Michael Howell | Why Monetary Inflation will Drive Gold Higher
In this interview, Michael Howell from Cross Border Capital suggests that the Fed will be forced to step in to fund US federal government deficits.
Deficits will rise for two reasons:
- An ageing population means greater spending on Medicare, Medicaid and social security.
- Defense spending rising to 5.0% of GDP.
Japan and China are no longer buying Treasuries and the private sector doesn’t have the capacity. The Fed will have to step in.
In Howell’s words: “THERE IS NO OTHER WAY OUT”.
Conclusion
Gold is a great hedge against expected monetary inflation.
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Investing in Real Estate
In Monday’s update, we compared investing in stocks to investing in financial securities and concluded that stocks offer better long-term performance. Today, we use long-term data series for US and Australian real estate to evaluate their comparative performance.
US real estate data was sourced from Prof Robert Shiller, who created the Case-Shiller Index series. The chart below shows that US home prices from 1933 to 2023, a period of ninety years, appreciated to 69.5 times their original value.
Adjusting for inflation, we get real appreciation of 2.9 times.
Again, CPI seems to understate inflation. Comparing the home price index to Gold, rather than CPI, provides a more accurate measure of appreciation in real terms. Gold appreciated 94.5 times over the same period, so the home price index actually lost value.
Calculation: 69.5/94.5 = 0.735 (i.e. a 26.5% loss of value)
Comparing data sources
A second source of home price data compares median prices, based on sales of existing homes, from 1953 to 2023. That shows growth of 22 times over the past seventy years, which is close to the Home Price Index appreciation of 21.25 over the same period.
Australia
Australian housing data is harder to come by but we found an excellent source of long-term median house price data in the 2007 UNSW thesis of Dr Nigel David Stapledon. Using data from within the thesis, we were able to adjust nominal house prices to reflect constant quality (house values with no improvements) below.
Australian house prices appreciated 191.4 times between 1933 and 2006.
Unfortunately the data ends there, so we had to calculate a weighted average of median houses for 2007 to the present.
CoreLogic kindly provided us with values for their hedonic Home Value Index (for 5 Capital Cities) which also adjusts for quality:
Property Type 31/01/2007 31/07/2023 Houses $399,182 $891,747
The gain of 2.23 is slightly higher than the 2.14 calculated from weighted average data for the 8 capital cities provided by the ABS.
We opted for the higher figure from CoreLogic as likely to be more in line with the earlier Stapledon data. That gives a total nominal gain, adjusted for quality, of 426.8 for the ninety years from 1933 to 2023.
The price of Gold fines was fixed at £6-3/9 per troy ounce fine according to the Sydney Morning Herald on 2 January 1933, that converts to 12.375 Australian Dollars. Total gain for Gold in Australian Dollars over the past ninety years is therefore 232.9 times (A$2881.90/12.375).
We calculate the real gain for Australian house prices as 1.83 times over the past ninety years (426.8/232.9).
Conclusion
The US Home Price Index lost 26.5% in real terms, over the past ninety years (1933 – 2023), when compared to Gold.
The S&P 500 appreciated 6.8 times over the past ninety years when measured against Gold, and 9.7 times compared to US real estate (Home Price Index).
Using Gold as the benchmark, we conclude that Australian real estate prices appreciated faster than US real estate over the past ninety years, growing 1.83 times in real terms, whereas the US depreciated to 0.735 of its original real value.
We suspect the difference is largely due to the substantial fall in US real estate values after the 2008 sub-prime crisis, whereas Australian home prices continued to grow. We expect that performance of the two will converge in the long-term.
Lastly, when measured against Gold, US stocks outperformed Australian real estate. The S&P 500 grew 3.7 times against Australian home prices, in real terms, over the past ninety years.
This does not mean that we should ignore real estate as an investment medium. But a portfolio concentrated in real estate, without diversification into stocks and precious metals, could underperform in the long-term.
Acknowledgements
- Robert Shiller at Yale for Home Price Index data.
- DQYDJ for median home prices.
- Nigel David Stapledon, UNSW: Long term housing prices in Australia and some economic perspectives.
- CoreLogic Home Value Index 2007 – 2023.
- ABS Capital Cities House Price Data (Excel Spreadsheet)
Why invest in stocks?
Some clients are understandably nervous about investing in stocks because of the volatility. Invest at the wrong time and you can experience a draw-down that takes years to recover. Many shy away, preferring the security of term deposits or the bricks and mortar of real estate investments.
The best argument for investing in stocks is two of the most enduring long-term trends in finance.
First, the secular down-trend in purchasing power of the Dollar.
Inflation has been eating away at investors’ capital for more than ninety years. Purchasing power of the Dollar declined from 794 in 1933 to 33 today — a loss of almost 96%. That means $24 today can only buy what one Dollar bought in 1933.
