Increasingly we find ourselves being asked about the outlook for commodity prices and, more specifically, commodity stocks over 2006 and beyond.
Whilst many scarce raw materials have seen prices driven up to new all time highs, it is the performance of the still talismanic gold price that has perhaps caught the general public’s imagination.
At the time of writing gold is flirting with $500 an ounce, its highest level since 1983. Back in the distant past, governments and monetary authorities (sometimes one and the same thing in all but name) fought periodic battles against inflationary pressure. Some see gold’s revival as evidence of inflationary pressure at work.
We don’t! We see the precious metal’s ascent as evidence of investor hedging against even more pernicious forces at work, forces which are known to be out there but which are hard for financial markets to ascribe a probability too. Anything that tests the market’s ability as a successful discounting mechanism represents a clear and present danger to the cosy status quo within which investors have wrapped themselves at the first onset of winter’s icy blast.
Reasons supporting the gold price rally are, inevitably, numerous. Clearly, the metal’s price is being driven by speculative, notably hedge fund interest, but why are hedge funds interested in the first place?
Financial market practitioners refer to a cocktail of supportive factors. They cite concerns regarding the outlook for inflation (convinced that there must be some underlying justification for central bank, particularly US central bank, rate hikes). They examine the nature of demand and supply, in particular incremental demand from Asian populations and from Asian central banks increasingly looking to diversify away from an over-dependence on dollars.
Concerns regarding supply have also received an airing. Industry sources indicate that global mining supply may have peaked and that many producers were suffering from falling ore grades.
Financial market operators, many gold price apologists of old, remain upbeat regarding medium-term prospects, whilst accepting that in the very short-term, investors might chose to cash in their bets and take some chips off the table. They see the gold price overcoming any near-term bumpiness and resuming its upward path towards $600 per ounce!
But in our view the strength of the gold price has got nothing to do with a hedge against inflation (which, as regular readers will be aware, we believe to be the dog barking in the night) and only partially to do with incremental demand from Asia. In our view, it has most to do with providing a defensive hedge against the next big economic crisis, the descent into deflation, recession and eventually, and inexorably, depression!
Gold – a hedge against economic crisis
We have written often about the dramatic expansion in productive capacity caused by the arrival of China as a genuine economic superpower and the freeing up of Russia and Eastern European economies from communism’s command-driven grip. The world has turned from the inflationary bias of the mid-to-late twentieth century, to a more pernicious deflationary bias early in the twenty first. Countries on the Pacific Rim have been growing at c10% per annum since the 1950s, but the 10% that the region finds itself growing at now is a significantly larger figure than it was fifty years ago.
We have often noted that the path towards deflation and economic Armageddon is not rutted and uneven, it actually appears beguilingly smooth and often strewn with sweet scented rose petals. This lulls the unwary into a false sense of security. Prosperity may prove skin deep but while it lasts it brings robust profit growth to corporations, big pay increases to employees and a superabundance of supply to satisfy the inevitable surge in animal spirits which such prosperity inevitably calls forth.
But while prosperous times in a deflationary environment are very prosperous, the tightrope along which the demi-monde teeter is strung very high and the winds treacherous indeed. Put simply, where demand is robust and can match the upsurge in supply, all is well. But when demand falls short, severe economic dislocation follows swiftly and sharply.
The economic landscape of the late nineteenth and early twentieth century was pock-marked by such occasions. In those days, governments and senior economists felt powerless to act. Unable accurately to foresee such crises, economic policy was generally confined to clearing up the ensuing mess. These days we can at least feel comfortable in the knowledge that, largely thanks to the estimable Mr Greenspan, the central bankers economic rule book has been overhauled.
Economic management is now much more imaginative, much better able to foresee the consequences of earlier economic policy measures and intellectually much more aware of the consequences of a profound supply / demand mis-match. Mr Greenspan, now in the last few days of a golden aged tenure largely of his own crafting, is keenly aware of what must be done to address the threat of a possible mismatch.
In a few words, this means keeping demand stronger for longer.
