Description

Gold is effectively a high P/E stock that requires a significant surge in inflation to justify its current price. The two major potential sources of inflation are government deficits and central bank action.

Government Deficits Unlikely To Cause Surge in Inflation

The strongest argument in favor of owning gold is the threat of government deficits that have built up over the past several decades. Fiat currency has, in the past, been devalued by governments seeking to avoid less attractive measures of dealing with debt. The price of gold assumes history will repeat itself.

I believe taking this viewpoint is unrealistic. Consider Europe. Most governments in Europe borrowed too much money. Based on the gold owner’s theory, Europe should have simply printed money to solve the crisis. Yet, it is clear that Europe’s constant need for refinancing (regular bond auctions) gives the bond market control over Europe’s actions. Had Europe simply tried to print money, as opposed to actually fixing the problem, bond investors who have fled and the EU would be faced with life without access to affordable credit.

The U.S. will be in a similar situation to the EU sometime in the next ten years. Once the bond market determines that the U.S. needs to start fixing its balance sheet, yields will rise until something is done. Simply printing money to monetize debt or pay government bills would result in an immediate collapse in U.S. bond prices. And, because Congress’s only constitutional way to spend money is via tax receipts and borrowed money, elected officials in Washington will be strongly opposed to anything that cuts off access to the debt markets. If the Federal Reserve Board of Governors decides to go rogue by either fully monetizing the national debt, letting the Treasury write checks off of a zero balance or any other measure that resulted in an economic default ,either the President or Congress can impeach any or all of the members of the Board of Governors at any time.

One could argue China is on the verge of expanding its money supply. However, a significant number of governments in China failed primarily because of food price inflation so I do not expect hyper-inflation in China. Regardless, I consider the situation in China to be a risk to my thesis. China is an inefficient economy experiencing a serious downturn with an M2 base that is twice as large as the U.S. M2 base adjusted for GDP.

Gold as a potential alternative to fiat currency further limits the potential money printing from governments. In other words, because gold could become the de facto standard of value for the global economy, governments know any significant money printing will result a shift towards gold-backed transactions.

Quantitative Easing Is Deflationary

In chemistry, there is the concept of a limiting reagent. If a reaction with substances A and B results in some of B left over but not A then A is the limiting reagent. This result implies that adding more of B will not result in a larger amount of the combined product. Additionally, any reduction in A reduces the total quantity produced.

The Fed’s quantitative easing works the same way. By forcing rates lower the Fed gives corporations cheap credit. However corporations in the aggregate already have surplus capacity due to sluggish demand. Furthermore, corporate balance sheets are very strong and many companies can finance expansions with operating cash flow. Therefore, access to slightly cheaper capital is unlikely to result in meaningful economic expansion.

On the demand side of the equation where stimulus is needed, quantitative easing is hurting consumption (especially those now living on greatly reduced investment due to low interest rates). Furthermore, a lot of the cheap credit corporations have access to is being used to implement cost saving initiatives which in most cases results in job cuts (less consumption). The dynamic explains why corporations have record profits as a percentage of GDP while labor’s share of GDP is at multi-decade lows. Additionally, the average net worth of a U.S. household is only $50,000. That data point combined with low job security (or no job) makes it difficult for U.S. consumers to benefit on the credit side from the Fed’s easing.

Another reason quantitative easing is deflationary is its impact on a company’s total cost of production. Prices in any economy, after all, are a mark-up on the cost of producing a good or a service. Capital is one aspect of any company’s cost structure. Therefore, lower capital costs imply lower prices, economy wide. Additionally, lower capital costs imply the NPV positive point for the construction of new capacity is lower. Therefore, the supply of goods and services is likely to remain high which puts further downward pressure on inflation.

Regardless of capital costs, the global economy has a huge surplus of capital. With the 10 year yield at sub-2% levels, capital is always itching to go to work in a real investment. The result of this pressure is more supply which lowers prices. Furthermore, due to agency issues, there is a strong bias towards taking risks via expansion. Many iron ore produces are a good example of this dynamic. Despite obvious signs China was overspending on fixed assets, companies like Fortescue Metals and Vale spent heavily to increase production capacity.

Going Long Gold Implies Being Short Productivity Growth

Productivity keeps inflation low holding other factors constant. And gold’s intrinsic value is positively correlated with inflation. Therefore, increases in productivity result in lower gold prices. Currently, the global economy is experiencing a steady rise in productivity due to technological advances and operational improvements. Here is an example of the techniques that are being gradually implemented across the global economy:

A company was designing a mobile, weather-resistant antenna (construction, military, etc.) but found its design did not have enough strength to hold up under colder conditions (ice building up on the structure added weight, wind speeds were also very high). The engineers thought about creating a thicker pole, however, the added weight would require two individuals to help transport the device (higher costs).

Using an ideation process (attribute dependency in this case) the team created a cause and effect between two existing variables that both kept the device light enough for one person  to carry but also strong enough to withstand strong winds and cold temperatures (a pole made from a substance that gets stronger as temperatures drop).

Ideas like the one just mentioned keep inflation low and create downward pressure on alternative currencies like gold.   

Surplus Capacity

Apart from quantitative easing, there are several deflationary forces in play. For example, companies are very eager to reduce per unit costs because of the economy’s surplus capacity. With surplus capacity, the primary way a company can reduce its total costs (including fixed) is to drive volumes higher. But, because of the downward sloping nature of the demand curve, the primary way to drive volume is to lower prices. The prisoner’s dilemma dynamic typically insures this process moves forward on a continual basis across most industries.

Record High Corporate Margins

Companies across the globe are earning returns well above the cost of capital. In the U.S., for example, margins are at record highs. All this implies that if cost pressures did accelerate, companies would take a hit to margins as opposed to raising prices (assuming production is below capacity and somewhat competitive industries).

Surplus Debt and Demographics

According to the Boston Consulting Group, developed economies have $20 trillion in surplus debt. Because debt is money, the deleveraging implies low to no inflation. Lastly, the aging demographic trends in the U.S. and China are likely to be deflationary.

Marginal Cost Issue

The average total production costs of gold producers is between 800-900 $/ounce. However, now that so many investors believe gold is a more attractive alternative to more aggressive projects with high costs are underway. If investors stop believing gold is a safe alternative to currency, the high cost projects will come off line as demand declines. The declining average costs will create additional downside for the price of gold.

Risks

-          The bond market loses its ability to control deficit spending at the political level.

-          A surge in inflation 

Catalyst

Outlook and Catalysts

-          Gold falls 50%+ towards average costs longer-term as speculative buyers realize the bond market has control over the deficit spending issue and the Fed has no ability to generate additional inflation

-          Time frame: 1 – 5 years. While I wait, shorting gold is a good hedge against deflationary risks in the global economy.