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Thursday, 12 June 2008

How gold will perform in a U.S. recession

Commentary: Economic slowdown unlikely to have major impact

By Natalie Dempster

Natalie Dempster is investment research manager with the World Gold Council.

NEW YORK (MarketWatch) -- Macro economic data and the U.S. Federal Reserve Bank's swift loosening in monetary policy underline the risk that the U.S. economy is on the brink of, or already in, recession. Not surprisingly, consumers are distinctly less confident now than they were just one quarter ago and leading indicators suggest that worse is to come.

There are obvious winners and losers in terms of asset performance in a recession.
Cyclical stocks, such as car manufacturers and homebuilders, as well as financial stocks tend to under perform as consumption is cut back and bank lending slows.
But it is not true of all stocks. "Defensive" stocks like biotechs or foodstuffs whose markets are largely unaffected by the economic cycle tend to perform well. So do fixed-income assets, as interest rates are lowered in a bid to boost consumer demand. Commodities, on the other hand, tend to under perform as slower economic growth reduces demand for the metals and energy used in the production of cyclical goods or in the provision of services.

During the recession that followed the high-tech bust, the Dow Jones Industrial Average index and Reuters/Jefferies CRB Commodities Index fell by 0.3% and 8.4% respectively, while U.S. 10-year bond futures rose by 1.9% and the NASSAQ Biotech index rose by 23.4%. But what about gold: how is the yellow metal likely to fare if the economy falls into recession?

An independent asset

Gold moves independently from the economic cycle. It's not difficult to understand why when one considers the diversity of its supply and demand base, the ultimate determinants of price movements.

Commodities typically fall during a recession, as noted, as the raw materials used in the production of non-essential goods and services declines. However, demand for gold as an intermediate good is relatively small in comparison to many other commodities. Last year, just 14% of gold demand came from the industrial sector (mainly electronics). This is in stark contrast to base metals and even other precious metals, where the vast majority of demand comes from industry. As a result, gold is much less vulnerable to the vagaries of the economic cycle. That said, demand for gold in electronics is likely to fall if the economy falls into recession as consumer spending on non-essential electronics goods declines.

A U.S. recession would undoubtedly have negative implications for gold jewelry demand in America, as consumer spending slows. However, this negative implication could be at least partially offset by the higher share of gold jewelry in the retail market. Moreover, gold is much less vulnerable than other jewelry materials, such as diamonds or platinum, to a U.S. recession as far more demand for gold comes from outside of the U.S. -- 70% of diamond jewelry demand comes from the U.S. market, compared with just 10% for gold.

The final source of demand comes from investors. Investors buy gold for many reasons. Chief among these are gold's inflation and dollar-hedging properties, both of which have been proven over long periods of time. How a recession affects investment demand would depend, in part, on how inflation and the dollar react.

The brewing recession has so far been positive for gold on both fronts. The dollar has continued its downward trajectory, while inflation has (unusually) headed higher. U.S. consumer prices increased at an annual rate of 4.0% in February this year, up from 2.4% just a year earlier. If these trends continue, investment demand for gold as an inflation and dollar hedge is likely to remain strong. And if the recession deepens concerns over the health of the U.S. banking sector, demand for gold as a safe haven asset is also likely to remain robust.

On the supply side, there are three main sources of gold supply: mine production, official sector sales and scrap or recycled gold. Mine production is by far the largest element, accounting for 70% of total supply last year. Changes in annual mine supply bear no relation to changes in U.S. or even global GDP growth. The upward trend in mine production that was underway in the late 1980s was not arrested by the 1990 recession (the U.S. economy suffered an outright contraction, while world GDP growth slowed to 1.6% from 2.9% the previous year). Nor was the downtrend in mining output that began in 2001 reversed by the sharp acceleration in world growth that followed.

Mine production is influenced by very specific factors, such as the level of exploration spending, the success or otherwise in discovering new gold deposits and the cost of extraction (some new discoveries may not be economically viable). Lead times in gold mining are often very long. It can take years to re-open a closed mine, let alone find and mine new reserves.

Central bank decisions to buy or sell gold (they remain net sellers) are also usually strategic in nature, rather than reactive to the economic cycle. The decision to buy or sell gold is often made years in advance and then carried out over a period of years. In Switzerland, for example, the proposition to sell gold (the first gold sales program) was first recommended by a group of experts in 1997. However, the actual sales program did not commence until May 2000, with the sales then taking place over a period of five years.

Scrap supply is influenced by many factors, perhaps the most important being price and price volatility, but recessions and periods of economic distress have also had an impact. The most dramatic example is when Korea was pushed into recession during the 1998 Asian currency crisis; its scrap supply increased by almost 200 tonnes as the government bought gold from the local populace in exchange for won-denominated bonds. It then sold the gold on the international market in order to raise the dollars necessary to avoid defaulting on its external debt.

In summary, a U.S. recession does not have negative implications for the gold price thanks to the unique drivers of gold demand and supply. The only element of demand likely to be affected by a recession is investment demand, but that in turn will depend on the "type" of recession. So far, the brewing recession has been positive for gold, as it has been accompanied by a rise in inflation and a falling dollar, which has boosted demand for gold as a dollar and inflation hedge.

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