Last week’s horrible bombing in Spain proved one thing ¯ that the specter of global terrorism has not been removed. No doubt terrorism will remain on the front burner both politically and militarily for the foreseeable future which augurs poorly for government budgets. It is increasingly likely that with the current economic weakness in the West, that governments will ask their citizens to shoulder the costs of fighting the global war on terror and budget deficits will likely soar. Although the bombing was terrible and brought the war to continental Europe, the price of gold barely budged as this crisis unfolded. Equity markets, however, went for a nosedive when the news broke. Currently, gold pricing is struggling under the weight of a short-term correction in the US dollar. But rest assured that gold should go higher in the years to come.

But why will gold prices increase? The reasons are varied but one important reason is the current trend to reflation that we are witnessing in the US. Reflation is a policy response to deflation and is intended to stop prices from falling, including low/negative interest rates and government spending (budget deficits). Today, the combination of US government debt, household debt and corporate debt stands at 200% of GDP ¯ a level that hasn’t been experienced since the great depression. These reflationary conditions are very favorable for the long-term price of gold as investors flee intangible assets such as stocks and bonds and buy up gold ¯ a tangible asset and former currency.

Additionally, the weak US dollar should also benefit long-term gold prices. It is highly likely that the US economy will start to slow again in the second half of 2004 and early 2005, which will be negative for the stock market but will lend further support to the price of gold. The US administration has made it very clear that they would like the dollar to decline, particularly against the Asian currencies. The last time the US dollar experienced a significant decline was in the 1985-87 time period when the US current account deficit exceeded 3% of GDP. Today the current account deficit stands at 5% of GDP.

Lastly, there is the issue of massive government deficits. With the government beginning to pile up huge debts and the war on terror showing no end in sight, the prospect of this continuing is heightened. Additionally, the aging population of the west and the huge responsibilities for the caring elderly make the prospect of a reversal of government indebtedness unlikely. In countries such as Germany (which has an older population than the US) the situation is more acute. In 2002, the ratio of government assets to liabilities (gross liabilities minus government assets) stood at 50% of GDP. By 2030, this ratio is expected to soar to 216% of GDP. Faced with soaring government expenditures and increasing deficits, Western governments can follow one of two possible paths. They can transfer the problem to the household sector which will result in less disposable income for consumption and weaker economic performance, or they can print more money. In either case, gold should do well.

Our forecast for gold for the coming year is for the metal to close in around $430 an ounce by year-end with a 35% probability of an average price of $470 for the year. If you haven’t considered gold as a potential investment before, now might be the time to take a look. Given an uncertain economic backdrop, gold is poised to perform well and should help defend some of the value of your portfolio.