Why Gold should be at least US$2451 an ounce – guest post

Doesn’t it seem sometimes that everything is going up in price?  Inflation is relentless whatever governments may say.  Want to have a guess what the decline in the purchasing power of the US Dollar has been since the Federal Reserve was established in December 1913?  Pat yourself on the back if you said 96%.  That’s right, a Dollar 100 years and a month ago would buy you 4 cents of goods and services today.  More recently, the reduction in purchasing power of a Dollar has been about 10% since quantitative easing started five years ago. 

To beat the relentless march of inflation over time is not easy in financial markets.  Cash?  Useless.  Bonds?  Any fixed principal investments is useless unless accompanied by a massive yield.  Equities?  Companies can inflation-proof their earnings by raising prices but the challenge is to hold the right companies. Want to have a guess how many constituents of the FTSE-100 have been (in some form) in the index since its launch 30 years ago? 19. 

There is only one asset class which has a history of holdings its purchasing power and that’s gold.  With its near indestructability, portability and limited new supply year-on-year, gold has had the attributes over time to be at the core of an economy.  Its anti-inflation credentials can be shown by the observation that, apparently, an ounce of gold would buy you a smart tunic in Roman times.  The current per ounce gold price of over US$1200 would go a long way in Marks & Spencers or Selfridges I would suggest.

Let’s take this a stage further.  Take a look at the chart below which appeared in Forbes magazine a few months ago. It shows the price of gold at mid-2013 prices over a near 40 year period.   Over this near two generational period gold has increased its real purchasing power, albeit with some volatility.  Unless you were super smart with your stock picks, you are not going to match that with equities.  As for bonds and cash, well I am not going to embarrass them.  Let’s just say that 1970s were not kind to them, before we even worry about the last 35 years.  

Prior to recent years, early 1980 was the high point of the previous global financial crisis.  And despite the best efforts of Bear Sterns, Lehman Brothers, Royal Bank of Scotland, AIG and the like in real-terms, as measured in mid-2013 prices, we never took out that high price. 

Of course we are cleverer now.  Quantitative easing kicks in and we can limit the damage and pressure to the global financial system.  All it takes is to raise the size of a Central Bank’s balance sheet by over four times (in the case of the Bank of England, Federal Reserve and Swiss National Bank) over the last six years.  Nice and easy yes?

Every action has an impact though.  When I was at school, studying for my Economics A-level, I was taught the basics of monetary economics by trying to imagine an island economy where all they have to sell is one product.  Let’s call it (inevitably) coconuts.  If there’s one tree producing one coconut for sale and you the buyer have one Pound to spend, then the price is going to be…one Pound per coconut. 

So what happens when the Bank of England gives you four Pounds to spend? 

Now we have not seen this impact yet.  For the monetary economics aficionados out there you will be familiar with the concept of the Quantity Theory of Money and as touched upon in the blog here – http://www.spreadbetmagazine.com/blog/qe-the-reverse-robin-hood-why-it-will-ultimately-end-in-soci.html as well as the velocity of money.  In essence, because banks today are not lending and consumers are not spending, this enlarged pool of money is just sloshing around the economies of the world in a lacklustre fashion.  To continue our island economy example, we are scared to buy the coconut for even a Pound or two, despite having four Pounds in our pocket.  At some point we will spend though and then prices will go up. 

So how will any of this have anything to do with gold? Given gold has been maintaining its purchasing power since Roman times, there is no reason for it to stop now (a reality reflected in the rampant desire of consumers and governments in key emerging markets like India and China to buy gold).  The trouble is that the numbers thanks to quantitative easing have not got much, much bigger…

The below chart was put together by Societe Generale two years ago since when, thanks to QE3, the amount of US Dollars printed has gone up further.  What it suggests to me is that a case can be made for a gold price of US$7,500 per ounce…or six times the current level, if the full inflationary threat of quantitative easing is priced in. 

Scary stuff. 

I come back to the first chart I showed to help draw some conclusions.  All this easy money sloshing around the system will one day come back to haunt us.  And the sign for that will be a new high in the inflation-adjusted price of gold.  In mid-2013 prices that’s over US$2,451 an ounce for those of you keeping score.  Or a near doubling from the current spot price.

And I haven’t even touched on the potential for carefully selected gold equities to do better than this. 

By Chris Bailey from Financialorbit.com