The second trend, by no coincidence, is the appreciation of real asset prices over the same time period.
The S&P 500 grew from 7.03 at the start of 1933 to 4546 in June 2023 — 649 times the original investment.
Gold data is only available since 1959. In April 1933, President Franklin Roosevelt signed Executive Order 6102, forbidding “the hoarding of Gold Coin, Gold Bullion, and Gold Certificates” by US citizens. Americans were required to hand in their gold by May 1st in return for compensation at $20.67 per ounce. Since then, Gold has appreciated 94.5 times its 1933 exchange value in Dollar terms.
Over time, investing in real assets has protected investors’ capital from the ravages of inflation, while financial assets have for long periods failed to adequately compensate investors in real terms (after inflation). The chart below compares the yield on Moody’s Aaa corporate bonds to CPI inflation.
Conclusion
Purchasing power of the Dollar depreciated by 24 times over the past ninety years due to inflation. Adjusting for inflation, the S&P 500 has grown to 27 times its original Dollar value in 1933, while Gold gained 3.9 times in real terms.
We would argue that the consumer price index understates inflation. Gold does not grow in value — it is constant in real terms.
If we take Gold as our benchmark of real value, then the S&P 500 has grown 6.8 times in real terms — a far more believable performance.
Stocks are a great hedge against inflation provided the investor can tolerate volatility in their portfolio. How to manage volatility will be the subject of discussion in a further update.
Acknowledgents
- Multpl.com for S&P 500 index price data.
- GoldHub for Gold price data
Economic Outlook, March 2023
Here is a summary of Colin Twiggs’ presentation to investors at Beech Capital on March 30, 2023. The outlook covers seven themes:
- Elevated risk
- Bank contagion
- Underlying causes of instability
- Interest rates & inflation
- The impact on stocks
- Flight to safety
- Australian perspective
1. Elevated Risk
We focus on three key indicators that warn of elevated risk in financial markets:
Inverted Yield Curve
The chart below plots the difference between 10-year Treasury yields and 3-month T-Bills. The line is mostly positive as 10-year investments are normally expected to pay a higher rate of investment than 3-month bills. Whenever the spread inverted, however, in the last sixty years — normally due to the Fed tightening monetary policy — the NBER has declared a recession within 12 to 18 months1.
The current value of -1.25% is the strongest inversion in more than forty years — since 1981. This squeezes bank net interest margins and is likely to cause a credit contraction as banks avoid risk wherever possible.
Stock Market Volatility
We find the VIX (CBOE Short-term Implied Volatility on the S&P 500) an unreliable measure of stock market risk and developed our own measure of volatility. Whenever 21-day Twiggs Volatility forms troughs above 1.0% (red arrows below) on the S&P 500, that signals elevated risk.
The only time that we have previously seen repeated troughs above 1.0% was in the lead-up to the global financial crisis in 2007-2008.
Bond Market Volatility
The bond market has a far better track record of anticipating recessions than the stock market. The MOVE index below measures short-term volatility in the Treasury market. Readings above 150 indicate instability and in the past have coincided with crises like the collapse of Long Term Capital Management (LTCM) in 1998, Enron in 2001, Bear Stearns and Lehman in 2008, and the 2020 pandemic. In the past week, the MOVE exceeded 180, its highest reading since the 2008-2009 financial crisis.
2. Bank Contagion
Regional banks in the US had to be rescued by the Fed after a run on Silicon Valley Bank. Depositors attempted to withdraw $129 billion — more than 80% of the bank’s deposits — in the space of two days. There are no longer queues of customers outside a bank, waiting for hours to withdraw their deposits. Nowadays online transfers are a lot faster and can bring down a bank in a single day.
The S&P Composite 1500 Regional Banks Index ($XPBC) plunged to 90 and continues to test support at that level.
Bank borrowings from the Fed and FHLB spiked to $475 billion in a week.
Financial markets are likely to remain unsettled for months to come.
European Banks
European banks are not immune to the contagion, with a large number of banking stocks falling dramatically.
Credit Suisse (CS) was the obvious dead-man-walking, after reporting a loss of CHF 7.3 billion in February 2023, but Deutsche Bank (DB) and others also have a checkered history.
3. Underlying Causes of Instability
The root cause of financial instability is cheap debt. Whenever central banks suppress interest rates below the rate of inflation, the resulting negative real interest rates fuel financial instability.
The chart below plots the Fed funds rate adjusted for inflation (using the Fed’s preferred measure of core PCE), with negative real interest rates highlighted in red.
Unproductive Investment
Negative real interest rates cause misallocation of capital into unproductive investments — intended to profit from inflation rather than generate income streams. The best example of an unproductive investment is gold: it may rise in value due to inflation but generates no income. The same is true of art and other collectibles which generate no income and may in fact incur costs to insure or protect them.
