The U.S. Dollar As A Store Of Value
             


 
Summary
  • The US Dollar Index has broken above July 2013 highs as the US economy strengthens.
  • The Trade Weighted Index also reflects this trend.
  • But the Trade Balance remains in deficit.
       
(click to enlarge)
Source: Barchart.com

As the US economic recovery continues to gather momentum, what are the prospects for the US Dollar versus its principal trading partners? This is key to determining how swiftly and to what degree the Federal Reserve will tighten monetary conditions. Above is a 25 year monthly chart of the US Dollar Index and for comparison, below is the US Dollar Trade Weighted Index (TWI) as calculated by the Philadelphia Federal Reserve. The TWI shows the initial flight to quality during the onset of the Great Recession, the subsequent collapse as the Fed embarked on its increasingly aggressive programme of QE, followed by a more orderly recovery as the US economy began its long, slow rebound. It is still only a modest recovery and I would not be surprised to see a slow grind higher towards the initial post crisis highs around 113 - this is only a 50% retracement of the 2001-2011 range. In the longer term a return to the "strong dollar" policies of the late 1990's might be conceivable if the current industrial renaissance of the US continues to gather momentum:-

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Source: St Louis Federal Reserve

During the late 1990's the US Dollar soared on a combination of strong economic growth, a technology asset bubble and relatively benign inflation due to the disinflationary forces of globalisation, emanating especially from China. During the current decade another technology revolution has been underway as the US becomes self-sufficient in energy production. I am not referring simply to "fracking" as this paper from the Manhattan Institute - New Technology for Old Fuel - April 2013 explains: -
Between 1949 and 2010, thanks to improved technology, oil and gas drillers reduced the number of dry holes drilled from 34 percent to 11 percent.
Global spending on oil and gas exploration dwarfs what is spent on "clean" energy. In 2012 alone, drilling expenditures were about $1.2 trillion, nearly 4.5 times the amount spent on alternative energy projects. 
Despite more than a century of claims that the world is running out of oil and gas, estimates of available resources continue rising because of innovation. In 2009, the International Energy Agency more than doubled its prior-year estimate of global gas resources, to some 30,000 trillion cubic feet-enough gas to last for nearly three centuries at current rates of consumption. 
In 1980, the world had about 683 billion barrels of proved reserves. Between 1980 and 2011, residents of the planet consumed about 800 billion barrels of oil. Yet in 2011, global proved oil reserves stood at 1.6 trillion barrels, an increase of 130 percent over the level recorded in 1980. 
The dramatic increase in oil and gas resources is the result of a century of improvements to older technologies such as drill rigs and drill bits, along with better seismic tools, advances in materials science, better robots, more capable submarines, and, of course, cheaper computing power.
The productivity gains are substantial within the Oil and Gas industry, but the benefits are just beginning to percolate out to the broader economy.

Here is US GDP over the last twenty years: -

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Source: Trading Economics


Growth since the Great Recession has been relatively anemic. To understand some of the other influences on the US Dollar we also need to consider the US Trade Balance: -


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Source: Trading Economics

The USA continues to be the "consumer of last resort". Here, by contrast are the EU GDP (1995-2014) and Trade Balance (1999-2014): -


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Source: Trading Economics
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Source: Trading Economics

Europe is also a major export market for Chinese goods but nonetheless appears to rely on trade surpluses to generate sustainable growth. Since the Great Recession the EU has struggled to achieve any lasting GDP growth despite a significant increase in its trade surplus. This is because a large part of the terms of trade improvement has been achieved by reducing imports rather than increasing exports, especially in the Euro Zone (EZ) peripheral countries. The austerity imposed on EZ members by the ECB has encouraged some external trade but the prospect for any sustained recovery in EZ growth is limited.

China has, of course, been a major beneficiary of the US trade deficit, although, since the Great Recession, trade surplus data has become significantly more volatile: -

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Source: Trading Economics

The chart above doesn't really articulate the colossal increase in Chinese exports - between 2004 and 2009 China's trade surplus increased ten-fold. Despite the more recent policy of "Rebalancing" towards domestic consumption, the latest data takes this surplus to a new record.