But how do you keep demand from faltering when an economic cycle is near its end and consumers are naturally being encouraged to draw in their horns? If consumers are spending all the money they possess, they must be allowed access to more. Mr Greenspan, utilising the extraordinary reach of the state-sponsored mortgage providers, has been able to achieve this by encouraging every adult US citizen the opportunity to make money from property… and oh boy have they ever!
How the housing boom can make you rich…and poor
If you borrow £400,000 at 7% on a £600,000 property your interest payment is £28,000 per annum and your equity is £200,000. One year later you can refinance, borrowing another £200,000 and paying say 5% in interest. Your total annual interest bill is now just £30,000 and if in the meantime the property has risen to, say £1m, your equity has risen to £400,000… and you have the additional £200,000 borrowings to spend.
This policy has worked here and in the United States in spades. So much so that across the Atlantic the savings ratio is now in negative territory and consumers are, in popular parlance, “going backwards”.
Time and again we are asked “Well this is all very well, but when might it happen?” This is, of course the impossible question to answer. One might, with the benefit of the 20 : 20 vision that hindsight confers, have wondered whether roads in the West Country might have been gritted more effectively ahead of last weekend’s snow storms. One might, equally, have wondered whether the United States was asking for trouble in failing to maintain the levees around New Orleans in sufficient a state of repair to withstand a ferocious hurricane… in the hurricane season! Fact was, nothing was done and in the end the price paid, particularly in the latter case, was a heavy one. The reason why we believe a crisis is inevitable is that for the immense weight of borrowings to be supportable, assets have to keep on going up in value… and one day they won’t!
If you own a house worth £600,000 and it doubles to £1.2m, you are £600,000 richer. If you own two £600,000 houses, with borrowings of £600,000 and they rise in value to £2.4m, your worth rises to £1.8m. But if they halve in value, your wealth is wiped out.
In real life the situation is likely to be even worse as the flight to cash, or cash equivalent will be happening by everybody simultaneously. Some people are likely to be considerably worse off.
The process by which the house of cards is likely to collapse is more than likely to be default. Investors should watch personal bankruptcy levels closely. A period of pressure on the corporate sector might bring about a switch in investor preference for government bonds, particularly if it is the guaranteed income stream that’s required.
But sometimes governments can default too. Investors are already very familiar with the risks associated with high yielding emerging market bonds, but one doesn’t need to cast one’s mind back to the heady days of the 1970s to see what happened when developed government bonds got into trouble too.
More Than Just Georgie Best! (an icon)
The surprise to the Keynesian economists of the time was that inflation actually broke out in peacetime (a function in fact of chronic supply shortages and an over-empowered labour force). Governments, concerned about the consequences for growth and employment, kept interest rates lower than they should.
The system could have defaulted, but the unlikely hero of the hour proved to be inflation! Inflationary pressure gave the impression of easing the damage to investors done by falling asset prices, while negative real interest rates ensured that lenders picked up as much of the tab for earlier bingeing as borrowers did.
Bring on Wayne Roonie (praetorian guard)
Now the economic landscape looks very different. The world is characterised by too much supply, not too little. Central bankers have learnt much more about economic management and understand better the consequences of their policy adjustments. Furthermore, unlike their predecessors, they are independent and thus not trammelled by the strictures of political expediency. Not only can short-term interest rates be shifted up and down, influence can be brought to bear on currencies and long-term interest rates sufficient to ensure that negative real rates can be manufactured if necessary.
The inevitable consequences of deflation, negative real interest rates and currency collapse would be extremely adverse for investors in the financial markets in general and for equity and fixed interest investors (including low yielding index linked gilt-edged too) in particular. Again, the timing of such events is hard to guage. All we can say is that we feel that investors and financial markets are increasingly caught up in a spiralling vortex, with an inevitably catastrophic conclusion. When the big bad wolf comes to call, one would naturally prefer ones house to be built of bricks rather than straw. It is for this reason, not the vague waftings towards inflationary pressure or Asian demand that has driven the gold price to twenty-two-year highs. It will go higher yet.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley