Markets rejoice, but gold sounds a warning noteBy Justin Lowes

By Justin Lowes

A rally that began towards the end of October continued throughout November, with almost all markets posting extremely strong gains. In the US, a relaxing of concerns over inflation eased investors' nerves. Productivity figures jumped, inflation declined and the minutes of the Federal Reserve meeting suggested that, despite another 0.25 percent increase in interest rates, the practice of continually tightening monetary policy might be nearing its end. Although housing market news was mixed, GDP was revised upwards, industrial output and business orders rebounded after the hurricanes and consumer confidence levels increased.

In the euro area, a similar story unfolded. Unemployment decreased to 8.4 percent, industrial productivity in Germany increased by 3.3 percent, inflation fell slightly and retail sales improved. Industry was buoyed by a weak currency as the euro fell to a two-year low against the US dollar. Even a well-flagged 0.25 percent increase in interest rates by the European Central Bank failed to dent enthusiasm. For the UK, news was more mixed, with lower inflation being offset by a fall in labor productivity. Hopes that the Bank of England was moving towards cutting rates were quashed when the published minutes showed that the decision to hold rates at 4.5 percent had been unanimous.

Of major markets, Japan posted the strongest gains. Although figures showed that prices were still in deflation, a 3 percent increase in GDP and industrial production figures continued evidence that bank lending is on the increase. This, combined with a rise in the ratio of vacancies to applicants to the highest levels seen in more than a decade, all helped to push up the Nikkei by more than 9 percent.

So why, amidst all this euphoria, was the performance of world markets matched by a similar increase in the price of gold? Throughout November, gold increased steadily to just under $500 per ounce - a gain of nearly 9 percent. (At the time of writing, gold has now increased to $536.5). Usually, an increase in the value of gold is associated with concerns about the health of the economy, so why have we seen this rise whilst at the same time markets have been in overdrive?

Most of the mainstream media decry the current increase. The Economist labels gold 'a barbarous relic', pointing out that gold is merely reflecting a general increase in the value of metals and has only risen by 40 percent of the average increase in these metals' prices. However, gold is uniquely seen as an ultimate store of value - a currency that cannot be printed or devalued at will. A more ominous take on the rise in the price of gold is that central banks are too dovish on inflation, despite recent rises. When the short-term interest rates available are lower than the prevalent inflation rate gold becomes a superior store of value. Gold is today less than a quarter of its value (in real terms) when it hit a peak of $850 per ounce in 1980. This suggests that it still has the potential for further, substantial increases.

While in many ways the global economy looks healthy, potential problems are not hard to see. These include fuel prices likely to remain high (and which may well rise again if the winter is particularly cold); heavily indebted consumers slashing spending with stuttering (if not falling) housing markets as the catalyst; inflation that is well in excess of central bank target rates; the threat of terrorist attacks, especially on oil infrastructure, etcetera. A contrarian would do well to question the consensus that diversifying into gold is a redundant strategy.

Justin Lowes is the Managing Director for Tenbridge Asset Management, a company offering discretionary portfolio management to its clients. You can contact him by email at justin.lowes@tenbridge.com