The US response to the trade deficit

The US government is concerned about the structural nature of their trade deficit but this is balanced by capital account surpluses as this report from the Congressional Research Service - Financing the U.S. Trade Deficit - March 2014 explains: -

According to the most commonly accepted approach to the balance of payments, macroeconomic developments in the U.S. economy are the major driving forces behind the magnitudes of capital flows, because the macroeconomic factors determine the overall demand for and supply of capital in the economy. Economists generally conclude that the rise in capital inflows can be attributed to comparatively favorable returns on investments in the United States when adjusted for risk, a surplus of saving in other areas of the world, the well-developed U.S. financial system, the overall stability of the U.S. economy, and the generally held view that U.S. securities, especially Treasury securities, are high quality financial instruments that are low risk. In turn, these net capital inflows (inflows net of outflows) bridge the gap in the United States between the amount of credit demanded and the domestic supply of funds, likely keeping U.S. interest rates below the level they would have reached without the foreign capital. These capital inflows also allow the United States to spend beyond its means, including financing its trade deficit, because foreigners are willing to lend to the United States in the form of exchanging goods, represented by U.S. imports, for such U.S. assets as stocks, bonds, U.S. Treasury securities, and real estate and U.S. businesses.
The chart below shows the continued increase in foreign holdings of US assets between 1994 and 2012: -

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Source: US Commerce Department

The Congressional Research Service concludes:-
The persistent U.S. trade deficit raises concerns in Congress and elsewhere due to the potential risks such deficits may pose for the long term rate of growth for the economy.  
In particular, some observers are concerned that foreigner investors' portfolios will become saturated with dollar denominated assets and foreign investors will become unwilling to accommodate the trade deficit by holding more dollar-denominated assets. The shift in 2004 in the balance of payments toward a larger share of assets being acquired by official sources generated speculation that foreign private investors had indeed reached the point where they were no longer willing to add more dollar-denominated assets to their portfolios. This shift was reversed in 2005, however, as foreign private investments rebounded. 
Another concern is with the outflow of profits that arise from the dollar-denominated assets owned by foreign investors. This outflow stems from the profits or interest generated by the assets and represent a clear outflow of capital from the economy that otherwise would not occur if the assets were owned by U.S. investors. These capital outflows represent the most tangible cost to the economy of the present mix of economic policies in which foreign capital inflows are needed to fill the gap between the demand for capital in the economy and the domestic supply of capital. 
Indeed, as the data presented indicate, it is important to consider the underlying cause of the trade deficit. According to the most commonly accepted economic approach, in a world with floating exchange rates and the free flow of large amounts dollars in the world economy and international access to dollar-denominated assets, macroeconomic developments, particularly the demand for and supply of credit in the economy, are the driving forces behind the movements in the dollar's international exchange rate and, therefore, the price of exports and imports in the economy. As a result, according to this approach, the trade deficit is a reflection of macroeconomic conditions addressing the underlying macroeconomic factors in the economy likely would prove to be of limited effectiveness. 
In addition, the nation's net international investment position indicates that the largest share of U.S. assets owned by foreigners is held by private investors who acquired the assets for any number of reasons. As a result, the United States is not in debt to foreign investors or to foreign governments similar to some developing countries that run into balance of payments problems, because the United States has not borrowed to finance its trade deficit. Instead the United States has traded assets with foreign investors who are prepared to gain or lose on their investments in the same way private U.S. investors can gain or lose. It is certainly possible that foreign investors, whether they are private or official, could eventually decide to limit their continued acquisition of dollar-denominated assets or even reduce the size of their holdings, but there is no firm evidence that such presently is the case.
The author appears to be saying that, so long as foreign private investors are prepared to continue acquiring US assets, the US need not be overly concerned about the deficit. Given that this should be negative for the US, what are the medium-term implications for the US Dollar?

Gold vs. US Dollar

Evaluating the US Dollar, in a world where all the major fiat currencies are attempting to competitively devalue, is fraught with difficulty, however, the price of gold gives some indication of market perceptions. It seems to indicate a resurgence of faith in the US currency:-

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Source: Barchart.com


The substantial appreciation in the price of gold since 2001 is evident in the chart above, however, since the US economy began to recover from the Great Recession and financial markets perceived that QE3 might suffice to avert deflation, gold has lost some of its "safe-haven" shine. 10 yr US Treasuries yield 2.56%, the S&P 500 dividend yield is 1.87% - whilst these are historically low they look attractive compared to 10 yr German Bunds at 0.97% or 10 yr JGBs at 0.54%.

