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This is the second of three posts by Abhishek Preetam on why he is bullish on the yellow metal. Please welcome him to StockViz and follow him on twitter @AbhiPreetam

Throughout history, countries with high debt-to-GDP ratios are seen to have trouble getting back to their pre-crisis growth story. They can’t grow enough to repay their debts, and have little choice but to default.

A sovereign default usually comes in one of the following three forms:

1. The country willfully does not repay, force its debtors to take a haircut to reduce its debt burden, readjust its policies and starts growing again (Russia, Argentina).
2. The country starts printing more money and repays its debtors in worthless new currency (Brazil in the late 1980’s and early 1990’s)
3. The country devalues its currency (Iceland) and goes through the trouble of cutting expenses, high unemployment levels, and decreased GDP growth in the short run and comes up well at last.

In all the these scenarios, countries will have high inflation for a brief time (brought on by increased money supply). During this period of hyperinflation, whoever is left holding the country’s debt (or its currency), gets wiped out. But, once the readjusted economy gets back on its foot, sound fiscal and monetary policies puts economic growth back on track.

During the period of readjustment, there is usually a rush into hard assets (gold and commodities in general) whose value cannot be touched by the devaluation/default. Let’s look at the present debt to GDP ratio of various world economies.

We all are aware of Greece’s condition and its upcoming obligation to start making payments on its earlier debts. According to the updates from the Greek government this October, they were not in line with the necessary economic reforms and are also predicted to be stuck in the same rut of economic stagnation in the coming months.

Currency devaluation could have been a way out for Greece. However, it is not feasible for EU economies (thanks to the Euro), and big economies like US. The Euro cannot be devalued because of the diverse set of countries involved, and the impact it will have on the other well off countries (Germany, for example). If Greece, decides to devalue their currency alone, they will have to move out of the union, which will have serious impact on its trade and economic relation with other countries.

The US could get rid of its high debt load by printing more money. This will help it get rid of its debt in the short run, but the dollar will lose its value compared to other world currencies. This also would mean that no other country will buy US bonds and hence won’t lend to US in the future. In short, the USD will lose its reserve currency status and result in a permanent global shift in power.

Looking at the present conditions and hoping that the current turmoil will be over soon seems too optimistic. We seem to be headed down a path that involves Greek default, maybe the abandonment of the Euro and more money-printing in the US.

Some strategists believe that market forgets these issues pretty fast. Just like when Brazil, that had lot of debt during the late 80’s and early 90’s, hyper inflated its way to a 7% Debt-to-GDP ratio. Investors quickly put the past behind and made Brazil one of the shining stars of world’s emerging economies. This story can happen in the case of US as well.

No matter what the outcome, during periods of uncertainty and hyperinflation, investors will look toward Gold as a haven and a preserve of wealth. This looks to me like a pretty good factor driving demand and yet another reason for gold prices to surge. Investors the world over increased their allocation to the yellow metal starting in 2008, and the current lull in the market after the Aug 31^st correction in prices may provide investors with enough reason to start buying again.

This is the first of three posts by Abhishek Preetam on why he is bullish on the yellow metal. Please welcome him to StockViz and enjoy the post!

Gold has been in news for quite some time. With prices touching their highest values recently, the yellow metal is becoming red hot day by day. What is causing this sudden spur in the price?

Let’s look at the trend of gold prices (In USD and Euro) for the last 3 decades:

Prices were initially range bound nearly for two decades. Starting from 2001, prices have risen almost non-stop and have been on an absolute tear since 2003, rising over 325% and 150% since 2007. Following the trend, Gold just reached an all time high of $1813.5 an ounce on August this year. Let’s look for the reasons of this trend.

Supply side

Historically gold and silver were used as currencies and it was not until a few centuries ago that fiat currencies came into existence. The value of gold and silver did not lose their actual values, but instead were looked as commodities (a barter resource) and not actual money. Almost all currencies around the world are now fiat currencies.

Gold and silver are non-renewable resources, and with their production decreasing, the supply side of market looks shallow. Looking at the long term production level of gold, we can see the dipping production levels from 2000 till 2007.

Mining on an average contributes 63% of gold production; the rest comes from recycling of gold. Recycling takes place majorly in South East Asian countries. In the Q2 2011, 429.3 tons of gold was recycled. This is 3% down Y-O-Y and slightly above for the trailing 10 months average of 407.3 tones.

Global demand report from WCG for Q2 2011 states “Over the ten years that preceded the 1997/98 Asian financial crisis, net new jewelry and investment demand amounted to more than double the tonnage accumulated during the ten years to the end of 2010. This suggests a considerably lower stock of gold to supply the market through recycling.”

As per the data from World gold council, supply of gold for the year 2010 increased by 1.81% whereas the demand shot up by 10% compared with 2009. For Q1 11, supply decreased by 4% whereas demand increased by 10% compared to year ago period.

Demand Side:

Gold is used for 3 main purposes – Jewelry, Technology (Electronics and Dentistry) and Investments. Pre 2008, Jewelry formed 69% and % investments formed 11.5% of the total demand, but after that they form 53% and 25% respectively.

For the last 2 year central banks have turned into the net buyers of gold. Even European countries have started buying up gold for their reserves. The central banks currently stand as the largest holder of gold at 16.5% of all the gold produced.

Finally, applying simple economics lesson of supply and demand on gold, the future looks promising. With almost stagnating supply (mining and recycling) and continuous rise in the investment related interest of central banks and also various end users, there will be a huge gap to fill. There might be some correction in the short run, but long term outlook of the asset seems bright.

So, whether paper or real, they should form some part of your portfolio.