Economic & Market Update: November 9, 2009

“Will There Be Gold At The End Of This Rainbow?”

Chris Maxey, Senior Analyst

http://www.Fortigent.com

Last Week’s Highlights:

Economics This Week:

Stronger Data Reinvigorates Investors

Following a 6% loss for the S&P 500 index during the last 2 weeks of October, buyers quickly stepped in to reverse that trend last week.  In the end, the S&P and Dow Jones Industrial Average both rose by 3.2%.  Behind the increased risk appetite was better than expected economic data, impressive earnings reports and Warren Buffet’s “all-in” play on the American economy through the purchase of Burlington Northern. 

From an economic perspective, the news was mostly bullish with the exception of Friday’s employment report.  A strong report on the ISM index kick started the week.  The October ISM registered 55.7, marginally ahead of consensus expectations.  New orders slowed slightly (from 60.8 to 58.5) although they do remain well within expansionary territory, suggesting further gains in the coming months.  Manufacturing employment crossed into expansionary territory (53.1 from 46.2 in the previous month), another sign that managers are hiring to fulfill future demand.

Source: Federal Reserve Bank of Cleveland -

On Wednesday the Federal Open Market Committee voted to leave interest rates unchanged.  The Fed acknowledged that the economy “continued to pick up” but cited built up slack as a factor that would dampen future growth and weigh on inflation.  It was also announced that the agency debt purchase program of $200 billion was trimmed to $175 billion due to scarcity of securities. 

Digging into the jobs report it is evident that labor markets are not ready to turn the corner and follow the lead of the broader economy.  The unemployment rate surged to 10.2%, the highest level since early 1983.  It was initially believed this was the result of workers re-entering the labor force, but unfortunately that was not the case.  Household employment fell by 589,000 but the labor force stayed mostly constant, causing the rate to jump.  The average workweek held steady at 33.0 hours, while average hourly earnings rose 0.3%.  Year over year, average hourly earnings are up 2.4%, the slowest rate since late 2004.

Source: Econoday

There are two bits of good news, depending on one’s opinion.  First, if we look at the chart above the red line represents the yearly percentage change in nonfarm payrolls.  It is clear that declines bottomed in June/July and are beginning to “hook” upwards – far from a great sign, but a step in the right direction, nonetheless.  Secondly, this is where opinions may differ; President Obama signed legislation on Friday extending unemployment benefits up to 99 weeks in certain states.  Benefits will last an additional 14 weeks in all 50 states, but in those with an unemployment rate above 8.5%, the unemployed will be able to collect benefits for 20 extra weeks.   This will obviously help individuals that are struggling to find employment, but a continuation of the payroll tax is burdensome.   

They Call It Mellow Yellow

It was once widely thought that Donovan’s song “Mellow Yellow” was written about smoking dried banana peels for illicit purposes (this rumor was later debunked).  Given the recent surge in gold prices, some are left wondering whether those same people are trying to experiment with a new yellow substance. 

The most recent catalyst behind the surge in gold prices was the announcement from India that the country purchased 200 tons from the International Monetary Fund.  It turns out this was not as unusual a purchase as it may have seemed on the surface.  Consider if you will, India’s holdings of gold as a percentage of reserves now total a mere 7.1%, up from 4% previously.  Many market participants view India’s purchase as setting a floor on the price of gold.  If gold prices broach that level again, India will step right back in to pick up additional allocations. 

Source: New York Times

So, this begs the bigger question, are central banks covertly returning to the gold standard?  Not so fast.  To begin with, there is not nearly enough gold in circulation to back the massive amounts of fiat currency that were printed over the last century.  But, an interesting phenomenon is developing as a result of the credit crisis.  An extremely brief background of gold’s evolution is necessary to understand what may be happening.      

Beginning in 1967, central banks became net sellers of gold – the catalyst at that point was the disintegration of the London Gold Pool, a group of leading central bankers that worked to hold the price of gold around $35 an ounce.  The cartel was designed to hold the dollar-gold exchange standard constant during the 60’s.  In 1967, France backed out of the pool and come April 1968, the gold pool vanished for good.

By August 1971, gold’s history was permanently altered.  President Nixon removed the gold standard and thus began a changing in the guard.   According to the World Gold Council, from the peak in 1965 through 2008, central bank holdings of gold fell from 38,348 tons to 29,727 tons.  The trend of central banks as net sellers is seemingly at an end. 

Source: CPM Group

In addition to India, China is making waves in the world of reserve diversification.  By September, the country held 1,054 tons of gold, up sharply from the end of 2008, when it held 600 tons.  That increase might be a tad more surprising if it weren’t for the fact that gold as a % of reserves still only accounts for 1.9%.  Given the rapid recovery in China’s economy, we would expect its reserve base to multiply quickly.  To simply hold a constant proportion of reserves, China will need to accumulate huge amounts of gold but, if China seeks to diversify further out of dollars, there is one logical location for those extra dollars – you guessed it: gold.  The IMF is looking to sell an additional 200 tons in the coming months, with China appearing to be a likely suitor. 

Those two groups alone would be enough to support the price of gold, but they are not alone in their quest.  Outside the central bank channel, the growing middle class in China and India is showing an increased appetite for the precious metal.  What is likely taking place is that investors (large and small alike) are increasingly realizing that fiscal profligacy holds the potential to decimate fiat currencies in the coming years and gold in any form is an obvious store of value. 

An interesting sidebar on gold actually pertains to the US governments’ store of gold bars.  People are constantly lambasting the explosive growth of the Federal Reserve’s balance sheet and decrying the asset/liability mismatch that blossomed over the past 12+ months.  It turns out the Fed is holding a “golden” quiver in their cap, in the form of gold bars.  Since 1971, the Fed decided to price those bars at $42.22 per troy ounce, for a value around $11 billion.  For anyone without a news feed recently, the price of gold is trading well north of $1,000 per ounce, making those holdings worth nearly $250 billion.  The Fed never felt it necessary to float those holdings to market.  This is not enough to compensate for the Fed’s $2 trillion balance sheet, but does provide additional options should the Fed need access to liquidity.   

At the end of the day it looks like gold fever is going to outlive the current swine flu pandemic.  The role of currency reserves is in a rapid evolutionary phase with gold being the logical place to park money.  We frequently shudder when we hear investors say the dreaded “this time is different” but in the case of gold, central banks may actually make this time different.  In an era where commodities are shattering previous record highs, the price of gold would need to reach $1,885 an ounce before it touches the previously established inflation adjusted record. 

The Week Ahead

It is going to be a somewhat quiet week on the economic side.  The only indicators worth watching are the trade balance and consumer sentiment on Friday. 

The Treasury Department is firing up the printing press again this week.  On Monday, it will issue $40 billion in 3-year notes, Tuesday brings $25 billion of 10-yr notes and Thursday sees $16 billion of 30-year issuance.  Government bond markets will not be open on Wednesday due to the Veteran’s Day Holiday.  

Only a few companies are left to report third quarter earnings.  That list includes Applied Materials, Wal-Mart, Walt Disney and Abercrombie & Fitch. 

On Tuesday, the International Energy Agency will release its World Energy Outlook.  Whispers in the market indicate that the IEA will revise its long term oil forecast downward based on the emergence of energy efficient measures.  Next Saturday, the Asia-Pacific Economic Co-operation group meets in Singapore to discuss a range of economic and political issues.   President Obama will be in attendance to hold bilateral meetings with Southeast Asian leaders before he moves to China for talks in Beijing and Shanghai. 

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