President Bush's re-election will advance Washington's unilateralist foreign policy. Spreading US military intervention in the Middle East and Asia ensures the fiscal deficit will continue to increase. Advancing oil prices will fuel higher inflation, weaker economic growth and a larger current account deficit. When combined, these factors will cause a sharp depreciation of the dollar, pushing the price of gold higher next year.
US Foreign Policy to Raise Global Geopolitical Risk
Since the Bush administration's war on terrorism began in late 2001, new extremist-centred conflicts have erupted in the Middle East, Africa and Asia while existing conflicts in these regions have all intensified. In addition, the scale, frequency and geographical dispersion of terrorist strikes have increased. Heightened global geopolitical risk, which has arisen from these conflicts and terrorist strikes, is rooted in the war on terrorism and the unilateralist US foreign policy inherent to this war.
The rightward shift of the US electorate is the most salient feature of the electoral victory of President Bush and his Republican party. The Bush administration is expected to use this shift as the foundation for expanding US unilateralism. Vice-President Dick Cheney made this all but explicit in his short victory speech stating: "This has been a consequential presidency which has revitalized our economy, and reasserted a confident American role in the world. Yet, in the election of 2004, we did more than campaign on a record. President Bush ran forthrightly on a clear agenda for this nation's future, and the nation responded by giving him a mandate."
Expanding unilateralism suggests that US policies that led to the invasion of Iraq and disengagement from the Arab-Israeli conflict will be deepened and extended. The probability of US military action against Iran and Syria will increase. Meanwhile the conflicts in Iraq, Israel and the Palestinian territories are likely to become much more violent.
In addition to escalating violence in the Middle East, expanding US unilateralism will inflame existing conflicts in Asia. The probability of confrontation between the US and North Korea will increase while extremist-centred violence in Thailand, the Philippines and Indonesia will intensify. Finally, terrorist strikes worldwide can be expected to become more frequent and violent, while the US becomes further isolated from other countries.
Impact on Oil Prices
By creating new conflicts and escalating existing conflicts worldwide, the war on terrorism has strongly undermined oil production and the growth of global oil supply. Deteriorating security in many oil-producing countries has prevented investment in new production despite very high oil prices. It has also contributed to declining production from existing sources. More significantly, countries with excess capacity such as Venezuela, or the potential to increase capacity such as Russia, are purposefully constraining oil supply.
Another term for President Bush and the escalation of the war on terrorism will make investment in new oil supplies and production even more difficult as security deteriorates further in oil-producing countries. Those countries keeping potential new oil supplies off the market will continue to do so as a means of influencing US foreign policy. The probability of international oil prices approaching $100 per barrel next year is high.
Impact on the US Economy
Rising international oil prices will push global inflation higher. In the US, and other countries, rising energy prices have yet to fully feed through the production and distribution systems. In the hope that higher energy costs prove temporary, producers and distributors have withheld price increases. As high energy costs become entrenched and increase further, broad price hikes will follow. Rapidly declining prices for technology goods and automobiles will no longer offset these broad price increases.
Rising energy costs and increasing inflation will slow US economic growth. Though the Federal Reserve may limit the rise in official interest rates, market-driven interest rates are likely to adjust to higher inflation rather quickly. Long-term interest rates could increase by as much as 250 basis points next year, slowing private consumption and investment. Increasing government expenditure will partially offset weaker private demand.
Expansion of the war on terrorism will push military and homeland security expenditure much higher while slowing economic growth, and further tax cuts will force budgetary receipts lower. As a result the US general government deficit, which includes both federal and state deficits, will remain well above 6% of GDP. Simultaneously, the growing cost of oil imports and slowing external demand will keep the US current account deficit around 5% of GDP.
Impact on the Dollar
The massive twin deficits in the US did not undermine the dollar in 2004. Nor did the jump in international oil prices and energy costs. However, in the weeks prior to the general election, the dollar began to slide. The dollar continued to weaken after it became clear that President Bush had won re-election, despite significant advances made by US equities.
The risk of substantial dollar depreciation in 2005 is high. Foreign investors, who hold very large dollar assets, may have been waiting on the outcome of the US election before making any changes to their portfolios. The substantially different foreign policy approaches between President Bush and Senator Kerry, and their implications for the US economy, support this notion as does recent dollar weakness. With the road now clear for an expansion of unilateralism, the probability of mass exit from US assets by foreign investors is increasing.
Impact on Gold
As the dollar has weakened, the price of gold has increased. The reverse correlation between the value of the dollar and the price of gold has historically been quite strong. A weaker dollar implies a higher gold price. In the last few months, the correlation between the price of oil and the price of gold has also been very strong. Continued advances in the price of oil also imply a higher gold price. Finally, the balance of supply and demand for gold also appears favourable for a higher gold price.
The strong appreciation of the rand against the dollar this year has led to a jump in the cost of gold production in South Africa, the world's largest gold producer. Much higher production costs have reduced investment in new production, limiting potential new supply. A similar situation occurred this year in Australia, the world's second largest gold producer. Continued dollar weakness is expected to strongly impede production increases in both South Africa and Australia next year.
Against flat to declining gold production, global demand for gold is very likely to increase next year. Speculative purchases of gold by investors will be supported by the weak outlook for the dollar and strong outlook for oil prices. In addition, central banks, particularly in Asia, could become large buyers of gold should the dollar depreciate precipitously. Asian central banks, which hold enormous dollar reserves, have only very small gold positions. Dollar weakness could encourage these banks to diversify into gold. The stage is set for the price of gold to surge higher in 2005. By early 2006, the price of gold could easily be above $700 per ounce.
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