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OPINION

Golden game changers

Golden game changers
November 14, 2014
Golden game changers

 

Switzerland may only have a population of 8m, but when its people vote in a referendum on 30 November, the outcome will be felt across the globe. That's because under Swiss democratic law any proposal for a change in law that gains 100,000 signatures must be put to a public vote, a fact that the rightwing ultra-conservative, eurosceptic and nationalist Swiss People's Party (SVP) have taken advantage of by rallying support for a material change in the monetary policy pursued by the Swiss National Bank (SNB). To understand why, it's worth considering how the central bank has changed its monetary policy to counter the effects of the eurozone crisis in recent years.

For the past three years, the central bank has maintained a cap against the euro at one Swiss franc to €1.20, after an exodus from the single currency sent the safe haven Swiss franc soaring during the eurozone debt crisis in 2011. This currency appreciation threatened to derail the country's economic growth and risked sending it into price deflation. So to maintain the currency cap the SNB has been intervening in the foreign exchange markets, so much so that the country is now the world's largest holder of euros and its foreign currency reserves have ballooned from CHF207bn to CHF470bn (£307bn).

 

Growing resistance to monetary policy

However, there is growing resistance to this monetary policy in some quarters, and for a number of valid reasons. Firstly, it has created a real estate bubble as investors exploited the ultra cheap borrowing rates on offer. It is also seen as a one-way bet for wealthy investors, no matter the consequences, as through the currency peg the SNB has tied its monetary policy to that of a beleaguered eurozone where interest rates have been slashed to record lows, and are likely to remain there for years to come. Secondly, the policy of a weak Swiss franc has benefited banks and exporters, but at the expense of Swiss households and the less well off who have seen their living costs rise due to the effects of a weaker franc.

For example, the country imports a high percentage of its food, and from its neighbours in particular, so households would benefit from lower food costs if the currency were allowed to appreciate without the central bank's intervention. Also, the housing bubble has led to higher rents and has punished lower income families unable to own their own homes. The flipside is that high earners and the wealthy, and those who have benefited from substantial increases in wealth from their holdings of Swiss property and equities, will be in favour of a weaker currency.

But it is a backlash against the central bank's handling of its gold reserves, in part a consequence of maintaining the Swiss franc-euro currency peg, that is really the issue here. In fact, Switzerland's reserves of gold have shrunk to their lowest level (as a proportion of the total reserves held by the SNB) since the International Monetary Fund (IMF) started collecting data in 1948. The SVP argues that the best way of preserving national wealth is to boost the country's gold reserves and reverse a policy that resulted in 1,550 tonnes of the country's holding of 2,590 tonnes of the yellow metal being sold off between 2000 and 2008. Switzerland currently owns 1,040 tonnes of gold worth CHF39bn, or only 8 per cent of the SNB's foreign currency reserves.

 

SNB foreign currency reserves (CHFm)

 

Prior to 1997, the Swiss franc had to be backed 40 per cent by gold holdings and was subsequently reduced to a 25 per cent backing as a precursor to the demonetisation of gold. In April 2000, the link between the Swiss franc and gold was severed entirely when the Swiss parliament passed a new Federal law and opened the flood gates for the aforementioned gold sales.

 

Save our Swiss gold

In their 'Save our Swiss gold' initiative that collected 107,000 signatures by the time it was filed with the Federal Chancellery in March 2013 - or 2 per cent of the total electorate of 5.22m Swiss voters - the SVP makes the case that post the global financial crisis both the European Central Bank and US Federal Reserve intentionally pursued policies intended to devalue their currencies by expanding their balance sheets aggressively and in a short time frame too. In turn, this impacted the relative strength of the Swiss franc against these major currencies, and put pressure on the Swiss franc to devalue.

So the argument goes that by holding a certain percentage of reserves in gold - as the country had prior to 1997 - this would allow the Swiss franc to act as a strong, gold-backed currency, and constrain its devaluation. In addition, SVP has always maintained that Switzerland's gold should be considered to be the "property of the Swiss people", so the SNB and politicians had no right to sell it in the first place.

And it's worth taking the SVP seriously. The party not only has a strong power base in Zurich, but at the 2011 Swiss Federal elections it was by far the most popular political party in the country, boasting over 26 per cent of the votes cast. Moreover, it has one of the seven elected representatives on Switzerland's seven member governing Federal Council, controls 54 of the 200 seats in the Federal Assembly (lower house of representatives) and has five of the 46 seats in the Council of States (upper house).

 

A game-changing proposal

In the forthcoming referendum, SVP's proposal is that the SNB should be made to hold at least 20 per cent of its assets in gold, up from less than 8 per cent at present, repatriate all Swiss-owned gold back to Switzerland and be banned from making any gold sales whatsoever.

