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Matthew Cowie
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Independent financial analyst currently living in Beijing, China. Articles written for Fidelity Independent Adviser have appeared on CNBC.com, Yahoo Finance, theStreet.com and Seeking Alpha.
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  • Gold Lied, Inflation Died 8 comments
    Apr 13, 2013 10:18 AM | about stocks: GLD

    Update 4/15: The title refers to gold's march to $1900. Gold is now very much telling the truth......

    What is happening in the gold market? The destruction of inflation expectations. The gold trade is crowded with people making a similar mistake to the Keynesian economists who completely missed the 2008 disaster because their models do not account for debt. The inflationists are not incorrect in their fundamental analysis, extremely far from it, but they are ignoring the role of credit in the economy with a narrow focus on money supply. Ultimately, I believe the gold bulls will be proven correct (and there is a deflationist case for gold too), but they are missing an intervening step.

    Inflationists point to this as evidence for inflation:

    (click to enlarge)

    but offsetting this rise in money supply is a drop in velocity:

    (click to enlarge)

    Instead of looking at only base money, or even the $10+ trillion M2, I prefer to watch total credit.

    (click to enlarge)

    Economist Steve Keen has shown that banks are in the business of creating money first, and finding reserves second. One of the Federal Reserve's main jobs in the banking system is to create the reserves that sustain credit creation. The Federal Reserve itself doesn't "print money," in fact all the Fed does is swap debt-for-debt. It issues Federal Reserve notes backed by the Treasuries or MBS it buys. Thus, the Fed lags the market, it doesn't lead it.

    At the end of 2008, the U.S. had total credit of $53.3 trillion. (Source:L.1 Credit Market Debt Outstanding) At the end of 2012, total credit stood at $56.3 trillion, an increase of $3 trillion.

    At the end of 2008, total federal debt in the credit market stood at $6.4 trillion. At the end of 2012, it stood at $11.6 trillion, an increase of $5.2 trillion. Thus, on net, the credit market ex-federal debt contracted by $2.2 trillion. If it were not for the massive federal deficit, total credit would be contracting. Thus we see this change in the makeup of the credit market:

    (click to enlarge)

    (click to enlarge)

    This is not the picture of a healthy credit market. Instead, it is the picture of a credit market where the federal deficit is the only thing preventing a full on depression. There is no inflation in the total supply of credit without the obscenely large annual federal deficit and the outstanding amount of credit dwarfs money supply.

    How much does the Federal Reserve need to "print" before credit creation will begin again? I don't have an answer, but a ballpark guess is somewhere in the neighborhood of $3 to 8 trillion (today), give or take a few trillion. (Why QE3 Will Fail) That's because all bubbles return to their beginning, and in the case of the credit bubble, it will return to a point where the ratio of credit to fiat began. Using M2, it is 3 to 1 ($8 trillion print) or using M1, about 10 to 1 (a $3 trillion print).

    (click to enlarge)

    What is gold telling us? It is telling us that the Federal Reserve isn't doing nearly enough to create inflation, and a move to taper off QE will be bad news for the economy. It is telling us that "austerity" in Washington, D.C., mild cuts in the growth of the deficit, are enough to derail the economy. Ironically, the inflationists have more faith in the Fed and the government than I do at this point.

    What everyone looking for massive inflation is missing is that the inflation already happened. The growth of the financial sector accompanies an inflation (with Wiemar Germany the most prominent example) because people are taking on debt. In the early 1990s, after the S&L crisis, financials were 7% of the S&P 500 Index. They peaked at 22% in 2008 and are almost 16% today.

    The Fed is backfilling the massive debt creation from the previous two decades and it has a long way to go before it shores up all the existing credit. Unless there's a massive deflationary event that destroys trillions in credit (which would dwarf 2008), at the current rate of monetization the Fed could continue for several more years, perhaps as much as a decade or more if nominal GDP remained stagnant.

    Gold is not alone in signaling weakness: nearly all commodities are sending a similar signal. On top of this deflationary force, the Chinese leadership appears ready to rebalance the economy towards the consumer sector, something that will dry up demand for many raw materials. Copper faces a far darker future than gold.

    Why own gold if prices are set to fall? Let 2008 be your guide, with a dose of Cyprus. Gold tumbled from a peak of above $1000 in March 2008 to below $800 in autumn 2008, before rebounding and finishing the year with a slight gain. Stocks are going to follow gold lower, but gold has already taken a big chunk of losses from its high and will rebound first.

    Furthermore, this round of deflation will likely have more bank failures than 2008. Investors who held gold may be down more than 20% from $1900, but that beats the losses in Cypriot savings accounts above $100,000. Cash and U.S. Treasuries (not money markets) may be the best bets, but gold is going to shine once again in the midst of a deflation because it will survive bank failures.

    Finally, after the next round of deflation, there's going to be another round of money printing. Eventually, the government is going to get its inflation-in this the inflationists are correct in their observation of the trend. To oversimplify, imagine a massive hole into which the Fed is pouring money: my argument is that the hole is far larger and deeper than the inflationists realize. As for predictions: the deeper the resulting deflation, the larger the ensuing QE and the closer we come to inflation. The shallower the decline and smaller the next round of QE, the longer the U.S. remains stuck in the Japan scenario.