Leading Indicators

The Philadelphia Federal Reserve - Leading Indicators shows the breadth and depth of the prospects for the US economy, below is their latest heat map: -


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Source: Philadelphia Federal Reserve

Below is a chart of the evolution of US Leading Indicators since 1995:


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Source: St Louis Federal Reserve

The relative strength of the Leading Indicators has not been as evident in the GDP data. This supports arguments such as CEPR - Is US economic growth over? September 2012 by Robert Gordon in which he promulgates his theory of structurally lower productivity growth in the US over the coming decades.

Personally I am not convinced that we have seen the end of productivity growth. I believe the extraordinary improvements in energy technology and productivity will begin to show up in broader data over the next few years.

Which leads me back to pondering on Governor Yellen's recent comments after the FOMC Press Conference:-
...If we were only to shrink our balance sheet by ceasing reinvestments, it would probably take, to get back to levels of reserve balances that we had before the crisis. I'm not sure we will go that low but we've said that we will try to shrink our balance sheet to the lowest levels consistent with the efficient and effective implementation of policy. It could take to the end of the decade to achieve those levels.
This suggests the Federal Reserve may never sell any of the assets they have purchased but simply hold them to maturity. In an oblique way this view is supported by a paper from the Chicago Federal Reserve - Measuring fiscal impetus: The Great Recession in historical context which was published this week. They examine the link between changes in fiscal policy in the immediate wake of the Great Recession and more recently the slow pace of this cyclical recovery. Looking forward they opine: -
Fiscal policy during the Great Recession was more expansionary than in the average post-1960 recession, with declines in taxes, increased in transfers, and higher purchases all contributing to higher than typical fiscal impetus. This pattern reversed itself following the cyclical trough, with declining purchases, particularly among subnational governments, accounting for most of the shortfall. By mid-2012, cumulative fiscal impetus was below the average level in other post-1960 recessions. Although fiscal restraint is expected to ease somewhat over the coming years, there is no indication that fiscal policy will be a meaningful source of economic growth in the near future.
If fiscal policy is unlikely to be a meaningful source of economic stimulus in the near future then monetary policy will have to do the lion's share of the heavy lifting.

Where next for the US Dollar

The economic fundamentals of the US economy look solid. Regions like Texas might even be in danger of overheating as this report from the Dallas Federal Reserve - Regional Growth: Full Steam Ahead - makes clear:-
The regional economy is surging, with the Texas Business Outlook Survey (TBOS) production and revenue indexes at multiyear highs and annualized job growth of 3.6 percent year to date. Second-quarter job growth was 4.6 percent annualized, and July job growth was just as fast. Energy production continues to increase, and the rig count has risen since last August in spite of a decline in oil prices. Texas exports rebounded in July. 
... All told, the regional economy is growing at an unsustainable pace. Texas employment has grown at more than twice its long-run average rate over the past four months. Declines in unemployment measures have slowed, suggesting Texas is near full employment and slack is being depleted. The rapid growth has led to labor shortages, which can cause bottlenecks in production and hurt productivity. Tight labor and housing markets are leading to mounting wage pressures and increasing prices.
Dallas Federal Reserve President Richard Fisher has been a hawk for as long as I can remember, however, he plans to retire in April of next year. As does his fellow hawk Charles Plosser - President of the Philadelphia Fed, although Jeffrey Lacker - President of the Richmond Fed - will take up the hawkish cause in 2015. Nonetheless this weakens to case for any rapid tightening of policy beyond the tapering of QE.

Given the zero bound interest rate policies of all the major central banks, growth rather than expectations of widening interest rate differentials is more likely to determine the direction of currencies. Therefore, the slower the Federal Reserve act in tightening policy, the stronger the momentum of US GDP growth, the larger the capital inflows and the stronger the support for the US Dollar.

Elsewhere, the prospects for EU growth are much weaker. Further QE is imminent after last week's disappointing uptake of TLTRO funds - Bruegal - T.L.T.R.O. is Too Low To Resuscitate Optimism has more detail. The BoJ, meanwhile, continues with its policy of QQE yet, without the Third Arrow of the Abenomics - serious structural reform - Japan is unlikely to become an engine of economic growth. China continues its rebalancing but the momentum of growth is downward. In this environment the US looks like a land of opportunity to the optimist and the "least worst" safe-haven in an uncertain world for the pessimist. Either way, barring a substantial escalation in direct geopolitical risk, the US Dollar is unlikely to weaken.