Residential real estate is also widely used as a hedge against inflation. While it may generate some income in the form of net rents, the returns are normally negligible when compared to capital appreciation.
Productive investments, by contrast, normally generate both profits and wages which contribute to GDP. If an investor builds a new plant or buys capital equipment, GDP is enhanced not only by the profits made but also by the wages of everyone employed to operate the plant/equipment. Capital investment also has a multiplier effect. Supplies required to operate the plant, or transport required to distribute the output, are both likely to generate further investment and jobs in other parts of the supply chain.
Cheap debt allows unproductive investment to crowd out productive investment, causing GDP growth to slow. These periods of low growth and high inflation are commonly referred to as stagflation.
Debt-to-GDP
The chart below shows the impact of unproductive investment, with private sector debt growing at a faster rate than GDP (income), almost doubling since 1980. This should be a stable relationship (i.e. a horizontal line) with GDP growing as fast as, if not faster than, debt.
Even more concerning is federal debt. There are two flat sections in the above chart — from 1990 to 2000 and from 2010 to 2020 — when the relationship between private debt and income stabilized after a major recession. That is when government debt spiked upwards.
When the private sector stops borrowing, the government steps in — borrowing and spending in their place — to create a soft landing. Some call this stimulus but we consider it a disaster when unproductive spending drives up the ratio of government debt relative to GDP.
Research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggests that states where sovereign debt exceeds 100% of GDP (1.0 on the above chart) almost inevitably default. A study by Cristina Checherita and Philip Rother at the ECB posited an even lower sustainable level, of 70% to 80%, above which highly-indebted economies would run into difficulties.
Rising Inflation
Inflationary pressures grow when government deficits are funded from sources outside the private sector. There is no increase in overall spending if the private sector defers spending in order to invest in government bonds. But the situation changes if government deficits are funded by the central bank or external sources.
The chart below shows how the Fed’s balance sheet has expanded over the past two decades, reaching $8.6 trillion at the end of 2022, most of which is invested in Treasuries or mortgage-backed securities (MBS).
Foreign investment in Treasuries also ballooned to $7.3 trillion.
That is just the tip of the iceberg. The US has transformed from the world’s largest creditor (after WWII) to the world’s largest debtor, with a net international investment position of -$16.7 trillion.
4. Interest Rates & Inflation
To keep inflation under control, central bank practice suggests that the Fed should maintain a policy rate at least 1.0% to 2.0% above the rate of inflation. The consequences of failure to do so are best illustrated by the path of inflation under Fed Chairman Arthur Burns in the 1970s. Successive stronger waves of inflation followed after the Fed failed to maintain a positive real funds rate (green circle) on the chart below.
CPI reached almost 15.0% and the Fed under Paul Volcker was forced to hike the funds rate to almost 20.0% to tame inflation.
Possible Outcomes
The Fed was late in hiking interest rates in 2022, sticking to its transitory narrative while inflation surged. CPI is now declining but we are likely to face repeated waves of inflation — as in the 1970s — unless the Fed keeps rates higher for longer.
There are two possible outcomes:
A. Interest Rate Suppression
The Fed caves to political pressure and cuts interest rates. This reduces debt servicing costs for the federal government but negative real interest rates fuel further inflation. Asset prices are likely to rise as are wage demands and consumer prices.
B. Higher for Longer
The Fed withstands political pressure and keeps interest rates higher for longer. This increases debt servicing costs and adds to government deficits. The inevitable recession and accompanying credit contraction cause a sharp fall in asset asset prices — both stocks and real estate — and rising unemployment. Inflation would be expected to fall and wages growth slow. The eventual positive outcome would be more productive investment and real GDP growth.
5. The Impact on Stocks
Stocks have been distorted by low interest rates and QE.
Stock Market Capitalization-to-GDP
Warren Buffett’s favorite indicator of stock market value compares total market capitalization to GDP. Buffett maintains that a value of 1.0 reflects fair value — less than half the current multiple of 2.1 (Q4, 2022).
Price-to-Sales
The S&P 500 demonstrates a more stable relationship against sales than against earnings because this excludes volatile profit margins. Price-to-Sales has climbed to a 31% premium over 20-year average of 1.68.
6. Flight to Safety
Elevated risk is expected to cause a flight to safety in financial markets.
Cash & Treasuries
The most obvious safe haven is cash and term deposits but recent bank contagion has sparked a run on uninsured bank deposits, in favor of short-term Treasuries and money market funds.
Gold
Gold enjoyed a strong rally in recent weeks, testing resistance at $2,000 per ounce. Breakout above $2,050 would offer a target of $2,400.
A surge in central bank gold purchases — to a quarterly rate of more than 400 tonnes — is boosting demand for gold. Buying is expected to continue due to concerns over inflation and geopolitical implications of blocked Russian foreign exchange reserves.
