Come What May, Gold Still Shines

01/23/2012 10:15 am EST


Gavin Graham

Chief Strategy Officer, INTEGRIS Pension Management Ltd

There are a lot significant issues that remain unresolved in the global economy, but one metal still retains its allure observes Gavin Graham of The Canada Report.

At the beginning of each year, it is customary amongst writers on investments to offer some forecasts for the year ahead.

While it is somewhat artificial to do so merely because the calendar has changed, it’s always a useful discipline, especially after such a tumultuous year. I believe that identifying the one or two themes that are most likely to develop is helpful in deciding how to position your portfolio.

The year just finished has to rank as one of the most disappointing in the last decade, behind only 2008 and 2000-01 in terms of investors’ returns. While the Dow Jones Industrials were positive and the S&P 500 was flat, every other developed market index was down for the year. The losses ranged from 6% in the UK, through 10% to 15% for the Eurozone markets of France and Germany, to almost 20% in Japan.

Emerging markets such as China, Brazil, and India were off by more than 20% as governments raised interest rates to combat inflation. Commodity exporters selling to them were also down sharply. In Canada’s case, the S&P/TSX Composite Index was off more than 11%.

Meanwhile, investors fled to the perceived safety of non-Eurozone (German excepted) government bonds. Yields on ten-year US, UK, German, and Canadian bonds fell to 60-year lows of around 2%, producing a total return of 14% to 15%. Investment-grade corporate bonds lagged a little, delivering 7% to 8% total returns.

It seems reasonable to expect that this pattern will not be repeated in 2012, with the exception of blue-chip stocks continuing to produce positive absolute returns.

Bond yields in developed countries are now so low that any increase in GDP growth rates or inflation will lead to a fall in prices that will more than offset the very low amounts of interest investors receive. Once the Fed stops targeting low long-term Treasury bond yields through Operation Twist, which involves selling short-term Treasury paper to buy long-term bonds, US bond rates are likely to rise.

Similarly, the continued Quantitative Easing (QE or money-printing) this year by various central banks such as The Bank of England, the Swiss National Bank, and the European Central Bank will lead to investors demanding higher nominal yields on government debt.

The Eurozone debt crisis will be resolved one way or the other in the next few months. There are two possible scenarios. The first is that fiscal union is achieved, which President Sarkozy of France and Chancellor Merkel of Germany hope the next few summit meetings will confirm. If that fails, the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) are likely to leave the Eurozone and devalue their way to growth.

While one should never underestimate the ability of European politicians to ignore reality, the markets will not allow them to continue kicking the can down the road. Italy and Spain cannot fund their deficits at interest rates above 7%, so something must be done this year.

Once some resolution is achieved, the flight to safety into developed-market bonds will come to an end. The extra liquidity created by central banks will flow into other asset markets, primarily those which benefit from increased economic growth and moderate inflation, such as equities and commodities.

This actually happened the last two times QE programs were introduced, in early 2009 and mid-2010. Stocks doubled between March 2009 and April 2011, when QE2 was coming to a close in the US, and selected commodity prices more than doubled.

It would be too optimistic to expect a similar result this year because of the write-downs on Eurozone government debt that will hit the European banks.

However, it certainly seems probable that economically sensitive sectors will benefit, especially as the major emerging markets are beginning to reduce their interest rates and reserve requirements as their inflation begins to fall. This in turn means it is likely that commodity producers such as Canada and Australia will benefit from a revival in demand for their resources.

I especially like the prospects for gold in the year ahead, particularly the mining companies whose shares have lagged behind the rise in the price of bullion. One stock to seriously consider is Goldcorp (GG), the second-largest gold mining company in North America.

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