MarketNotes
Anchovies, Hurricanes and the Price of Gold
Inflation has a way of sneaking up on investors–and, with it, the price of gold. It has happened before. The runaway inflation of the 1970s began with, of all things, some missing fish. The chain reaction that ensued led to rising prices across the board and a quadrupling in the price of oil over several years. Although the era was rough on most asset classes, gold came out the undisputed investment champion.
The question is: have we already entered a new gold decade?
Inflation in the 1970s started with the now famous "missing anchovies" incident off the coast of Peru (the anchovies harvest was virtually non-existent); a seemingly innocuous event that started a chain reaction that would take the world's economy years to work through. Briefly, the missing anchovies forced consumers on the other side of the world, Japan to be precise, to turn to Soy as a source of protein. This, in turn, caused agricultural prices to be bid up, followed closely by other commodity prices. Eventually, oil prices quadrupled in a matter of a few years.
The inflationary domino effect didn't occur overnight, but as it built strength, the price of gold rose along with it, climbing from $38 an ounce in 1971 to $786 by 1980 - an increase of more than 20 times.
In October 2005, gold is approaching $500 an ounce, with various industry watchers predicting significantly higher prices to come. That is coming off a bottom of about $250 in July 1999.
In the week after hurricane Katrina, gold surged by $25 from $445 to $470. The reason? New Orleans is the hub of 2 major American industries: agriculture and oil. Many crops make their way to market down the Mississippi through New Orleans (being forwarded from the port there; or, more precisely, the port that was there). The region is also responsible for 30% of America's oil production (8% of which was idled by the storm).
A backdrop not entirely dissimilar to the 70s: inflation is considered tame and not a threat, but global demand for commodities is on the rise - with the rising giant of China gobbling up an ever-greater share of resources. What's more, the traditional safe harbour of $U.S. is not what it once was, as the U.S. increases its debt load to record heights and the Euro gains dominance.
In short: inflation has a certain inevitability about it, at the moment, and the yellow metal might just be the safest place to hide. Do recent facts support this hypotheses? You bet.
So far, gold has risen steadily, commodity prices are at 17-year highs and oil has tripled. ABN AMRO pegs the value of gold at $1,100 an ounce based on its historical ratio with crude while others have expectations of $470 in 2006 (CitiGroup and Deutsche Bank), $570 in 2007 (Deutsche Bank) and $725 in 2010 (Merrill Lynch).
Central banks are selling, though, right? Not as much as they used to. Aggregate sales were 428 tonnes in 2004–down 28% from 2003 and expectations are that sales will be as muted this year as well. Argentina's central bank (as stated by its head of market operations, Juan Basco) is even thinking of buying gold this year.
And demand for gold is on the rise. In the first half of 2005, there was a 16% increase (to 200 tonnes) in gold used for jewelry, and there seems to be no reason for gold to fall out of favour any time soon. In many parts of the world, gold still is a store of wealth. Gold is 10% of the asset allocation of urban Indian households, where mutual funds represent just 2%. Global investment jumped by 25% in dollar terms (11% in tonnage) in 2004 and another 45% in dollars (36% in tonnage) in the first half of '05. Basically, people are putting their trust in gold.
What about the 'hot money'? Hedge funds and speculators have started taking meaningful positions in the metal (net long gold futures were up 10% in the week ended Sept. 13th). Speculative long positions outnumbered shorts by 126,798 contracts on the Comex in the same week, up 11,546 contracts from the week earlier.
And now, the floor. Many gold producers sell forward in order to smooth their earnings. These hedges are at about $400 or $425 an ounce. This floor automatically rises as spot prices increase-which means about 1,000 tonnes (BMO estimate in Sept. '05) would need to be sold at these hedged prices before producers would be in the spot market.
That means, there is a structural limit to the downside. Finally, correlations. Compared to other investments, gold looks very good from a correlation–or lack of correlation–perspective. While global stock markets are highly correlated–80% to 90%–and stocks and bonds are also strongly in line, gold has negative correlation with other asset classes.
| Gold's (lack of) Correlation with Other Asset Categories |
| G7 | -62% |
| Asia | -14% |
| TSX60 | -4% |
| Energy | -14% |
| S&P500 | -22% |
| Global Balanced | -63% |
Total positive correlation (+100%) between two investments means that there would be no advantage of diversification. Most asset classes are positively correlated to some extent. Gold, however, demonstrates negative correlations with major asset classes–increasing the power of diversification it brings to a portfolio.
In conclusion, even though the anchovies have since recovered, gold still has a lot going for it today. Inflation is expected to be a growing characteristic of the global economy, and the price of gold will rise along with it. Fundamental demand from the industry (both in the U.S. and developing countries such as China) is growing as the metal is seen more as the one, true, inflation hedge left in the world, not only for individual investors and hedge funds, but also central banks. Production is steady and hedged, producing a price floor of sorts that could mitigate downdrafts. Correlation is negative vis-à-vis many other assets, meaning that the overall volatility/risk of a portfolio can be lowered simply by holding gold.
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This article was written by ONE Financial and is based on our opinion of events and market conditions at the time of writing, November 8, 2005.
†For the ONE Financial Profit Lock-In (& Cashflow) Notes, 100% of the amount by which the highest NAV of the portfolio the returns of the note are linked to (and for the Cashflow Notes, the highest NAV net of all dividends and other distributions paid by any of the Note's Underlying Investments, if any) during the term of the Notes exceeds the principal amount is locked-in and guaranteed to be paid by Maturity.
The portfolio may also include investments in notional bonds, and is subject to "Dynamic Asset Allocation" such that the performance of the Notes will not track the performance of the relevant Underlying Investment basket - see Master Information Statement (available on request). An investment in any of the Notes may not be suitable for all investors. Important details about each of the Notes are described in each product's Master Information Statement and the relevant Information Statement Supplement (the "Offering Documents"); investors should obtain and read carefully a copy of the relevant Offering Documents (available on request) prior to investing, paying particular attention to the risks associated with an investment in the relevant product. In the event of any discrepancy between the information described herein and the relevant Offering Documents, the terms of the relevant Offering Documents shall govern. This document has been prepared by ONE Financial based on information that ONE Financial believes to be fair but cannot be guaranteed as to its accuracy, and BNP Paribas shall bear no responsibility for the contents hereof. This document is for information purposes only, and does not constitute an offer to sell or a solicitation to purchase. 100% of investors' principal is guaranteed to be repaid only for Notes purchased at the Issue Price on the Issue Date and held until the Maturity Date, and there is no assurance that any additional returns will be generated. Returns on the Notes may not mimic, and may significantly underperform, returns in an otherwise identical portfolio consisting entirely of Underlying Investments invested according to the allocations described herein. No assurance can be given as to the tax treatment of investments in any of the Notes. Commissions, trailing commissions, management fees and expenses all may be associated with these investments. ONE Financial, the ONE Financial logo, "Profit Lock-In", "Profit Lock-In & Cashflow", "Guaranteed Linked Notes", "Upside Only", "We believe in better ideas" and "wealth through innovation" are trademarks of ONE Financial Corporation. BNP Paribas and the BNP Paribas logo are registered trademarks owned by BNP Paribas S.A. and used under license. ONE Financial Corporation ©2006 All rights reserved.