Defensive sectors
Defensive sectors normally include Staples, Health Care, and Utilities. But recent performance on the S&P 500 shows operating margins for Utilities and Health Care are being squeezed. Industrials have held up well, and Staples are improving, but Energy and Financials are likely to disappoint in Q1 of 2023.
Commodities
Commodities show potential because of massive under-investment in Energy and Battery Metals over the past decade. But first we have to negotiate a possible global recession that would be likely to hurt demand.
7. Australian Perspective
Our outlook for Australia is similar to the US, with negative real interest rates and financial markets awash with liquidity.
Team “Transitory”
The RBA is still living in “transitory” land. The chart below compares the RBA cash rate (blue) to trimmed mean inflation (brown) — the RBA’s preferred measure of long-term inflationary pressures. You can seen in 2007/8 that the cash rate peaked at 7.3% compared to the trimmed mean at 4.8% — a positive real interest rate of 2.5%. But since 2013, the real rate was close to zero before falling sharply negative in 2019. The current real rate is -3.3%, based on the current cash rate and the last trimmed mean reading in December.
Private Credit
Unproductive investment caused a huge spike in private credit relative to GDP in the ’80s and ’90s. This should be a stable ratio — a horizontal line rather than a steep slope.
Government Debt
Private credit to GDP (above) stabilized after the 2008 global financial crisis but was replaced by a sharp surge in government debt — to create a soft landing. Money spent was again mostly unproductive, with debt growing at a much faster rate than income.
Liquidity
Money supply (M3) again should reflect a stable (horizontal) relationship, especially at low interest rates. Instead M3 has grown much faster than GDP, signaling that financial markets are awash with liquidity. This makes the task of containing long-term inflation much more difficult unless there is a prolonged recession.
Conclusion
We have shown that risk in financial markets is elevated and the recent bank contagion is likely to leave markets unsettled. Long-term causes of financial instability are cheap debt and unproductive investment, resulting in low GDP growth.
Failure to address rising inflation promptly, with positive real interest rates, is likely to cause recurring waves of inflation. There are only two ways for the Fed and RBA to address this:
High Road
The high road requires holding rates higher for longer, maintaining positive real interest rates for an extended period. Investors are likely to suffer from a resulting credit contraction, with both stocks and real estate falling, but the end result would be restoration of real GDP growth.
Low Road
The low road is more seductive as it involves lower interest rates and erosion of government debt (by rapid growth of GDP in nominal terms). But resulting high inflation is likely to deliver an extended period of low real GDP growth and repeated cycles of higher interest rates as the central bank struggles to contain inflation.
Overpriced assets
Vulnerable asset classes include:
- Growth stocks, trading at high earnings multiples
- Commercial real estate (especially offices) purchased on low yields
- Banks, insurers and pension funds heavily invested in fixed income
- Sectors that make excessive use of leverage to boost returns:
- Private equity
- REITs (some, not all)
Relative Safety
- Cash (insured deposits only)
- Short-term Treasuries
- Gold
- Defensive sectors, especially Staples
- Commodities are more cyclical but there are long-term opportunities in:
- Energy
- Battery metals
Notes
- The Dow fell 25% in 1966 after the yield curve inverted. The NBER declared a recession but later changed their mind and airbrushed it from their records.
Questions
1. Which is the most likely path for the Fed and RBA to follow: the High Road or the Low Road?
Answer: As Churchill once said: “You can always depend on the Americans to do the right thing. But only after they have tried everything else.” With rising inflation, the Fed is running out of options but they may still be tempted to kick the can down the road one last time. It seems like a 50/50 probability at present.
2. Comment on RBA housing?
We make no predictions but the rising ratio of housing assets to disposable income is cause for concern.
3. Is Warren Buffett’s indicator still valid with rising offshore earnings of multinational corporations?
Answer: We plotted stock market capitalization against both GDP and GNP (which includes foreign earnings of US multinationals) and the differences are negligible.
Current turmoil and its impact on Gold
Michael Every from Rabobank is bearish on Gold in his recent video:
“I can’t see the case for Gold while the Fed is hiking — you don’t get a correlation with the Fed hiking aggressively and Gold going up…..If you want to buy into the Gold argument you are buying into the end of the US system. You are implicitly backing a New World Order and Commodity-backed currencies.”
Several readers have written, asking if this changes our view on Gold.
The short answer is NO, for three reasons:
1. The Fed can only hike rates until something breaks
Michael qualifies his view: he is bearish on Gold while the Fed hikes interest rates.
The Fed is expected to tighten — but only until something breaks. Not stocks, which they are unlikely to support, but the bond market. Credit is the lifeblood of the economy. When it stops flowing, the Fed is forced to inject liquidity into financial markets to maintain the flow.