    I do not see a coordinated central bank beatdown in the gold market, rather the capitulation of inflation bulls, combined with incorrect "all is well" sentiment created by the stock market highs. Investors can trade ETFs such as SPDR Gold Shares (NYSEARCA:GLD) or hedge physical holdings, but if 2008 is a guide, physical gold will trade at high premiums during a global financial market panic. It will likely trade at higher premiums, and be harder to acquire, if the next round of deflation exceeds that of 2008. Opportunities to short will be greater in other assets, possibly including gold miners.

    Assets positively impacted in a crisis: U.S. dollar, cash, Treasuries. Negatively impacted: equities, high yield credit, emerging markets, commodities.

    Stocks: GLD
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Comments (6)
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  • Reven
    , contributor
    Comments (61) | Send Message
     
    Excellent analysis. I finally understand what's going on.
    15 Apr 2013, 03:59 PM Reply Like
  • WaveRider007
    , contributor
    Comments (650) | Send Message
     
    Agreed, good article summing up what I see going on around in businesses. My chart also shows that gold may be getting ready to make a major head and that the last price peak we saw, may have been the left shoulder. There is a psychological tie to money, especially fiat, which if creates doubt, also deflates value of the currency. The Fed needs to play the mind game so that people don't freak out when they realize the economy is shrinking rapidly. Don't even get me started on home prices and their dangers tied to deflation. Rates are so low for a reason, and the prices of the homes, with usually 20% liquidity due up front are another major issue as being overpriced, this is starting to remind me more and more of the late 70's and 80's Reaganomics era and the housing bust (which as usual people don't think can happen again).
    27 Oct 2014, 10:37 AM Reply Like
  • Brian Dightman
    , contributor
    Comments (121) | Send Message
     
    It seems to me it may take a very long time to break the current debt cycle. The world of fiat currencies could go on for much longer if productivity continues to take away jobs. Many of today's innovations are job destroying and there does not appear to be many new industries that are cropping up with high paying jobs. Maybe in a few more decades when space travel, mining, etc, has emerged, but that seems a stretch. Until there is wage pressure that allows balance sheets to be repaired and then growth to resume, inflation will likely be parked. The wild card might be emerging market countries. Can they change their culture and stimulate domestic demand? So far it appear to be slow in developing. This too appears to be a longer process. Again with productivity taking away jobs, what are all the people in EM's going to do for work, beyond low paying service jobs? We have a major conundrum that few policy makers appear to be addressing with any seriousness. Could it be they simply do not have any idea how to grow employment so the best they can do is hit the print button?
    16 Apr 2013, 05:22 PM Reply Like
  • WaveRider007
    , contributor
    Comments (650) | Send Message
     
    Yes, they are trying to shore up the top levels, but ignoring the massive amount of lower income levels that actually purchase and create. They look at the macro picture and expect the money to "trickle" down. Again, FDR comes to mind where the QE should have gone to creating job works, not more "reserves" that people don't/can't want to borrow. Another government failure to step up to the Fed that owns the country.
    27 Oct 2014, 10:41 AM Reply Like
  • Matthew Cowie
    , contributor
    Comments (517) | Send Message
     
    Author’s reply » Here is one contrary data point on inflation from the Billion Price Project: http://bpp.mit.edu/usa

     

    If the deflationary scenario plays out then the socionomic argument also seems more likely: there will be reductions/halts to immigration and global trade will plunge. The U.S. is best positioned to "win" because it has a trade deficit and lets in a lot of low skill labor. If these trends are slowed or reversed, a lot of jobs would come back to the U.S. and wages would climb. There are technological innovations working in this direction as well, such as 3D printing that will move manufacturing geographically closer to the consumer. If this plays out, the U.S. will fall into growth and wage inflation, and if China rebalances, the losses in commodities will keep overall inflation at bay. We will see what China can do, the current Premier Li Keqiang is determined to build a big middle class.
    17 Apr 2013, 05:47 AM Reply Like
  • Brian Dightman
    , contributor
    Comments (121) | Send Message
     
    I think the 3D printing phenomena is over-hyped. Yes, it will play a major role in prototype development and parts replacement in some industries. But the complexity of the products in my home that a 3D printer is supposed to be able to produce is way beyond current technology. My kid’s small plastic toys now have RFID tags. Household Utensils use high heat silicon, etc. Besides, all the time and energy to actually create the funnel or whatever it is the 3D printer is supposed to produce is much higher than running down to the local store to get a replacement, IMO. Some day they may be practical but I don't think we are even close yet.

     

    I agree if international trade slows and immigration reduced it will be a net positive for the U.S. worker, short term. Long term the expansion of trade via low cost provider ultimately produces economic growth, not trade barriers, subsidies, etc. We import a lot of products from external sources so new factories (for shoes, electronics etc.) would need to be built. This could be an initiative that makes sense if we think the global wage for manufacturing is going to reach parity in the next decade. I'm not sure we are even close on that one either.

     

    I think the Dems are very focused on the flow of votes coming from immigration so I am not sure we can expect much slowing.

     

    Keep the articles coming and consider publishing versus instablog posts.
    17 Apr 2013, 10:10 AM Reply Like
  • Matthew Cowie
    , contributor
    Comments (517) | Send Message
     
    Author’s reply » Have you seen companies such as Proto Labs (PRLB)? I'm thinking industrial, not desktop.
    17 Apr 2013, 11:05 AM Reply Like
  • Brian Dightman
    , contributor
    Comments (121) | Send Message
     
    Yes, I agree industrial is the angle for 3D printing and new entry ExOne Company (XONE) also may be worth keeping an eye on.
    22 Apr 2013, 12:01 PM Reply Like
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