High global investment risk a boon for gold in 2004

At the same time, the value of the dollar has declined to multi-year lows against the euro, yen and sterling while the price of gold has consolidated above $400 per ounce for the first time since the mid 1990s.

Recent stock market performance indicates that investment risk is perceived to be low. Recent performance of the dollar and gold indicate the opposite. Several factors could undermine U.S. economic growth in 2004, thrusting both global investment risk and the price of gold higher.

These include the large U.S. current account and budget deficits, the substantial accumulation of foreign investment in U.S. fixed-income securities and increasing global geopolitical instability. These factors are all leading long-term U.S. interest rates higher. Rising long-term interest rates could erode personal consumption expenditure, weakening U.S. and global economic growth.

The risk is high that expectations for U.S. economic growth will not be met. This implies equally high investment risk across global equity markets. High investment risk will push the price of gold well above $500 per ounce in 2004.

Last year the U.S. current account deficit was estimated to have been equivalent to a record 5.2 percent of gross domestic product (GDP). At the same time, the general government deficit, which includes both federal and state government budget deficits, reached an estimated 5.8 percent of GDP, the largest such deficit in over 20 years. While the current account deficit is expected to decline toward four percent of GDP in 2004, the general government deficit is expected to climb to about 6.5 percent of GDP. Both the U.S. current account and budget deficits have been partially financed by foreign investment in U.S. fixed-income securities.

This investment, attracted by declining long-term U.S. interest rates, reached a cumulative total of over $800 billion in 2003. The combination of dollar depreciation and rising long-term U.S. interest rates is strong incentive for foreign investors to sell their U.S. fixed-income assets. This process, known as foreign capital flight, could feed continued dollar depreciation and rising long-term interest rates.

In addition to foreign capital flight, the expanding U.S. budget deficit and increasing global geopolitical instability can also conspire to push U.S. interest rates higher. Increased sales of U.S. Treasuries are required to finance the budget deficit. If investors expect interest rates to rise, demand for Treasuries will decline as supply increases, pushing interest rates higher.

Growing geopolitical instability, generated by heightened insurgent activity in the Middle East, an elevated threat of international terrorism and deteriorating U.S. foreign relations, have already contributed to the weakness of the dollar. Dollar depreciation encourages foreign capital flight from U.S. fixed-income securities, forcing interest rates higher.

The U.S. Federal Reserve appears committed to leaving official short-term interest rates at current levels for the foreseeable future. The Fed, however, has little control over long-term interest rates, which are determined by supply of, and demand for, U.S. Treasuries.

If, as expected, the supply of Treasury securities is greater than demand, long-term interest rates will increase. Rising long-term interest rates will reduce personal consumption expenditure. Since 2000, economic growth in the U.S. has been buttressed by rapid personal consumption expenditure growth. Underlying this growth has been plunging long-term U.S. interest rates, house price inflation and unprecedented mortgage refinancing.

The home equity gains realized through refinancing have propelled personal consumption expenditure. It has also pushed household debt higher. In 2003 the ratio of household debt to personal disposable income is estimated to have reached 112 percent, up from 98 percent in 2000.

The high level of household debt combined with rising long-term interest rates could be disastrous for personal consumption expenditure growth in 2004. With employment growth and wage growth expected to remain muted and mortgage refinancing to slow dramatically, households will have few resources for financing continued rapid expenditure growth.

Business investment is not likely to compensate for weaker personal consumption expenditure growth. Manufacturing capacity utilization remains near a 20-year low. With ample excess capacity, the prospect for manufacturing investment is very limited. This leaves government expenditure and tax reduction as the only feasible means for keeping private demand stimulated. This implies a larger budget deficit and higher long-term interest rates.

Expectations for rapid U.S. economic and global growth in 2004 appear overly optimistic, as do world equity markets. If these high expectations are not met, equity markets will retreat sharply, pushing the price of gold much higher.