Gold to Outshine U.S. Dollar?

By: Axel_Merk

As the price of gold has gone up fivefold over the past 10 years, why would one buy it at today's prices? For the same reason an investor would buy any other asset: if one believed it would be a good investment now, that is if one believed it may appreciate in value and add portfolio diversification benefits. A key reason to hold gold today might be to prepare for the crisis tomorrow.

I am no gold bug. But I hold a substantial portion of my personal assets in the yellow metal. To understand why, let me give a little bit of background. When I wrote the book 'Sustainable Wealth: Achieve Financial Security in a Volatile World of Debt and Consumption' in early 2009, my editors wanted me to talk about the financial crisis in the past tense. I balked, arguing that the crisis will be far from over by the time the book would be published later that year. The crisis has long been in the making and may be far from over. Indeed, I started investing in gold back in 2002 and made it part of my family's "golden college savings plan" (discussed in the book) in 2003:

• "Back in 2003, we contemplated the hypothetical question: If you had to choose one asset class over the next 10 or 20 years, which one do you think would perform better than many others? We picked gold. The trends that we see unfolding these days were already in the making years ago. It was our view that in the absence of some miraculous reform of entitlement programs such as Social Security, odds would be high that policymakers would nominally keep their promises, but erode the purchasing power of the dollar." (SustainableWealth page 217ff)

• While anyone can argue that deploying gold to save for college isn't particularly diversified - and my plan should not be considered investment advice for others - it's the discipline in pursuing a plan, any plan, that is key to success. It helps that the price of tuition has been going down every year since we started the plan - that is, when college tuition is priced in gold.

Here we are almost 10 years into the plan. In 2008, we remained focused on our priorities by fully funding the savings plan. However, the motivation for the plan was not the Eurozone crisis (by the way, has anyone noticed that, of the major currencies, the euro has had the highest correlation to the price of gold, not the so-called commodity currencies?). The motivation was that, and it is worth repeating: in the absence of some miraculous reform of entitlement programs such as Social Security, odds would be high that policymakers would nominally keep their promises, but erode the purchasing power of the dollar.

If there is one good thing to be said about our policy makers, it is that they are rather predictable. And while we hope for change whenever we elect a new politician, odds are that business as usual continues. This isn't merely an American phenomenon. Just about anywhere in the world, politicians running for office promise to cut wasteful spending. The definition of wasteful spending tends to be what "the other party" spends money on; in turn, when elected, the politician will redirect resources to more productive projects. Of course, those other projects are similarly considered wasteful spending by their political opponents. And as we have seen in the U.S., those budgets tend to balance only under rosy scenarios, with spending cuts only projected to take place once the politicians that imposed the cuts will have retired. In practice, the cuts rarely ever take place.

The last time the debt ceiling rhetoric raged in Congress, the one area both Republicans and Democrats agreed on was to consider changing the definition of the Consumer Price Index (CPI) so that, nominally, contractual obligations are kept, yet the purchasing power of such promises is eroded. That change, if implemented, is reported to reduce the deficit by $220 billion over 10 years.

While the Obama administration has a clear track record of running record deficits, don't get your hopes up too high that the deficit trend will reverse should we get a Romney administration. The presidential hopeful has already committed to continue subsidizing student loans and to keep up defense spending. He might have some miracles up his sleeves, but short of that, we don't get a warm and fuzzy feeling about his ability to implement major entitlement reform - key to making U.S. budgets sustainable. By the way, when politicians refer to "reducing the deficit", they typically mean reducing such deficit as a percentage of Gross Domestic Product (GDP), rather than in absolute terms.

By now it is no secret anymore that the finances of the U.S. government are heading towards a fiscal train wreck - a positive step, as at least the discussion on how to tackle the deficit has started to broaden. Each year, the Congressional Budget Office (CBO) is warning in ever-clearer terms that the current path is unsustainable. In its 2012 long-term budget outlook, the CBO is warning of a 199% debt-to-GDP ratio by 2037 under its "extended alternative fiscal scenario" that considers "what might be deemed current policies, as opposed to current laws, implying that lawmakers will extend most tax cuts and other forms of tax relief currently in place, but set to expire and that they will prevent automatic spending reductions and certain spending restraints from occurring." With regard to the forecast, the CBO cautions "the projections... understate the severity of the long-term budget problem... because they do not incorporate the negative effects that additional federal debt would have on the economy."