Bank credit still grows at a healthy rate.
The ratio of Copper/Gold (orange below), however, is a good indication of the economic cycle. When the economy is growing — and long-term interest rates (blue) are increasing — industrial metals, like Copper, rise faster than Gold and the ratio rises. When the economy contracts, the ratio falls.
Copper/Gold going sideways at present warns that the global economy is stalling. It is highly unlikely that the Fed would continue to tighten if the economy starts to contract — which would be signaled by a falling Copper/Gold ratio.
Consumer sentiment (blue, inverted scale below) also gives a recession warning, at levels normally associated with high unemployment (red).
Investment grade corporate bond issuance (green below) is still within its normal range, albeit on the low side, but high yield (light blue) has slowed to near its March 2020 low, warning that we are close to an economic contraction.
A fall of investment grade issuance below $50 billion (the Dec 2020 low) would be cause for concern.
2. A strong Dollar is destroying US industry
The US has been running twin deficits for several decades, supporting the US Dollar as global reserve currency and offering US Treasuries as the global reserve asset.
This has allowed the Financial sector to grow to a point where it dominates the US economy.
Wall Street may be reluctant to relinquish their “exorbitant privilege” of cheap debt but it has come at a huge cost to the US economy.
In order to supply international financial markets with sufficient Dollars, the US has to run large trade deficits. But every foreign exchange transaction has to have a buyer and a seller, so the large outflow of Dollars on current account is balanced by an equal and opposite inflow on the capital account.
The resulting trade imbalance boosts the Dollar exchange rate to the point that US manufacturers find it difficult to compete against foreign manufacturers in export markets and against foreign imports in domestic markets.
The strong Dollar decimated the manufacturing sector which has shed almost 7 million jobs over the past four decades.
The inflow of surplus capital also encourages malinvestment in nonproductive areas — dressed up to look attractive through leverage and artificially low interest rates — as in the sub-prime crisis. The ratio of GDP (output) to private non-financial debt has declined by more than 50% since the 1960s.
Cheap debt also enabled the federal government to run large deficits at low cost, spending more than they raised in taxes and softening the impact of the growing trade imbalance.
The largest portion of capital inflows was invested in Treasuries. As the Current account balance plunged, federal debt held by foreign investors ballooned to almost $8 trillion.
3. US debt above 120% of GDP would destroy the bond market
Overall federal debt climbed to more than 120% of GDP, well above the sustainable level of 70% to 80% of GDP posited by Dr Cristina Checherita and Dr Philip Rother in their ECB study of highly indebted economies.
Earlier research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggested that states where sovereign debt exceeds 100% of GDP almost inevitably default.
That doesn’t mean that the US is about to default but it does mean that the federal government is precariously close to the point of no return, where it can no longer service the interest on its debt and is forced to capitalize it, compounding the problem.
The only viable alternative is inflation. If the borrower suppresses interest rates below the rate of inflation, then GDP is likely to grow faster than the debt. This is already evident on the chart above, where US debt-to-GDP fell in the past 12 months. Federal debt (yellow) increased, but nominal GDP (blue) grew faster because of inflation.
Current turmoil
The global financial system — with a US Dollar reserve currency and US Treasuries as the global reserve asset –appears increasingly fragile as global geopolitical conflict escalates.
China & the Dollar
After China’s admission to the World Trade Organization (WTO), it rapidly accumulated foreign reserves — mostly US Dollars — as it built up its industrial base, reaching $4 trillion by 2014.
China maintained a strict peg against the Dollar until 2014, only allowing it to gradually rise in response to US pressure. But in 2014, a surging Dollar — in response to falling CPI and a shrinking deficit — started to cause problems.
The peg to a strong Dollar started to hurt Chinese exports; so in 2014 the authorities allowed the yuan to weaken, easing capital controls. Capital outflows and a falling Yuan attracted speculators like Hayman Capital who shorted the currency, forcing the PBOC to step in to support the currency in 2017.
In 2018, the Yuan again fell when Donald Trump imposed tariffs on China’s exports to the United States, setting off a trade war.
The third major fall, in 2022, is the result of China’s debt crisis. An over-leveraged economy threatens to contract — triggered by rising US interest rates, a strong Dollar, rising energy prices, and an ongoing pandemic — while regulators attempt to shore up the financial system.
The Belt-and-Road initiative
In 2013 the PBOC were unhappy with the Fed’s program of quantitative easing (QE) which could be seen as currency debasement at the expense of foreign creditors (China).
China’s response was the Belt-and-Road initiative (BRI). This loaned US Dollars to emerging market governments in exchange for lucrative construction contracts, secured against the underlying infrastructure assets. Africa was a prime target.
The capital inflow was diverted from US Treasuries — funding the federal deficit — and into the BRI. By 2022, BRI loans — denominated in Dollars to maintain the Yuan’s trade advantage over the Dollar — amounted to close to $5 trillion.