Technically the currency is looks set to appreciate further; in so doing this may create a virtuous circle reducing import price inflation and delaying - or possibly mitigating the need for - tightening by the Federal Reserve.

Technology revolution in nuclear power could slash costs below coal

A report by UBS said the latest reactors will be obsolete by within 10 to 20 years, yet Britain is locking in prices until 2060

 
9:23PM BST 24 Sep 2014

A general view of the security fence at Heysham Nuclear Power Station on March 17, 2011 in Heysham, United Kingdom
Scientists have already designed better reactors based on molten salt technology that promise to slash costs by half or more Photo: Getty Images
 
The cost of conventional nuclear power has spiralled to levels that can no longer be justified. All the reactors being built across the world are variants of mid-20th century technology, inherently dirty and dangerous, requiring exorbitant safety controls. 
 

This is a failure of wit and will. Scientists in Britain, France, Canada, the US, China and Japan have already designed better reactors based on molten salt technology that promise to slash costs by half or more, and may even undercut coal. They are much safer, and consume nuclear waste rather than creating more. What stands in the way is a fortress of vested interests.
 
The World Nuclear Industry Status Report for 2014 found that 49 of the 66 reactors under construction - mostly in Asia - are plagued with delays, and are blowing through their budgets.

Average costs have risen from $1,000 per installed kilowatt to around $8,000/kW over the past decade for new nuclear, which is why Britain could not persuade anybody to build its two reactors at Hinkley Point without fat subsidies and a "strike price" for electricity that is double current levels.
 
All five new reactors in the US are behind schedule. Finland's giant EPR reactor at Olkiluoto has been delayed again. It will not be up and running until 2018, nine years late. It was supposed to cost €3.2bn. Analysts now think it will be €8.5bn. It is the same story with France's Flamanville reactor.

We have reached the end of the road for pressurised water reactors of any kind, whatever new features they boast. The business is not viable - even leaving aside the clean-up costs - and it makes little sense to persist in building them. A report by UBS said the latest reactors will be obsolete by within 10 to 20 years, yet Britain is locking in prices until 2060.
 
The Alvin Weinberg Foundation in London is tracking seven proposals across the world for molten salt reactors (MSRs) rather than relying on solid uranium fuel. Unlike conventional reactors, these operate at atmospheric pressure. They do not need vast reinforced domes. There is no risk of blowing off the top.
 
The reactors are more efficient. They burn up 30 times as much of the nuclear fuel and can run off spent fuel. The molten salt is inert so that even if there is a leak, it cools and solidifies. The fission process stops automatically in an accident. There can be no chain-reaction, and therefore no possible disaster along the lines of Chernobyl or Fukushima. That at least is the claim.
 
The most revolutionary design is by British scientists at Moltex. "I started this three years ago because I was so shocked that EDF was being paid 9.25p per kWh for electricity," said Ian Scott, the chief inventor. "We believe we can achieve parity with gas (in the UK) at 5.5p, and our real goal is to reach 3.5p and drive coal of out of business," he said.
 
The Moltex project can feed off low-grade spent uranium, cleaning up toxic waste in the process. "There are 120 tonnes of purified plutonium from nuclear weapons in Britain. We could burn that up in 10 to 15 years," he said. What remained would be greatly purified, with a shorter half-life, and could be left safely in salt mines. It does not have to be buried in steel tanks deep underground for 240,000 years. Thereafter the plant could be redesigned to use thorium, a cleaner fuel.
 
The reactor can be built in factories at low cost. It uses tubes that rest in molten salt, working through a convection process rather than by pumping the material around the reactor. This cuts corrosion. There is minimal risk of leaking deadly cesium or iodine for hundreds of miles around.
 
Transatomic Power, in Boston, says it can build a "waste-burning reactor" using molten salts in three years, after regulatory approval. The design is based on models built by US physicist Alvin Weinberg at Oak Ridge National Laboratory in the 1960s, but never pursued - some say because the Pentagon wanted the plutonium residue for nuclear warheads.
 
