Inflation is Our Future

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On one hand, the deflationists are claiming that given the extremely high debt levels in the West, further inflation is impossible. On the other side of the argument, many proponents of inflation are calling for Zimbabwe style hyperinflation. In this business, everyone is entitled to their opinion; however it is my contention that we will get neither deflation nor hyperinflation. If my assessment is correct, once business activity picks up, our world will have to deal with high inflation.

Although I have great sympathy for the deflation crowd, given the reckless attitude of the central bankers and their ability to create debt-based money, I do not believe deflation (contraction in the supply of money and total debt) is very likely.

For sure, in this post-bubble environment, American consumer debt continues to contract, but this is being more than offset by the expansion in federal debt. Over the past year alone, federal debt in America has surged from US$9.645 trillion to US$11.813 trillion. In other words, during the past twelve months, American federal debt has risen by a shocking 24.47% and it now stands at 83.52% of GDP! Now, given the ability of the American establishment to essentially create dollars out of thin air, I have no doubt in my mind that it be able to inflate the economy. However, this will come at a huge cost and the victim will be the American currency.

In fact, the recent weakness in the US dollar is a sign that central-bank sponsored inflation has started to dominate the private-sector debt contraction in the West. Furthermore, over the past few weeks, various governments have issued US dollar-denominated debt and this suggests that the carry-trade is back in vogue. In a startling move, Germany recently announced that it plans to borrow money in US dollars!

Now, given the ongoing federal debt inflation, debasement of paper currencies, sky-high budget deficits and competitive currency devaluations, the macro-economic environment has never been better for precious metals. Yet, both gold and silver continue to frustrate the bulls by staying below the record-highs recorded in spring 2008.

So, what is going on here? Have we already seen the end of the precious metals bull-market or are we about to witness an explosive rally? Before I attempt to answer this question, I want to make it clear that even though gold failed to better its all-time high during last autumn’s panic, it was the only asset, (apart from US Treasuries) which stayed relatively firm. And looking at the various markets today, gold is the only asset that is flirting with its all-time high. So, whether you like it or not, gold deserves some credit for fulfilling its role as a safe haven.

Now, unlike some of the die-hard gold bugs, I don’t believe that gold is the ultimate asset to own at all times. Without a doubt, there have been times in history when gold has proven to be a lousy investment. For instance, between 1980 and 2001, the nominal price of the yellow metal fell by an astonishing 70%. This horrible price action spawned an entire generation who grew up hating gold and up until a few years ago, the vast majority considered gold a barbaric relic.

However, during other periods in history, when macro-economic uncertainty was high and inflationary expectations were running out of control, gold turned out to be a fantastic asset to own.

If my take on the macro-economic situation is valid, then we are in such a period now and gold must form a part of every investment portfolio.

You may remember that over the past year, central banks have injected trillions of dollars into the banking system and it is only a matter of time before inflationary expectations start spiraling out of control. Up until now, this ‘stimulus’ money hasn’t permeated through the economy in the West but once money velocity picks up, prices will start rising and the investment community will become very concerned about inflation. When the deflation scare abates and people start protecting the purchasing power of their savings, capital will start to flow towards precious metals.

Long-term clients and subscribers will recall that about two years ago, I highlighted gold’s tendency to rocket higher every other year. Figure 1 captures this trend perfectly and you can see that since the outset, gold’s bull-market has been punctuated by lengthy consolidations and the yellow metal has surged to a new high every alternate year.

Figure 1: Is gold about to shine?

So, if gold remains in a bull-market and its trend consistency is intact, its price should surge over the following months. Conversely, if the price of gold fails to climb above its all-time high before year-end, it should start to ring alarm bells as this would open up the possibility that the bull-market may be over. Remember, certainty does not exist in the investment world and savvy investors should remain open to all outcomes.

Now, given the uncertainty in the world today and the ticking inflationary time-bomb, my view is that gold will soon embark on its north-bound journey. So, I suggest that investors hold on to gold and the related mining companies which will probably continue to perform well until next spring.

As far as silver is concerned, it has always been a high-beta play on the direction of gold. If the next up leg in gold’s bull-market materialises, the price of silver will also head towards the heavens. Accordingly, investors may also want to allocate a portion of their investment portfolio to silver bullion and silver producing companies.

Regards,

Puru Saxena
for The Daily Reckoning Australia

Puru Saxena
Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Puru Saxena is the founder of Puru Saxena Limited, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.
Puru Saxena

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Comments

  1. Puru Saxena, really don’t get the nature of today’s carry trade do you? It isn’t about interest rate differentials anymore. You buy assets, take rents, and only plan to settle up your USD debt when it suits you (after the USD has dived). Once you have your position, if your collateral is good and you have income to service your debt, time is on your side. Just don’t take your debt on a spread to LIBOR.

    Ah, but there is a catch isn’t there? And this is what makes me an underground dollar bull on the back of my expectation of another deflationary deleveraging event. The liquidity there now is fake. The USD’s have been dispersed across the world on short term bets like the one I have described above, there was no real game shifting liquidity injected into the US economy beyond the auto programmes. All we have is bodgy balance sheets and the stalling on either foreclosure or loan writedowns at retail and wrapper levels and the freeze on mark-to-market.

    The aggregate of the collapse in value of the collateral at home in the US won’t be covered by investments in foreign currency offshore. They are only in a position to make the market and clip the ticket short term offshore. They can’t get up a position to bet the weight of their dodgy balance sheets because it is mainly committed to those stalled toxic assets (even though the US govt has loaded up on them to ease your burden). Then once home base has you by the curlies you are forced to liquidate offshore, your currency swap strategy fails you as those currencies take down your offshore collateral, you must settle up at home in USD and liquidate those assets at a time other than of your choosing.

    And Puru, you talk about creeping high inflation like that generated from gradual import price inflation is going to tip the US, but imports are small compared to US GDP, and beyond the discretionary imports and tightly bound Canada and Mexico they are miniscule. At that point too Germans and their overleveraged banks funding investments on US assets as collateral should be forced through a deleveraging and redemption cycle too, but who will have the wherewithalls to buy the US assets at firesale prices? How much USD money will be able to run back to Germany, China, Japan, Taiwan, Singapore in foreign currency? Nowhere near enough to offset the USD spike of all the hot USD funny money coming home. You see the USD is driven by leverage on the up and deleverage on the down.

    So what am I suggesting? A deflation event and then later an entirely US domestic driven hyperinflationary event because politically they won’t be able to resist an angry population. The US population basically has it’s head around what has happened now in any case and this too makes an upcoming ugly period inevitable.

    Reply
  2. Another correction call (I should snitch dyslexic’s handle), “You see the USD is driven by leverage on the down and deleverage on the up”.

    Reply
  3. Ross, You say “Then once home base has you by the curlies you are forced to liquidate offshore, your currency swap strategy fails you as those currencies take down your offshore collateral, you must settle up at home in USD and liquidate those assets at a time other than of your choosing”.

    what or who do you mean by homebase? what is forcing the liquidation?

    Can you shed some more light on the statement? thanks

    Reply

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