The Bowles-Simpson budget plan released in late 2010 suggested a way to bring the long-term deficit under control, but the committee was unable to move the blueprint forward. It is certainly possible to bring the long-term deficit under control, but as we have seen in Europe, austerity is not a popular policy. Indeed, I am even optimistic that we will eventually find a way to manage our deficits. However, the time may only come once the bond market forces policy makers to do so. From the European experience, it should be clear that the bond market is the only language policy makers listen to. Different from the Eurozone, however, the U.S. has a substantial current account deficit. In our analysis, currencies of countries with a current account deficit are more vulnerable, because such countries are dependent on inflows from foreigners to finance the current account. While the debt crisis weighs heavily on the borrowing costs in the Eurozone, the euro itself has held on remarkably well; we have our doubts that the U.S. dollar would has benign a ride should investors shun U.S. bonds.

Yet looking at the bond market, all is quiet on the Western front (for those not familiar with the pun, it relates to a 1929 novel covering the last days of WWI. The main character is killed in October 1918, on an extraordinarily quiet day). Remember the tech stocks that would always rise in the 1990s? Remember the housing market that could not possibly crash? Remember bonds that appear to be going nowhere but up? Former Federal Reserve (Fed) Chairman Alan Greenspan warned of irrational exuberance in 1996; yet the Nasdaq Composite index didn't peak until March 2000. As the saying goes, markets can stay irrational longer than you can stay solvent.

As such, we don't predict the bond market will crash tomorrow; nor do we even think the pending "fiscal cliff" will be insurmountable. But we simply cannot ignore the risks that come with keeping money in U.S. dollars. The question is not whether negative fallout on the U.S. dollar due to U.S. fiscal and monetary policy will happen, but whether there is a risk that it will happen. And if one acknowledges that risk, how does one prepare for that risk? For asset managers with fiduciary duties, how do you take the scenarios outlined above into account? Throughout my investment career, I have assigned probabilities to different scenarios; when I see a non-negligible risk for a scenario, I try to take it into account. Granted, this is no easy task in a world where there may not be such a thing as a risk free asset anymore. However, there is no reason not to engage in even classic portfolio optimization while throwing out the so-called risk-free asset, but adding in alternatives including gold and currencies.

And we have not even touched much on monetary policy. The Fed has helped finance deficits. Not just now, where Fed Chair Bernanke claims the Fed policies are not aimed at helping finance deficits, although they have done so in practice, but also in the late 1940s and early 1950s, where it was a stated policy to help the government to lower its borrowing costs. Compared to other major central banks, the Fed has one of the better printing presses and has been willing to deploy it. I don't even question the intent of policy makers - conspiracy theories suggest that kicking out "the bad guy" will fix the problem. But how can the Fed conduct sound monetary policy when it has taken away its own gauges? Specifically, the Fed would typically look at the yield curve (the relationship between short-term and long-term interest rates) to gauge the health of the economy; but by micro-managing the entire yield curve, the Fed looks itself in the mirror when assessing the impact of its policies. Similarly, by artificially depressing long-term yields, potential warning signs are taken away from Congress, allowing them to continue their fiscal largesse longer than might otherwise be the case.

While we have had a substantial rally in gold, we have not had the sort of blowout that occurred in 1980. At this stage, I am not particularly hopeful that a successor to Bernanke would "crush" inflation should it flare up in indicators the Fed cares about. We have simply too much leverage in the system for another (former Fed Chair) Volcker to come along and raise rates to 20%. Spain says it can't even sustain 7% on its 10-year debt. But even Volcker, the hero that rooted out inflation, did not bring the price level back down; he merely tamed future rises in inflation.

By all means, the price of gold is rather volatile. As such, investors must consider whether they can stomach the volatility of gold. It's a key reason why we historically advocate diversified baskets of currencies including gold to manage volatility. The trends outlined almost a decade ago remain in place. I have no reason to change our family's college savings plan; in our family of four, our youngest is scheduled to graduate from college in 16 years, so we still have a way to go...

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By Axel Merk

Manager of the Merk Hard, Asian and Absolute Return Currency Funds, www.merkfunds.com

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies. Axel Merk wrote the book on Sustainable Wealth; order your copy today.

The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

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