Inflation Brewing and Gold is Shining
There was a lot of news this month. Some of these developments affected the markets and some didn't, but they could in the future and here's what we're watching...
First, it was impressive that gold hit an 18 year high while bonds confirmed a major downward reversal. Since both of these markets are very sensitive to inflation, they're now both reinforcing that more inflation is coming.
In fact, gold has always led inflation and interest rates, and it's happening this time too. Gold has been rising for over four years, and inflation and interest rates have been following. The rises in inflation, however, have been intensifying lately (see Chart 1). Last month, for example, U.S. consumer prices surged the most in 25 years at a 14.4% annual rate. In the past two months, producer prices soared 22.8% and 8.4% annualized and, along with import prices, both rose the most in 15 years last month. And it's not only in the U.S... inflation moved up in the U.K. in its strongest jump in eight years, and the story is similar in other countries as well.
The main reason why is because energy prices have been soaring and worldwide monetary policies have been loose. But we don't think it's a coincidence that this inflation surge is coinciding with the appointment of Ben Bernanke to replace Alan Greenspan as the next chairman of the Federal Reserve.
The announcement was generally well received, but bonds didn't like it because prices declined significantly. Since the bond market looks ahead, this weakness suggests Bernanke is going to be an inflationary Fed head. Gold is signaling the same thing.
Tough Job Ahead
We wouldn't be surprised, considering his comment that the U.S. has a printing press allowing it to produce as many dollars as it wishes and they could drop money from helicopters if deflation became a risk. Okay, maybe he was kidding but there's no question that the job will be tough for an academic with little policymaking experience, or anyone else.
With debt, deficits and spending soaring at unprecedented levels, the economy has never looked so unbalanced. The Comptroller General of the U.S. says long-term government promises to retirees, veterans and others now amounts to a shocking $350,000 for every full time worker. He also said this past year may have been the most fiscally reckless in U.S. history, and fiscal irresponsibility is the greatest future threat to the U.S. Reinforcing this, former Fed chief Paul Volker feels there's a 75% chance of a crisis in the next few years. He's also warning about inflation and so is Greenspan.
Mr. Bernanke is certainly going to be faced with a delicate balancing act, especially with interest rates and inflation rising, the economy slowing, consumers nervous, an ongoing energy problem, a real estate bubble bigger than the 2000 stock bubble, Chinese competition, an expensive war that has already cost $700 billion, hurricane expenses in the hundreds of billions following the costliest natural disaster in U.S. history and so on. It makes you wonder how it's all going to work out. But for now, inflation, higher gold, commodities and interest rates, and lower stock and bond prices look like they'll be part of the mix.
Second Term Jinx and Wild Cards
The markets are usually volatile during a new Fed chairman's first year. When Greenspan took over in 1987, for instance, the stock market crashed shortly thereafter. It's interesting to note this is also coinciding with Bush's second term. We can't explain why but going back to 1960, there have been four presidential reelections, prior to Bush, and each time a scandal emerged which hurt the president and it was bearish for stocks with the market dropping between 25% and 45%.
Now we have Bush and as his second term unfolds, things aren't looking good this time either. Libby's indictment, which is the first for a White House official in 130 years, combined with suspicions over Rove and Cheney's involvement, the Miers withdrawal, the unpopularity and growing questions over the Iraq war and the Katrina delays have resulted in Bush's lowest approval rating yet. If history repeats, these problems could intensify along with stock market weakness, which would likely coincide with inflation and higher interest rates... Then there're the wild cards we also have to consider...
*We believe changing weather patterns will continue to be one of the biggest forces affecting the markets. That was clearly illustrated this hurricane season, which made several records. Not only did it start the earliest ever, but it included three category 5 hurricanes out of only five in this category over the past 70 years. Following Katrina, Wilma came along and it was the strongest and largest hurricane ever registered in the Caribbean.
Experts believe this is going to continue. Aside from the personal tragedies and losses involved, this will keep upward pressure on oil and commodities, which also reinforces this inflationary scenario.
*One very disturbing development is the radical turn in Iran. By calling for Israel's destruction, while defying world opinion with their nuclear program, which is run by Revolutionary Guards, celebrating the 25 year anniversary of the U.S. hostages, as they recall 40 ambassadors and form alliances with terrorist groups, Iran's new president seems to be deliberately looking for war as he continues insulting the West.
After Iraq, the prospect of another war is uninviting but if Iran continues, an invasion by someone seems almost inevitable. Since Iran has the world's second largest oil reserves, that would surely drive the oil price higher, fueling more inflation.
*There's also been a lot of news about bird flu, especially because it's spreading into Europe. The big fear is that it could turn into a pandemic like in 1918. Scientists agree a pandemic will happen sooner or later and many have asked how that would affect the markets.
We just finished a book about the 1918 pandemic, which killed over 50 million people worldwide. What stands out most is that panic and fear were so widespread, we doubt if anyone even cared about the markets.
Nevertheless, it's interesting to note that the economy generally came to a halt and the stock market dropped. There's no reason to believe it would be any different today. We can assume trade and travel would be totally disrupted and people would stay home, which would hurt businesses, stocks and the economy. Plus, prices would likely rise due to shortages, and so would gold because of fear and uncertainty. Considering the current flu hype, even a mini scare would likely affect the markets.
For now, inflation is the overall dominant economic trend. Deflationary forces have taken a back seat and the tug of war between these two forces has diminished, at least for the time being. Gold and bonds are both reinforcing this and they're the two best inflation leaders we know of.
The New Wave
In large part, this inflationary outcome is due to China's ongoing growth as it evolves into a super power, as well as the growth in India and other emerging countries. The soaring industrial, commodity and energy sectors are areas that have clearly been affected as demand for raw materials and energy increases.
Growing global demand has been the driving force pushing oil up in recent years, rising six fold since 1999, as it reached its latest record high in August when Katrina hit. Strong global demand will keep upward pressure on oil, especially as doubts continue about sufficient supply. This uncertainty at a time when known reserves could be depleted at the current consumption rate, will not only keep upward pressure on the oil price, but on inflation and gold too since gold and oil move together (see Chart 2).
China is also creating new demand for gold as an investment as it's been encouraging its citizens to buy gold. India has always been a major accumulator of gold and their gold consumption is expected to rise 33% this year. Inflation worries in general are also causing money to go into gold. Plus, more demand for gold is coming from the world's oil exporters, as they buy gold with some of their revenues.
Monetary inflation has also been growing by leaps and bounds over the years (see Chart 3). And monetary inflation leads price inflation, which means we have a double whammy... rising money supply and strong ongoing demand for commodities, which together will translate into higher inflation. It's already happening and it's good for gold.
A Secular Mega Uptrend
Gold, the precious metals, commodities and interest rates generally move together in major secular moves. The current bull market is five years old. This means it's just getting started, in spite of record highs in certain commodities. Secular bull markets tend to last 15-20 years on average and they tend to coincide with wars. In other words, we probably have more than a decade or so to go before this major move is over.
The road to good investing in the years ahead is going to be dominated by gold. Gold rises during economic and global uncertainty, and when the monetary system is unsound. It rises when the reserve currency of the world is burdened and when most countries don't want a strong currency in order to compete. Gold is basically a barometer for the economy and it's a safe haven. It's currently stronger than stocks or bonds and by all indications, this mega trend is going to stay intact. That is, gold will continue to outshine all other investment classes during the current secular bull market, despite normal ups and downs along the way.