Global stock market euphoria at the prospect of a good old-fashioned dollop of inflation coming back into the system, almost 1970s style, has put everyone in high spirits. With global growth being kick-started, courtesy of President 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.
So, why, after an initial spike in the gold price immediately following the election of Donald Trump last November, when investors believed the ‘surprise’ result would create uncertainty as well as inflation, is the gold price only now starting to gently move upwards?
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 truly believe that cash will accrue 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 just around the US$1,200 per ounce barrier, 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.
I think they’re wrong. 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. This, despite recent protestations from Fed Chair, Janet Yellen, stating that failure to lift US rates gradually could risk a ‘nasty surprise’.
The banking system, broken as a result 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 in my view.
So what is it that makes me so sure investors will continue to be worse off in real terms? 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 when President Nixon closed 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.
Is it possible then that history could indeed repeat itself? The writing already looks to be on the wall. After the onset of the global financial crisis, the endless amounts of quantitative easing employed, designed to avert a full-blown financial crisis, created the ultra-loose monetary system we have in place today.
Under my scenario, the pace of inflation rising faster than interest rate rises is a hugely optimistic environment for both gold and silver prices. It means real wealth will be eroded for some considerable time to come. If gold and silver prices continue to rise over 2017 so, too, should precious metal mining shares, courtesy of higher selling prices and lower costs. Watch this space.
 Bloomberg as at 19 January 2017.