Funding the federal deficit
China’s BRI left Treasury with a problem with funding the US deficit, So far, the gap has been filled by Fed QE and, to a lesser extent, commercial banks.
But QE is not a long-term solution. The twin deficits supporting the US Dollar status as global reserve currency are now broken. And US Treasuries are no longer attractive to foreign investors as the global reserve asset.
The US is faced with a difficult choice:
- Allow the Fed to continue its easy monetary policy in the hope that inflation will bail Treasury of its serious debt problem, lowering federal debt to between 70% and 80% of GDP. The risk is that foreign investors will increasingly shun Treasuries, threatening its status as the global reserve asset and driving up long-term interest rates in the USA.
- Encourage the Fed to adopt a hawkish stance, shrinking its balance sheet (QT) and raising interest rates. Lower inflation and a stronger Dollar would restore investor confidence in Treasuries. But the risk is that the US plunges into recession which would make the debt problem even worse. Tax revenues would fall during a recession, increasing the fiscal deficit.
It appears that the Fed are attempting to walk a fine line between the two options at present, talking tough but delaying action for as long as possible, but later this year, they will be forced to show their hand.
China
Rising US interest rates and the strong Dollar are a major problem for China. Not only is the strong Dollar undermining Chinese businesses who borrowed in USD at cheap rates, but the strong Dollar also threatens to collapse China’s $5 trillion Belt-and-Road initiative which is funded by USD-denominated loans. Despite official statistics, the country is in a heap of pain. The private sector has never fully-recovered from the initial COVID-19 pandemic and is now being dragged down by Xi Jinping’s zero-Covid policy lockdowns. Ports are in gridlock.
Falling natural gas consumption warns of an economic contraction, promising further disruption to commodity producers and supply chains around the world.
Team USA
This may be an over-simplification but “team USA” — to use Michael Every’s expression — is primarily split into two camps:
- Wall Street and the Federal Reserve, who want to maintain the US Dollar position as the global reserve currency; and
- The Department of Defense (DOD) and the manufacturing sector, who recognize the damage done by the Dollar reserve currency, with erosion of the US industrial base and offshoring of critical supply chains.
Weaponizing the Dollar against Russia, by seizing their foreign reserves, was apparently a DOD initiative, with the Fed not even consulted. The outcome is likely to be long-term damage to the Dollar’s reserve currency status, with non-aligned states — including China and India — increasingly reluctant to hold reserve assets in Dollars.
There are no ready alternatives to the Dollar — as Michael Every points out — but other asset classes, including Gold and Commodities, are likely to play an increasingly larger role.
Conclusion
Credit markets are tightening and warn of a recession. The Fed is unlikely to continue its hawkish stance if credit markets dry up or employment falls.
It is not in the US interest to continue running large current account deficits to support the Dollar’s reserve status. The economy has suffered long-term damage from its “exorbitant privilege” with the US Dollar as reserve currency. Support for the Dollar’s reserve status, from Wall Street, faces growing opposition from the DOD and manufacturing sector.
The US faces a tough choice between debt and inflation. A hawkish Fed may lower inflation but is likely to cause a recession, making the debt situation even worse. A dovish Fed, on the other hand, with higher inflation, may alleviate the debt problem but is likely to undermine foreign investor confidence in the Dollar and Treasuries.
The situation is further exacerbated by current market turmoil. The strong Dollar threatens to damage China’s economy and its Belt-and-Road initiative, raising tensions with the US. Weaponization of the Dollar in sanctions against Russia also threatens to undermine the Dollar’s reserve currency status.
Rising interest rates and a strong Dollar are bearish for Gold, but there are a number of developments that suggest the opposite. We remain overweight on Gold.
Acknowledgements
- Tom Mclellan for the Unemployment/Consumer Sentiment comparison
- Frankoz for the BRI insight
Gold and Copper: Towards a new measuring stick
Our old measuring stick, the Dollar, is broken and no longer fit-for-purpose. The Fed and other major central banks have consistently eroded the value of their national currencies through quantitative easing; expanding their balance sheets by 580% — from $5T to $29T — over the past 14 years, as the chart from Ed Yardeni below shows.
Currency debasement is easily hidden from view by simultaneous policies across central banks, affecting all major currencies.
Gold as a benchmark
Attempts to use Gold as an independent benchmark are frequently interfered with by government attempts to suppress the Gold price, dating back to the London Gold Pool of the early 1960s. Alan Greenspan even went so far as to base Fed monetary policy on Gold, not so much to suppress the Gold price but as an early warning of inflation (measured inflation figures are lagged and therefore useless in setting proactive monetary policy). The result was similar, however, suppressing fluctuations in the Gold price.