It would cost $2bn (overnight cost) for a 550-megawatt plant, less than half the Hinkley Point project on a pro-rata basis. Transatomic says it can generate 75 times as much electricity per tonne of uranium as a conventional light-water reactor. The waste would be cut by 95pc, and the worst would be eliminated. It operates in a sub-critical state. If the system overheats, a plug melts at the bottom and salts drain into a cooling basin. Again, these are the claims.
 
The most advanced project is another Oak Ridge variant designed by Terrestrial's David LeBlanc, who worked on the original models with Weinberg. It aims to produce power by the early 2020s from small molten salt reactors of up to 300MW, for remote regions and industrial plants. "We think we can take on fossil fuel power on a pure commercial basis. This is a revolution for global energy," said Simon Irish, the company's chief executive.
 
Toronto-based Terrestrial prefers the "dry tinder" of uranium rather than the "wet wood" of thorium, which needs a blowtorch to get started and keep going, typically plutonium 239. But it could use either fuel.
 
A global race is under way, with the Chinese trying everything at the Shanghai Institute of Nuclear and Applied Physics, reportedly working under “warlike” pressure. They have brought forward their target date for a fully-functioning molten salt reactor - using thorium - from 25 to 10 years.
 
Ian Scott, at Moltex, originally planned to sell his technology to China, having given up on the West as a lost cause. He was persuaded to stay in Britain, and is talking to ministers. "The first stage will cost around £1bn, to get through the regulatory process and build a prototype. Realistically, only the government can do this," he said.
 
A state-venture of such a kind should not be ruled out. The travails of Hinkley Point show that the market cannot or will not deliver nuclear power on tolerable terms. The project has degenerated into a bung for ailing foreign companies. We have had to go along with it as an insurance, because years of drift in energy policy have left us at an acute risk of black-outs in the 2020s.
 
There is no reason why Britain cannot seize the prize of molten salt reactors, if necessary funded entirely by the government - now able to borrow for 10 years at 2.5pc - and run like a military undertaking. A new Brabazon Committee might not go amiss.
 
The nation still has world-class physicists. The death of Britain's own nuclear industry has a silver lining: there are fewer vested interests in the way. We start from scratch. The UK's "principles-based" philosophy of regulation means that a sudden pivot in technology of this kind could be approved very fast, in contrast to the America's "rules-based" system. "I would never even think of doing it in the US," said Dr Scott.
 
It would be hard to argue that any one of the molten salt technologies would be more expensive than arrays of wind turbines in the Atlantic. Indeed, there is a high likelihood that the best will prove massively cheaply on a kW/hour basis.
 
Such a project would kickstart Britain's floundering efforts to rebuild industry. It would offer some hope of plugging a chronic and dangerously high current account deficit, already 5pc of GDP even before North Sea oil and gas fizzles out. It is fracking on steroids for import substitution.
 
Britain split the atom at the Cavendish Laboratory in Cambridge in 1911. It opened the world's first commercial reactor at Calder Hall in 1956. Surely it can rise to the challenge once again. If not, let us cheer on the Chinese.


Death Of 'Safe Haven' Gold Greatly Exaggerated

26 September 2014
       

By Mark O’Byrne


 
With escalating conflict in the Middle East, an unresolved conflict in the Ukraine, and various other geo-political risks on the horizon such as the contagion risk of Ebola, it would be expected that the longstanding 'safe haven' qualities of gold would come into play as they have done in the past. 

In September 2008, during the financial crisis, the gold price rose $50 in one day, September 18, as investors sought refuge in the one asset that they perceived to be a safe-haven of high liquidity and high credit quality. This one day move in September 2008 was the largest one day move since February 1980. 

Back in late 1979 and early 1980, some of the key drivers that propelled the gold price higher were the Russian invasion of Afghanistan and the Iranian hostage crisis.

Just looking back at old newspaper gold market commentaries in 1979 and 1980 will highlight that a lot of the key drivers for the rise in the gold price at that time were geo-politically related.

Today, the world appears to be as uncertain if not more uncertain. Indeed, in 1980 there was little risk of terrorism - state sponsored or otherwise.

In the late 1970s and early 1980s, the gold futures markets did not have nearly as large an impact on the world gold price as they does now, and the gold price was primarily driven by physical demand for gold, a lot of which was Middle Eastern and Asian demand. 

