Inflation Expectations Are Low, But The Risk Is High. Gold Is One Way To Play It
Summary
- With unemployment rising, record low oil prices, and weak economic growth, inflation risk may seem moot. This line of thinking is a mistake.
- The Fed, along with other central banks, has greatly increased the money supply.
- Supply chain disruptions could increase the cost of both input products and final products alike, driving total prices higher.
- Commodity prices often perform well during periods of stagflation, and gold in particular has a very strong historical track record.
Main Thesis
The purpose of this article is to discuss one of the key risks I see facing the market today, which is the potential for inflation, or worse, stagflation. In fairness, economic conditions do not seem to warrant much concern over rising prices. Economic growth has stalled, unemployment is rising, and oil prices have fallen off a cliff. However, these economic realities have prompted extreme action by the U.S. government, and other governments around the world. The end result has been a money supply that has vastly increased and a world that will likely emerge as less cooperative and less connected. When I add this up, I see a challenging economic environment for the remainder of 2020. While buying equities is a smart way to combat the risk of inflation, I am reviewing the attractiveness of gold in this piece for investors to consider a way to beat stagflation, which is a much more difficult economic condition.
What Is Stagflation?
I want to spend a moment discussing what stagflation is, and why it is harmful. The general point is, under stagflation, an economy sees a high level of inflation, but simultaneously sees rising unemployment and falling demand. This contrasts with normal inflation, which is generally positive for investors. Under normal inflation, rising prices result from a growing economy, rising employment figures or wages, and rising confidence about future economic conditions. Stagflation has the rising price component, but it is a result of negative conditions, such as a disruption in supply chains or an increase in input or commodity prices (such as oil). The result can be harmful to an economy, and difficult to correct.
I must point out that we are not in an environment where stagflation, or even inflation, exists. But I believe investors need to prepare, because if it does occur, investors will have wished they were proactive. My concern specifically is, if inflation does materialize, we could push to a stagflation environment quickly because of the other economic factors that are on work right now.
Inflation Expectations Set Up A Contrarian Play
Next, I want to consider the market's expectations on inflation risk at the moment. Simply, the expectation is it is unlikely. With a lack of inflation, stagflation risk is a moot point. In fact, my concern right now is not widely held at all, with inflation expectations at extremely low levels on a historic basis:
Source: Bloomberg
And there are valid reasons for this. A key component of inflation is rising consumer employment, wages, and demand, and neither of these components are alive right now. Unemployment worldwide is on the rise, including here in the U.S. In fact, U.S. unemployment reached 4.4% in March, and is expected to rise dramatically higher in the coming months, as millions more have lost their jobs due to the COVID-19 outbreak.
Similarly, economic growth around the world is expected to fall dramatically, especially in advanced economies. In April, the International Monetary Fund published its updated economic forecasts, which paint quite a bleak picture:
Source: International Monetary Fund
Clearly, these figures support the view that inflation could be a small risk. Therefore, why am I worried about it? There are two key reasons. One, I believe the market is overlooking other key elements that could contribute to a rise in prices, despite weak economic figures. Two, as an extension on the first point, rising prices without corresponding economic growth is exactly the type of environment where stagflation thrives. Therefore, I see this risk as very real, and very important, and will explain why below.
The Money Supply - Soaring
The first point for my thesis has been the rapid increase in the money supply. To combat the current, and potential, economic fallout from the COVID-19 crisis, Congress and the Federal Reserve have undertaken unprecedented measures. While we can debate the positives and negatives of these actions, the end result is clear - a massive increase in the amount of money available. While this is obvious, the real point here is how much the money supply has grown in the very short term, as shown below:
Source: Bloomberg
It is difficult to predict the exact impact of this action, but to me, it is clear the U.S. is going to face inflationary pressure very soon. We simply cannot expand the money supply by such extreme levels and expect few repercussions. If economic growth picks up, consumers and businesses should be able to manage a rise in prices. But, absent of that growth, prices are still bound to rise. Money is getting too cheap and too readily available, and investors need to begin to plan how to position their portfolios to mitigate the impact.
Supply Chain Disruptions Could Occur Around the World
My next point examines why input prices may rise, in both the short term and the longer term. Importantly, I view what is happening today as a fundamental shift in how advanced economies are going to operate in the months, and years, to come. Supply chains are going to be tested, re-examined, and re-positioned. In the short term, border lock-downs are preventing the easy flow of goods around the world, but in the longer term, I believe countries and corporations are going to bring more production back home. Simply, the world is losing its faith and trust in major world trading partners, notably China, but this loss of faith will resonate elsewhere. There is appetite, from both an economic and nationalistic point of view, to bring supply chains closer to home. This current crisis has exacerbated this, as consumers worry about shortages, lead times, and, ultimately, where strategically important goods like medicines are manufactured.
For support, consider comments made by various government officials. As reported by the LA Times, Commerce Secretary Wilbur Ross was quoted being critical of Apple's reliance on China for production of its products, stating:
"Globalization had gotten out of control. It takes 200 suppliers in 43 countries on six continents to make an iPhone"
Similar sentiment is shared elsewhere, notably in Australia and New Zealand, two countries that are heavily dependent on China for trade, as shown below:
Source: Bloomberg
In the wake of the pandemic, Winston Peters, New Zealand's deputy prime minister, floated the idea of a "Trans Tasman Bubble", to encourage both tourism and trade between Australia and New Zealand, likely at the expense of China. While both have benefited greatly from being a top trade partner with China over the past few decades, the current crisis will put those relationships to the test.