A new benchmark
Earlier than Greenspan, Paul Volcker had used a benchmark based on a whole basket of commodities to measure inflation.
Our goal is derive a similar but simpler benchmark that can be applied to measure performance across a wide range of asset classes.
Copper and other industrial metals, on their own, are not a viable alternative because demand tends to fluctuate with the global economic cycle.
Gold and Silver also tend to fluctuate but their cyclical fluctuations, especially Gold, tend to run counter to industrial metals. Demand for Gold is driven by safe haven demand which tends to be highest when the global economy contracts.
We therefore selected Gold and Copper as the two components of our benchmark because their fluctuations tend to offset each other, providing a smoother and more reliable measure. A mix of 5 troy ounces of Gold and 1 metric ton of Copper provides a fairly even long-term balance between the two components as illustrated by the chart below. The middle line is our new benchmark.
Copper (red) leads in times of inflation, when industrial demand is expanding rapidly, while Gold (yellow) leads in times of deflation, when the global economy contracts.
First, let’s address the weaknesses. China’s entry to the World Trade Organization (WTO) in the early 2000s, a once-in-a-century event, caused a surge in the price of both Copper and Gold. The change drove up commodity prices but drove down prices of finished goods; so we are undecided whether this is truly inflationary.
The sharp fall in 2008, however, is accurately depicted as a massive deflationary shock, caused by private debt deleveraging during the global financial crisis (GFC). Central banks then intervened with balance sheet expansion (QE). Accompanied by fiscal stimulus, QE caused a huge inflationary spike lasting from 2009 to 2011.
Fed expansion paused in 2011-2012 and was followed by a sharp contraction by the European Central Bank (ECB), causing deflation, as the breakdown from Ed Yardeni below shows. The ECB then reversed course — following Mario Draghi’s now famous “whatever it takes” — and, accompanied by the Bank of Japan (BOJ), engaged in another rapid expansion.
The Fed attempted to unwind their balance sheet in 2018-19, causing a brief deflationary episode before all hell broke loose in September 2019 with the repo crisis. Fed balance sheet expansion in late 2019 was, however, dwarfed by the expansion across all major central banks during the pandemic. Fed QE caused a sharp spike in the M2 money supply as well as in our Gold-Copper index (GCI), warning of strong inflation.
Market Values using our GCI benchmark
While not as high as some valuation measures (PE or Market Cap/GDP), plotting the Wilshire 5000 Total Market Index against the GCI shows stocks trading at levels only exceeded during the 1999-2000 Dotcom bubble.
The Case-Shiller Index plotted against GCI shows home prices are relatively low in real terms, most of the froth being created by a shrinking Dollar.
But if you think housing is cheap — after the China-shock — look what happened to wages.
Precious Metals
Plotting Gold against the GCI might seem counter-intuitive but it highlights, quite effectively, periods when Gold is highly-priced relative to its historic norm. The yellow metal retreated to within its normal trading range in March 2021.
The plot against GCI offers far less distortion than the Gold-Oil ratio below.
We only have 4 years of data for Silver (on FRED). Plotting against GCI warns that silver is highly-priced at present but we will need to source more data before drawing any conclusions.
Conclusion
Stock prices are high and overdue for a major correction but this is only likely to occur when: (a) government stimulus slows; and/or (b) the Fed tapers its Treasury purchases, allowing long-term Treasury yields to rise. Market indications — and dissenting voices (Robert Kaplan) at the Fed — suggest that the taper could occur sooner than Jay Powell would have us believe.
The Gold-Copper index (GCI) warns of strong inflation ahead, which should be good for both commodities and precious metals. But bad for stocks and bonds.
Gold versus Bitcoin
Interesting question from Steve:
Bitcoin has broken through $50k, so there is now some USD940 billion in circulation. What would be the impact on the Gold price? It seems to me that many Bitcoin purchasers are buying as an alternative to buying Gold as a store of assets.
Bitcoin may be diverting some investors from gold but we believe this is marginal. Global gold reserves ($9.6T according to Perth Mint) are still 10 times the size of Bitcoin.
If we look at 2018, when Bitcoin fell from $19,000 to $3,200….
There was little benefit to Gold which also fell for most of the year.
Again in 2020, when Gold peaked at the beginning of August….
Bitcoin remained flat for 3 months before commencing an up-trend in November 2020. And broke $20,000 on Dec 17th, while Gold was rallying.
Conclusion
The rise in Bitcoin is not the cause of recent weakness in Gold.
We see Bitcoin as speculative and would not hold it as a store of value — any more than Dutch tulips.
Gold has served as a store of value for thousands of years and this is unlikely to change.
