a third of world trade flows. Slowing demand in the EU would impact US export sales, an important component to US growth.

A 2012 recession in the Eurozone would be a large brick in the wall of worry. But as we have seen, economic shocks can come from unexpected quarters, at any time. No one expected the Arab Spring. And no one could predict the natural disaster that struck in Japan last year. Today we are seeing some worrisome developments in Iran that have the potential of upsetting the balance of power in the Middle East, and the price of oil.

Given the slow growth/negative economic growth scenario, it’s no wonder that prudent investors turn to gold. Gold gained 10.1% in 2011 extending its eleventh consecutive annual gain since the bull market began in 2001. Gold has gained 17% a year, on average, since 2001, making it one of the highest performing asset classes for investors over the last decade.

Gold is outperforming because it is sound money. As government debt continues to explode in Eurozone and in the US, governments print more paper money. Recent disclosures of the US Federal Reserve operations during the financial meltdown of 2009 show the Fed issued over $16 Trillion to bail out US and foreign banks. The ECB has issued more than $3 Trillion in Euros so far. These massive increases in the money supply are beginning to translate into higher commodity and producer prices. Printing more paper money reduces its purchasing power because paper currency has no intrinsic value and is not a store of value. Gold, on the other hand has proven to be a store of value for thousands of years precisely because it has intrinsic value.

We can expect gold to outperform other asset classes in 2012.

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