LBMA Seminar: Dealers dream or dealers nightmare?

These days, when two European countries agree on anything, it's time to pay attention. When the two countries in question are Germany and Switzerland - and when the agreement concerns fiscal policy - it's time to call in the experts.

Which is just what the LBMA did when, during Platinum Week, it held a seminar focusing on two major issues facing the gold market:

• What will central banks do with their gold reserves?
• What might be the effect on gold if the stock market were to finally undergo a correction?

And, what if central banks should decide to sell, and this action coincided with a stock market collapse? Would it be a dealers dream or a dealers nightmare?

Before introducing the seminar's speakers, outgoing LBMA Chairman Alan Baker put the question s in immediate perspective by offering one of the more succinct market analyses: nothing goes up forever.

It was then left to Ian Lamont, an economist with Yorkton Securities, speaking on the possibility of a long-overdue stock market correction, and Robert Pringle of the World Gold Council, who addressed the question of central bank gold reserves. to sort out what might and might not happen. Mr Pringle, head of the public policy centre of the World Gold Council, point ed out that, while the economic climate for gold was hardly favourable, some of the pessimism overhanging the market regarding central bank gold sales was perhaps overdone. In addressing the overall issue of what central banks might do with their gold reserves in the years to come, he examined the recent events in Switzerland and German y.

In his view, the Swiss National Bank's recent announcement that it was taking a fresh look at how it values its gold reserves should be seen as part of its general review and modernisation of reserve management functions. The conclusion that it came to regarding gold at this stage is that it ought to amend its legislation to enable the lending of a portion of its reserves.

Quite apart from these discussions in all but timing, a proposal was made to fund a Solidarity Fund from a transfer of gold - a crisis response to foreign criticism, and one which drew a storm of internal protest.

Across the border in Germany, Finance Minister Wai gel's proposal that his country should revalue its gold reserves merely parallels moves already taken by most other EU central banks. Of course, that did not save it from attracting much controversy and criticism as well. Developments since then have amply confirmed this, with the Bundesbank declaring its firm opposition to the government's proposal.

Pringle concluded by outlining positive reasons why a central bank would hold gold reserves:

1. Gold provides a means of diversifying portfolios, a factor which will grow in importance if EMU goes ahead, as a monetary union would effectively narrow the choice of reserve assets.

2. It provides long-term value maintenance and a multigenerational time horizon.

3. It is an asset that is not the liability of any other country - another motive that could become more powerfi.il after 1999 when the dollar will stand out even more as a reserve currency.

4. Because gold reserves are so sensitive, it is difficult for anyone political group to use them without being noticed, unlike currency reserves. What the popular opposition against the recent Swiss and German proposals reveals is that at least in these continental countries, the public needs to be convinced that the reasons behind any gold mobilisation are sufficiently serious before it accepts the moves.

Ian Lamont then took the self-professed minority view concerning the stock market - that it was overvalued, and ripe for a correction. Before addressing the question of whether or not gold and/or gold equities would provide a hedge under such a scenario, the first established the reasons why he thought the market was overvalued, and what might be the trigger for a downfall. He pointed to a number of measures trading at historic highs or lows which showed how overinflated the stock market had become. Among them:

• the dividend yield on the Dow Jones Industrial Average, at only 1.7%, is the lowest this century;
• the Dow is selling at almost 550% of its book value;
• the number of mutual funds, of registered stock and bond salesmen, of hedge funds and investment clubs are all at record levels.

What could cause the bubble to break? Lamont looked at the influence of the yen carry trade. Due to low domestic interest rates, money has been flowing out of Japan in search of higher yields elsewhere, principally into the US bond market. This has, until recently, contributed to a weakening yen and a strengthening dollar - and has enabled the US to fund its deficits with lower interest rate s. Lately, however, the dollar has experienced a correction, due possibly to a perception that Japan's economy is recovering and interest rates there may begin to rise. Should the yen carry trade reverse, this would cause money to flow out of the bond market, causing interest rates to rise. Secondly, it would weaken the dollar, causing inflation to rise in a rapidly growing economy.

Lamont then focused his attention on determining if gold or gold shares would provide a good hedge wider that scenario. Gold massively outperformed the Dow during the 1970s, but since 1982, Wall Street has experienced a great bull market and, with one brief exception, has well-outpaced gold. That exception was the 1987 crash, after which time the gold price rose, eventually managing to climb above $500 before year-end.

Bottom line: if the stock market experiences a sharp correction ... due to rising inflation and interest rates ... under that scenario, ·according to Lamont, "gold will provide an effective - and indeed perhaps the only - hedge against a tumbling dollar and stock market." But then, there's an old saying - related by Lamont himself - That God only created economists to make weathermen look good.