The US stock market’s euphoria at the prospect of a good old-fashioned dollop of inflation coming back into the system, almost 1970’s style, has put everyone in high spirits. With global growth being kick-started, courtesy of president-elect Trump’s intention to increase spending directly on bridges, roads and railways, interest rates can at long last start to rise steadily… apparently. And the global economy can return, apparently, to the good old days of the way we were before the onset of the global financial crisis.
But, hang on a minute, with inflation expectations rising, what’s happened to the price of gold? After all, it’s a precious metal that typically holds its value when inflation eats through the purchasing power of paper currencies, isn’t it? Inflation expectations rise and the price of gold rises with them.
So, why, after an initial rise in the gold price immediately following the election of Donald Trump, when investors believed the ‘surprise’ result would create an even more uncertain, and inflationary world, did the gold price, particularly in US dollar terms, fall?
Here’s my theory. Understanding gold is not about looking at future inflation expectations per se. Nor is it about looking at the future of interest rates per se. It is about studying the relationship between the future rates of inflation and the future path of interest rates.
In other words, if investors think that cash will be accruing purchasing power in real terms, gold will perform badly. If, on the other hand, they think the reverse is true and the purchasing power of their cash will be eroded then they will tend to favour gold.
The price of gold, currently trading at around US$1,165 per ounce, as opposed to a high of over US$1,360 for the year would suggest that investors are betting on one key thing: that US interest rates will outpace the rate of US inflation to the benefit of holders of cash, rather than gold.
Not so fast. The idea that the US Federal Reserve will be able to deliver any recognisable form of policy normalisation (i.e. a return to interest rate rises keeping pace with inflation) is pie in the sky in my view. The banking system, broken from the collapse of the fall of Lehman Brothers in 2008, is not healed, merely patched up. It will take years for interest rate rises, a reflection of the health of our global financial system, to return to a ‘normal’ trend.
So what is it that makes me so sure investors will continue to be worse off in real terms? Why am I labelled such a party pooper? I’m afraid it’s because, unlike so many others, I start to smell a whiff of stagflation. Low, sluggish growth, mixed with only very gently rising interest rates but increasing inflation… that’s a fairly toxic cocktail to swallow by anyone’s standards.
Those who can remember as far back as the 1970s will remember that, in 1971, the US effectively defaulted on its debt obligations by closing the gold window. Investors responded to what they saw as inevitable purchasing power degradation by buying precious metals, with gold rallying sharply between August 1971 and 1974 in anticipation of this.
While the yellow metal proceeded to correct sharply between 1974 and 1976, it then rallied strongly once more, spiking to over US$850 per ounce in very early 1980 as rampant inflation and low wage growth meant real wealth was eroded. The whole transition period for the step-change in the price of gold to reflect these toxic monetary conditions took just over eight years.
So here’s my happy ending as a gold investor. After the onset of the global financial crisis and start of quantitative easing in 2008, creating an ultra-loose monetary system, destroying real wage growth and fuelling inflation, it looks like history could repeat itself. The pace of inflation rising faster than interest rate rises is a hugely optimistic scenario for both gold and silver prices, as it means real wealth will be eroded for some considerable time to come. With gold and silver prices rising over 2017 in my view, so too should precious metal mining shares, courtesy of higher selling prices and lower costs.
 Source: Bloomberg as at 12 December 2016.
 Bloomberg as at 12 December 2016.