The concept of unallocated gold accounts in the London market was in its infancy and was only being discussed by the five gold fixing bullion banks as a security issue in not having to move gold shipments around London so often. The practice of having unallocated gold not fully backed by allocated gold was not encouraged at that time.



Fast forward to today, and the 'flight to quality' and 'financial insurance' characteristics of gold should in theory be as important now as they were in 1979-1980 given similar invasions and occupations in various countries, not least in the Middle East with ISIS, and the renewed bombing in Syria/Iraq by the US and/or a US coalition. 

Coupled with these worsening geopolitical developments, global macro economic risks remain elevated, with official interest rates at historically low levels, continued central bank balance sheet expansion through quantitative easing programs, and continued fiat currency debasement in the US dollar, Euro and other reserve currencies. 

Inflationary risks therefore remain at the forefront. But at the same time, the gold price barometer is not signalling these inflationary risks either.

The key driver of the gold price at the moment is perceived to be the relative strength of the US dollar, yet the US dollar is only stronger compared to the other main currencies because these currencies, such as the Euro, are weak due to their economies remaining weak and their money supplies having been debased. 




The economic recovery in the US is tentative at best. With the current weakness in the gold price, there is a growing cacophony that the safe haven qualities of gold are no longer relevant. Indeed, some in the financial markets are saying that the current gold bull market is dead. 

It would appear to us that the factors that would make gold a safe-haven asset have not gone away. 

In fact these factors are strengthening, as described above. The only rational explanation appears to be that gold remains an investment safe-haven as it has always done, but that this is not yet being recognised by the price discovery process in the market.

Adding in the fact that there is a continued disconnect between, on the one hand, the global physical gold market primarily driven out of China and India, and on the other hand, the New York gold futures market and unallocated London bullion market on the other hand, then this disconnect should not be expected to persist over the medium term.

This is especially the case given the heightened geopolitical and macroeconomic risks. 
With the gold price not yet signalling the geopolitical and macroeconomic alarm bells that many would have expected it to, the question of gold price manipulation remains a valid question.

Recent gold price manipulation by an investment bank for commercial reasons has been established in the case of the successful prosecution against Barclays by the FCA regulator. 

For strategic reasons, central banks do not welcome a disorderly increase in the gold price because it makes their fiat currencies look vulnerable and adds to inflationary expectations.

It is therefore not unrealistic to think that some of the current gold price weakness may be related to nonpublic gold market interventions by some of the world's central banks such as the Federal Reserve and the ECB, perhaps under the auspices of the Bank for International Settlements (BIS).
 
There is plenty of documentary evidence to suggest that the G10 central banks have historically discussed the gold price during their regular meetings and they also are very cautious on allowing more recent document releases through freedom of information requests. 

For different reasons, the Chinese government welcomes a low gold price since it allows China to continue to accumulate gold in large quantities. Even if this accumulation of gold by China is being done for other reasons, it does act as a way of hedging China's exposure to its vast holdings of US dollar denominated Treasuries. Time will tell if this has been China's strategy.  
  
Most markets these days are being manipulated. Therefore it seems very possibly that the gold and silver markets are too. This could be one of the factors in the precious metals surprisingly poor performance in recent weeks despite significant geopolitical and indeed economic uncertainty.

The Middle East is a powder keg that seems likely to explode. The U.S. and western nations have taken a hard stance against an increasingly powerful Russia. This is effecting an already fragile Eurozone and other economies.

Brinkmanship and a failure of diplomacy has brought the world close to a serious military conflict.

Gold has protected wealth throughout history from financial crises and war. We believe it will continue to do so in the coming years.

It is very likely that tensions will lead to safe haven demand for gold and higher prices. An economic war has broken out between major world powers and the historical record shows that sanctions and protectionism tend to lead to military confrontation and war.

Everybody should own some physical gold as a hedge and a safe haven asset to protect against the significant risks challenging us today which include bail-ins, currency wars, terrorism and war.



The contention therefore is that, for now, the death of safe haven gold has been greatly exaggerated.

Gold is a hedging instrument and a safe haven asset as seen in history and much academic research in recent years. That is not apparent in recent weeks but we believe it will be in the medium and long term.