There are a number of reasons why you as an investor might want to hold gold in your portfolio: it’s a safe haven asset in times of international uncertainty – reaching its peak following the invasion of Afghanistan by the Soviet Union; it’s a traditional hedge against inflation – which explains why the price of bullion firmed with the recent jump in oil prices; and it has a negative correlation with other asset classes – with its value, unlike equities, bonds or cash, not dependent on a promise from any agency.
Companies can go to the wall, borrowers can default on their bonds and currencies are debased as governments lose control of public spending and inflation. All of which pushes up the price of bullion.
So what relevance is this to you in the current investment environment? In the modern world what currency can possibly be under threat? The euro? Surely not.
After all, when the single European currency was launched the project was given an air of permanence – entry into European Monetary Union was described as ‘irrevocable’. This was a marriage made in heaven.
Certainly, back in 1999, no respectable politician had the temerity to question the euro’s longevity. A break up of the euro was simply seen as impossible. But not now.
The marriage made in heaven is heading for a messy divorce
The taboo about criticising the euro has been lifted. In Italy, a country mired in recession, Silvio Berlusconi is carefully cultivating an anti-euro movement designed to embarrass his political opponent Romano Prodi, the man who took Italy into the euro.
At home, Kenneth Clarke, hitherto the staunchest of europhiles, has admitted that “the euro has been a failure”, while in the Netherlands and Germany there is a popular groundswell of opinion against the single currency.
Indeed, the euro is not set in stone as its architects believe. The euro, like any other paper currency, is an illusion. For a currency to work, people must suspend any belief that notes are worthless pieces of paper and have faith that these pieces of paper can be exchanged for valuable goods and services. That belief in turn rests on the faith that the value of paper money will be upheld by a government.
But if the EU is not going to evolve towards a full-scale political union who exactly is going to guarantee the value of the euro? This is not to say that a break up of the euro is imminent – indeed, it is improbable over the next couple of years – but it is not impossible. And investors should recognise this fact.
The European currency dustbin is full of past failures
Although we in the UK have had the same currency for 1,000 years, this is not the experience of those in continental Europe. For instance, in the last 80 years some Germans’ currency has changed on four occasions (from the Rentenmark to the Reichsmark to the Ostmark to the Deutschemark and, finally, to the euro). In fact, during and after the Second World War, almost every continental European country experienced the reform and destruction of their currencies.
Former Nazi-occupied countries from France to Norway implemented overnight currency reforms whereby their grossly inflated wartime currencies were in some cases reduced by a hundred-fold. The governments were able to implement these draconian measures by saying that the new currency arrangements would penalise collaborators, profiteers and tax evaders.
Suffice to say, monetary arrangements have a habit of not lasting in Europe.
Italians are eyeing euro withdrawal already
The most plausible crack in the euro is likely to come from an Italian withdrawal. The combination of recession, mounting unemployment and runaway budget deficits are similar to the pressures that forced the ejection of the lira from the ERM in 1992. If the possibility of Italian withdrawal was ever taken seriously by the markets, foreign holders of Italy’s €1,500 billion public debt would suffer enormous losses, since the Italian government would simply convert its bonds into a devalued ‘new lira’.
Although a break-up of the euro is still improbable in the next couple of years, it is no longer impossible. When countries are faced with serious economic difficulties and the financial markets view the situation as unsustainable, events can move rapidly from impossible to inevitable without touching the sides.
In fact, history is full of examples of monetary arrangements collapsing. The Gold Standard was abandoned before the Second World War, the dollar- based Bretton Woods system collapsed in 1971 and, more recently, sterling was evicted from the ERM.
Protect yourself against euro disaster by holding gold
But what relevance is this to you as you are unlikely to directly hold Italian bonds? Well, as we have pointed out previously, when politicians and the media became more outspoken in blaming the euro for the eurozone’s economic malaise following the French and Dutch referenda on the EU constitution, the price of gold expressed in euro-terms broke through the €350 barrier for the first time ever. It remains above this level now.
You can be sure that as and when the EMU project is subject to mounting criticism, the price of gold will rise further.
Be sure to hold the yellow metal.
By Brian Durrant, Investment Director of The Fleet Street Letter.
Recommended further reading:
You may like to read more about the gold standard, or discover some more reasons why you should buy gold now. A full list of articles on all aspects of the gold market may be found in our section on investing in gold.