The coronavirus lockdowns are lifting, and stock markets are defying the odds. But as sovereign and corporate debt mounts, negative growth pervades, and unemployment rates tower, the markets will soon have to face another crisis: Stagflation. While devastating for the economy at large, gold has never been in a better position.
One glance at the stock market, and you wouldn’t think the global economy is shrinking. Those with a keen eye, however, only need to look at the gold market for validation that things aren’t quite as they seem.
A rally of over 30% has cemented gold as one of the world’s best-performing assets this year. Precious metals, in general, have scored fresh highs and the outlook remains solidly bullish, especially for silver too – reflecting investor concerns over unconventional monetary policy and the consequence of mainlining trillions of dollars of stimulus into the global economy.
The rally pushed the price of gold to strike $2,000 per ounce on Tuesday, as uncertainty ushered investors to remove risk from the table. The impetus this time came off the back of the news of yet more stimulus to come. With the second batch of stimulus checks on the way and Covid-relief package still in deliberation, the precious metal looks clear to sustain the climb – as will inflation.
With stimulus efforts ongoing, many are turning their attention to US monetary supply for indications of looming inflation; and they’ve not been disappointed. Since April, the US has “printed” the equivalent of $1 million per second. As a result, per data from the St Louis Fed, the US’ supply of cash, checking deposits, savings deposits, and money market securities have expanded 20% in just eight months – going from $15.3 trillion near the end of 2019 to around $18.3 trillion by the end of July.
To make matters worse, the Fed is actively seeking higher inflation to avoid a deflationary environment. As such, last week, the Fed stuck to its dovish stance, committing to keeping interest rates at rock bottom.
Fed losing control?
However, according to a recent research note from investment bank Morgan Stanley, the Fed may be losing control of the money supply. Which, in turn, could cause them to slacken their grip on the reigns of inflation.
“Congress is now in the driver’s seat when it comes to the money supply with its fiscal programs,” reads the research note.” This is potentially more inflationary than appreciated, which means that back-end rates can rise. Very few portfolios are prepared for such an outcome. Such shifts can happen quickly when they are so unexpected.”
To add fuel to the flames, the National Bureau of Economic Research has officially declared the United States in recession. And with the US economy marking its worst quarterly dive in history – shrinking at a rate of 32.9% in Q2 – it’s set to be the sharpest collapse on record. As the economic situation worsened, 1.18 million people filed for unemployment benefits in the states last week.
Should this aggregate blend of torpid growth, rising inflation, and persistent unemployment continue, it could bring about an inflationary environment, not unlike that witnessed in the 1970’s. If this is indeed the case, it bodes extremely well for gold.
An economic boom of mass proportions followed World War II. As a consequence, for many decades, unemployment was low, triggering inflation to increase incrementally. Unable to keep up with the rising cost of living, employers capped wages, leading workers to quit in search of greener pastures. At the same time, organisations were turning to mass layoffs to survive amid the inflationary environment.
Consequentially unemployment rose, and, thanks to a lack of spending, economic growth stagnated. Economists dubbed this rapid inflation – caused by unemployment and sluggish growth – stagflation. And, as they soon found out, there was only one hedge against it.
Within the decade in which the world economy was plagued by stagflation, gold rose over 1,800% from $35 in 1971 to around $670 per ounce by January of 1980. Gold’s stellar performance firmly established the precious metal as a veritable haven from both macro risks and, of course, resultant inflation.
Why gold? Because unlike the US dollar, gold’s finite supply cannot be artificially increased, it’s not confined to the whims of unconventional monetary policy, and it holds its value amid uncertainty.
With gold’s narrative as a safe haven, several major banks prescribed gold to their audience in 2020. Both Citibank and Goldman Sachs predicted that the precious metal would breach record highs as early as February – a forecast that investors have taken to the bank.
These recommendations seem to have penetrated through, with investors placing approximately $7.4 billion into gold-backed ETFs last month, according to data from the World Gold Council.
Rise of inflation and volatility
While the Fed is actively attempting to raise inflation to its predetermined sweet spot of 2%, it’s highly likely that it will soar past this level as the Fed loses control of the money supply expansion.
And that’s not the only knock-on effect of unabated money printing. Last week the greenback sunk to a two-year low as the Fed stood by its decision to keep interest rates flat. This devaluation will inevitably lead inflationary pressures to climb, as import prices rise, and retailers pass the buck to consumers.
There’s also asset inflation to consider. Both monetary and fiscal stimulus has led to what some have dubbed a stock market bubble. The equities market is a prime example. Its stellar display amid flat to negative interest rates and life-preserving stimulus boosts, present a stark contrast to the current economic conditions. However, they are mis-priced. With so much stimulus, money needs to be allocated to assets particularly given the downward pressure of fiat currencies associated with expanding M2 supply, coupled with negative rates. It is natural that we would see stock markets rally against historical norms (multiples), however the market is now repricing what is the norm. When the cost of capital is zero, or negative, what is the right forward P/E to price an equity off?
The market is looking at all of these factors, economic conditions, repricing equities, long-term adjustment to working conditions at the same time they are grappling with the largest increase in money supply we have ever witnessed. We could be at the precipice of the largest equity bull market we will ever witness going into 2021. Not because of the fundamentals that drive these companies but because the metrics we use historically are not longer applicable.
Regardless, it is going to be volatile, as market participants look to navigate these unchartered waters and are pushed into allocating capital at times when valuations might look stretched.
Gold in this environment will remain as a defensive asset which will benefit both from devaluation of global currencies and higher inflation (asset inflation). As market participants look to rotate risk, it is reasonable to assume that given sluggish economic growth and volatile markets, traders and asset managers will look for assets which offer both protection and capital gains opportunities in this environment.
Gold is the only asset that has proven through time to offer both of these attributes in testing times.
Jon Deane is CEO of InfiniGold, technology partner to The Perth Mint, which has digitalised their gold reserves via the GoldPass app and Perth Mint Gold Token. Prior to that he spent nearly 10 years at JPMorgan as managing director and as head of commodities trading in the Asia Pacific region.