Markets that are likely to outperform in 2021
There is no reliable benchmark for assessing performance of different markets (stocks, bonds, precious metals, commodities, etc.) since central banks have flooded financial markets with more than $8 trillion in freshly printed currency since the start of 2020. The chart below from Ed Yardeni shows total assets of the five major central banks (Fed, ECB, BOC, BOE and BOJ) expanded to $27.9T at the end of November 2020, from below $20T at the start of the year.
With no convenient benchmark, the best way to measure performance is using relative strength between two prices/indices.
Measured in Gold (rather than Dollars) the S&P 500 iShares ETF (IVV) has underperformed since mid-2019. Respect of the red descending trendline would confirm further weakness ahead (or outperformance for Gold).
But if we take a broad basket of commodities, stocks are still outperforming. Reversal of the current up-trend would signal that he global economy is recovering, with rising demand for commodities as manufacturing output increases. Breach of the latest, sharply rising trendline would warn of a correction to the long-term rising trendline and, most likely, even further.
Commodities
There are pockets of rising prices in commodities but the broader indices remain weak.
Copper shows signs of a recovery. Breakout above -0.5 would signal outperformance relative to Gold.
Brent crude shows a similar rally. Breakout above the declining red trendline would suggest outperformance ahead.
But the broad basket of commodities measured by the DJ-UBS Commodity Index is still in a down-trend.
Precious Metals
Silver broke out of its downward trend channel relative to Gold. Completion of the recent pullback (at zero) confirms the breakout and signals future outperformance.
Stock Markets
Comparing major stock indices, the S&P 500 has outperformed the DJ Stoxx Euro 600 since 2010. Lately the up-trend has accelerated and breach of the latest rising trendline would warn of reversion to at least the long-term trendline. More likely even further.
The S&P 500 shows a similar accelerating up-trend relative to the ASX 200. Breach of the latest trendline would similarly signal reversion to the LT trendline and most likely further.
Reversion is already under way with India’s Nifty 50 (NSX), now outperforming the S&P 500.
S&P 500 performance relative to the Shanghai Composite plateaued at around +0.4. Breakout would signal further gains but respect of resistance is as likely.
Growth/Value
Looking within the Russell 1000 large caps index, Growth stocks (IWF) have clearly outperformed Value (IWD) since 2006. Breach of the latest, incredibly steep trendline, however, warns of reversion to the mean. We are likely to see Value outperform Growth in 2021.
Bonds
The S&P 500 has made strong gains against Treasury bonds since March (iShares 20+ Year Treasury Bond ETF [TLT]) but is expected to run into resistance between 1.3 and 1.4. Rising inflation fears, however, may lower bond prices, spurring further outperformance by stocks.
Currencies
The US Dollar is weakening against a basket of major currencies. Euro breakout above resistance at $1.25 would signal a long-term up-trend.
China’s Yuan has already broken resistance at 14.6 US cents, signaling a long-term up-trend.
India’s Rupee remains sluggish.
But the Australian Dollar is surging. The recent correction that respected support at 70 US cents suggests an advance to at least 80 cents.
Gold, surprisingly, retraced over the last few months despite the weakening US Dollar. But respect of support at $1800/ounce would signal another primary advance.
Conclusion
Silver is expected to outperform Gold.
Gold is expected to outperform stocks.
Value stocks are expected to outperform Growth.
India’s Nifty 50 is expected to outperform other major indices. This is likely to be followed by the Stoxx Euro 600 and ASX 200 but only if they break their latest, sharply rising trendlines. That leaves the S&P 500 and Shanghai Composite filling the minor placings.
Copper and Crude show signs of a recovery but the broad basket of currencies is expected to underperform stocks and precious metals.
The Greenback is expected to weaken against most major currencies, while rising inflation is likely to leave bond investors holding the wooden spoon.
Gold and the Coronavirus
China’s Yuan plunged on scares of a coronavirus epidemic spreading from its Wuhan epicenter.
The flight to safety took 10-Year US Treasury yields with it. Breach of support at 1.75% warns of another test of primary support at 1.50%.
Flight to safety is also likely to directly strengthen demand for Gold, while lower long-term yields provide a secondary boost by lowering the opportunity cost of holding precious metals. Respect of support at $1540-$1560 would signal another advance.
Silver is weaker but continues to test resistance at $18 to $18.50. Breakout would confirm a bull market for precious metals.
A stronger Dollar, also benefiting from the flight to safety, should only partially offset the rising demand for Gold and Silver.
Australia
Australia’s All Ordinaries Gold Index continues to test resistance at 7200. Breakout above 7200 would strengthen the bull signal from 13-week Trend Index and Momentum recovering above zero.
Patience
Prospects of retracement to re-test support at 6000 are diminishing. Accumulate on breakout above 7200.
Model Portfolios
Our pick of Australian gold stocks is available to subscribers to the Australian Growth model portfolio. I am not sure how many readers are aware that Market Analysis updates are included as part of any model portfolio subscription.