To put this initiative into some perspective, the central bank currently has reserves and foreign currency assets of CHF508bn (£332bn), of which gold accounts for only CHF39bn (£25.5bn). However, if the SVP's proposal succeeds, then this would mean the SNB will have to buy an additional $65.5bn of gold, or the equivalent of 56m ounces of the yellow metal. At current prices that is almost equal to all the global holdings of physically backed exchange-traded products, according to analysts at Barclays Capital. It would also represent a seismic shift in central bank buying activity in the gold market since the SNB would need to buy 300 tonnes of gold a year for the next five years to raise its asset allocation of gold to 20 per cent of its total reserves.

Or put it another way, global central bank purchases of gold totalled only $4.8bn in the second quarter this year, according to data from The World Gold Council, and the five-year average is $4bn a quarter - so even if no other central bank purchased gold then demand from the SNB alone would be the equivalent of the total amount of central bank gold purchases made since 2010!

Put like that, if the Swiss people vote in favour of the SVP's proposals this would put a rocket up the gold price. And although only 10 of the 66 referendums raised in Switzerland since 2000 have been voted through, it's an incredibly tight call on this one. That's because an opinion poll at the end of last month, and the most reliable one to date, indicated that 45 per cent of those polled intended to vote in favour of the proposal and only 38 per cent against it.

A much-needed boost to the gold price aside - the yellow metal has slumped 39 per cent since hitting a record high of $1,920 an ounce in September 2011 - expect there to be massive ramifications in the currency markets too if the Yes campaign wins the day.

 

Currency market watch

Having fallen to parity with the Swiss franc at one stage in June 2011, a record low for the euro, the cross rate has held in a tight band for the past three years. But at the current rate of one Swiss franc to Euro1:203, the beleaguered single currency is now at its lowest level since November 2012 and testing the SNB's self-imposed currency ceiling once again.

The clear implication of a Yes vote in a fortnight's time is that, with 20 per cent of its assets bound to the gold price, the Swiss franc will return to being a quasi gold-correlated currency, as was the case before the country became a member of the IMF in 1992. In order to raise the SNB's gold holdings to 20 per cent of its total reserves, the SNB will have to: (a) sell down more than half its fiat money reserves or; (b) more than double its gold holdings or; (c) do a combination of both.

However, it's highly unlikely that the SNB would use Swiss francs to buy gold as it would mean that the central bank would have to run the printing presses to create the currency to fund its gold purchases, thus leading to a further unwanted expansion of its balance sheet. And since gold reserves would always have to equate to at least 20 per cent of its total assets, the net effect of printing new money is that the SNB would then have to buy even more gold than originally planned due to having a much larger balance sheet.

The alternative scenario is that the SNB would be forced to sell some of its vast foreign currency holdings - primarily euros - to buy gold. This undoubtedly would put severe pressure on the Swiss franc euro peg rate by weakening the euro every time the SNB dumped the single currency to fund its gold purchases. Either way, you would expect the Swiss franc to rise.

Of course there are strong arguments against hiking the country's gold reserves, the primary one being that it will restrict the ability of the SNB to manage its vast reserves. Indeed, a total ban on gold sales will mean that the SNB will have no choice but to purchase gold every time its balance sheet expands and to sell the single currency every time it contracts.

Furthermore, even though the SNB has not intervened in the currency markets since 2012, if the 20 per cent gold price ceiling had been in force back then the central bank would have been forced to acquire both euros and gold simultaneously, which would have undermined investor confidence that the currency ceiling would be maintained. Add to that the far greater volatility in the gold price, and it's difficult to see how the SNB will be able to maintain the currency cap and raise its allocation of gold at the same time.

 

Spot gold versus EUR CHF rate

 

Ultimately, the people of Switzerland will decide on their own fate, but a yes vote will have major implications way beyond the few million casting their vote. And that's something well worth being prepared for.

 

The oily truth

As anyone filling up their car in the past few months will know, the oil price has been falling, albeit at a much faster rate than the price at the pumps. In fact, both the one-month forward Brent Crude and West Texas Intermediate (WTI) benchmark contracts have fallen by around 28 per cent since mid-June.

Bearing this in mind, the Organization of the Petroleum Exporting Countries (Opec) meets on 27 November in Vienna. With WTI trading at $78 a barrel - the lowest level for over five years - the price is perilously close to the $75 level where Saudi Arabia slips into fiscal deficit, a "social stability line that the country's royal family will be eager not to cross", according to economist Dave Rosenberg at Gluskin Sheff, one of Canada's pre-eminent wealth management firms. That's something worth considering because the last down leg in the oil price has "largely been fuelled by Saudi driving up output and cutting prices to recapture share, evoking memories of when the kingdom was a swing producer in the 1980s and 1990s". Interestingly, Mr Rosenberg adds that there is talk on the other side of the Atlantic of production cuts in North America too, so supply is likely to respond to the new lower price environment which in turn could create a floor under the price.

Needless to say, I will be keenly watching how events unfold in Europe, not withstanding the fact that a rebound in the oil and gold price could set a more favourable backdrop for one of my favourite trades of the year: the Santa Claus rally. But that's an investment column for another week.

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'