As Comex gold hit a fresh record high, Societe Generale commodities skeptic Dylan Grice — of the long-term return on commodities is zero fame — wrote a stirring paean to gold in his latest research report.
Marked by his characteristic erudition, with references to gold’s use as a hedge in the world of antiquity, Grice’s report is worth reading and thinking about.
In a nutshell, Grice owns gold because he’s worried that developed economies are rapidly heading towards insolvency. This could cause a political crisis of such magnitude that Western societies might actually be willing to embrace painful, contractionary measures – which would be the signal to sell gold.
This is a good explanation for the sustained run-up in gold. But it doesn’t answer (nor is it even intended to address) what investment might make sense for today.
The run-up in gold has coincided with an economic crisis marked by fiscal irresponsibility, weakening currencies (above all, the dollar and the euro), low interest rates and quantitative easing (i.e., printing forests worth of dollars).
Massive government spending (“trillion” as the new “billion”), combined with a hot money press, has kindled fears of inflation — which only general economic weakness has so far held in check.
Now that commodities are soaring — with oil over $106 a barrel, and both the Producer Price Index and Consumer Price Index dramatically up in February — it’s no wonder that gold, the classic inflation hedge, has reached new highs.
This makes me wonder what the next major market shift will be and how to play it. Could inflationary pressures finally force central banks to raise interest rates? I believe such moves could be a significant market game changer.
By keeping rates at historic lows amid the economic crisis, Fed Chairman Ben Bernanke understood that wounded financial institutions would be able to make easy money that could enable them to recapitalize, and that people with money would turn to the stock market for capital returns, creating a wealth effect.
Few things would have a more powerful effect on the current market environment than a switch to rising rates — which central banks would only do if they perceived the threat of inflation to be real and imminent.
When inflation becomes a factor, money loses its value and real assets have the potential to appreciate. But if interest-rate hikes are the cure, I’d expect U.S. stocks to suffer — because the cost of capital to U.S. business will increase.
Food, oil and metals have already had a long run; and though inflation might give impetus to a weakened real estate market, rising interest rates would suppress buyers needing mortgages to finance their purchases.
A more promising area of interest would be foreign stocks.
From a top-down perspective, the trick would be to find a Goldilocks economy where the currency is strong but not so strong as to seriously injure its exporters (cross Switzerland off the list), and where inflation is under control such that central bank rate hikes are not just rearguard efforts to tamp down havoc in the economy.
Japan may be such a place, despite the tsunami and nuclear crises (and perhaps because of the market tsunami that followed); interestingly, Dylan Grice has advocated buying Japanese shares. Inflation in Japan is close to zero.
Israel is another market I’d look at carefully. Inflation there is 4.2%, about 20 basis points lower than in the U.K. But the U.K. has so far avoided the painful transition to rising rates (though market observers expect it may be first to do so among G-7 economies).
The Israeli central bank has raised its key rate eight times since August 2009, and is likely to do so again on Monday to keep its economy from getting out of control.
The U.S. Fed seems determined to be last among major economies to fight inflation, and the result could be a market malaise like that of the ’70s.
Grice is likely correct about gold continuing its forward momentum, but foreign equities could show signs of glittering, too.