My point here is two-fold. Over the longer term, I believe more advanced economies, such as the United States, Australia, and many countries in Europe, are going to begin moving operations out of China and closer to home. While this could be viewed positively, it will likely result in higher input costs, due to higher wages and more regulations in those countries compared to China. This could drive up the final costs of goods sold to consumers. The second point, which is more of a short-term look, is that global supply pressures are already driving prices higher, albeit not because supply chains have moved, but because the difficulty of moving goods around the world has increased. Essentially, travel logistics have been disrupted, with plants closed, businesses in lock-down, and border activity heavily restricted.
And the impacts have been extensive. For example, consider the graphs below, which detail this rising cost to move goods around the world, from various origins and destinations:
Source: Bloomberg
Clearly, costs are rising. But how does this relate back to stagflation, and gold? Simply, price pressures are rising in the short term not because of economic growth, but because of supply chain constraints. This is going to ripple through the economy, raising final prices, at a time when economies are slowing and consumers are strapped for cash. If this reality persists, and we do not know yet if it will, the end result could easily be an environment with stagflation. Under such conditions, commodities, especially gold, tend to perform very well, which I will touch on more in the following paragraph.
Gold's Price Is High, But Could Move Higher
Now that we have discussed a few reasons why we could see inflation or stagflation in the months ahead, how do we play it? As I alluded to above, I view gold as a very logical asset to protect, and diversify, a portfolio given our current climate. Simply, this is a real asset, whose value should rise if we experience inflation, but also stagflation, as investors will move into real assets over cash or bonds, whose purchasing power will erode in both those environments.
While I absolutely feel gold is a good bet, investors should consider that prices are quite high right now. In fact, gold has been one of the best performing asset classes in 2020, and its current price is very close to its all-time high, which was hit in 2011, as shown below:
Source: Yahoo Finance
Therefore, investors need to understand that the "easy money" has probably been made at this point, and there is a fair amount of downside risk. If economies re-open successfully, stimulus measures are curtailed, and employment figures reverse their negative slide, gold could move much lower. However, I do not see these scenarios occurring in the immediate term. Further, demand for gold among investors has been soaring across the globe:
Source: Advisor Perspectives
My point is there is plenty of appetite for gold right now. So while I view it as a smart asset choice right now, investors could also view it as a potential momentum play.
That said, investors would be wise to be concerned about the sudden influx in demand for gold, as well as the high current price. Some may feel they have missed the rising tide already, and don't want to be "late to the party", so to speak. However, there is another key reason why I feel confident in this asset class, despite valuation concerns. This is the long-term performance of gold, which has historically been quite strong. In fact, many investors may be surprised to realize that over the past twenty years, gold has been the second best performing asset class, on an annualized basis, as shown below:
Source: JPMorgan Asset Management
My takeaway here is that gold has been a top performer over the longterm, which includes bull and bear markets alike. Given the underlying tailwinds I see for the sector, I am not letting the current high price deter me from starting positions in this commodity.
Bottom-line
I dislike being the bearer of bad news, but our current economic conditions make finding value very difficult. With rising unemployment, slowing economic growth, and disrupted supply channels, it is hard to see most sectors performing well going forward. Fortunately, gold has had an inverse relationship with equities in 2020, and I see this relationship continuing going forward. Investors have a couple of reasons to invest in gold right now, as an equity hedge, but also to buy into an asset that can perform well during periods of stagflation. To do so, investors have a few different routes they could take. Obviously, they can buy the physical product itself. Beyond that, most investors choose the popular SPDR Gold Trust ETF (GLD), which tracks the spot price of gold. Another way would be to buy the companies that mine gold, rather than gold itself, as those companies should see increased profits as prices rise. One to consider is Barrick Gold Corporation (GOLD). Another option would be commodity ETFs, of which there are several. The difference between them and GLD is they offer more than just gold exposure, including exposure to silver, oil, or copper, among others.
The bottom-line is I expect gold to perform well, despite its already strong performance in 2020. Investors have multiple options to test this strategy, and I believe all of them have merit given our current economic climate.
This article was written by
I began my career in financial services in 2008, at the height of the market crash. This experience has shaped my investment strategy - which is focused on diversification, dividends, and growth opportunities. I am a competitive tennis player, and I competed at the Division I level in undergrad. I have a Bachelors and MBA in Finance.
(He is a contributing author for the investing group CEF/ETF Income Laboratory where he specializes in macro analysis. Features of CEF/ETF Income Laboratory include: managed income portfolios (targeting safe and reliable ~8% yields) making use of high-yield opportunities in the CEF and ETF fund space. These are geared toward both active and passive investors of all experience levels. The vast majority of holdings are also monthly-payers, for faster compounding and steady income streams. Other features include 24/7 chat, and trade alerts. Learn more.)Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GLD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
Recommended For You
Comments (26)
