Gold’s Finest Hour

As the global economy continues to slow under the increasing weight of soaring inflation, credit contraction and a bear market in financial assets, gold is approaching its finest hour since January 1980.

From its all-time intraday high in April, spot gold prices have declined 8% and remain 55% below its inflation-adjusted high since January 1980. Amazingly, gold, unlike many base metals this decade, remains miles off its inflation-adjusted high and just $106 above its best levels in the last bull market in 1980. Over the same period, U.S. inflation as measured by the consumer price index or CPI has averaged 3.9% per annum.

From a technical perspective, spot gold prices remain well above their 50-day and 200-day moving averages and should take-out the intraday high of $1,033 an ounce on the next up-crash cycle. This should occur during the summer or early fall. Seasonal strength for gold has arrived early this year, typically starting in the fall; but the latest price action can be interpreted as bullish as the United States and other countries increasingly lose control of inflation. In June, U.S. CPI hit 5% -- the largest annualized gain since 1991.

Gold prices are heading much higher before this bull lays to rest. This marks the first time in history that every facet supporting the bull market is riding on steroids!

Declining Production

Global gold production is now declining since 2005 with South African and Australian output virtually stagnant in 2008. Net supplies are approaching deficit as production fails to meet rising demand – mainly from a boom in exchange traded funds and a dramatic asset allocation shift among investors as they sell dollars and other fiat paper money and seek the relative safety of gold.

The Euro is no Panacea Longer Term

In Europe, where dollar-based investors have been dumping the buck in favor of the euro since 2002, growing economic problems will compromise or fracture the single currency at some point.

More than any other region, I visit Europe several times per year and can tell you with absolute certainty the Continent is suffocating under the strong euro.

Though unimaginable to many dollar bears now, the euro will unlikely remain strong over the next several years as weaker countries in the euro-zone plunge into a hard recession – namely Ireland, Spain, Italy and possibly, France. It’s also possible that one or two euro-zone members might leave the single currency altogether as deflation threatens economic growth and stifles export competitiveness.

In this scenario, which is growing more likely by the day, gold prices will rally as investors dump what was perceived to be the ultimate King of fiat currencies.

Even if the U.S. dollar does recover and posts a cyclical bear market rally, gold prices can still rise. This occurred in 2005 as spot gold prices climbed 18.3% while the dollar rallied 12.8% against the euro. There’s no steadfast rule that gold must decline if the dollar strengthens, especially in a counter-cyclical bear market rally. Provided investor demand remains strong for gold and global interest rates remain historically low, gold prices can climb to new highs as the dollar strengthens.

Inverse Stagflation and Gold

Unlike the 1970s when the global economy suffered through stagflation, the late 2000s offers a completely different economic paradigm. This is not stagflation all over again – or not exactly.

For the first time in the post-WW II period, investors are struggling with “inverse stagflation” or deflation in housing, credit and financial assets (stocks and bonds) combined with soaring inflation in food and energy prices.

If this was truly an inflationary economic cycle, textbook economics would support rising home values; this is certainly not the case as the S&P Case-Shiller Home Price Index has plunged more than 15% over the last 12 months through April (latest data available). This data is certainly not consistent with traditional inflation supporting housing values. In the 1970s, inflation-adjusted home prices increased, unlike in the post-2006 period.

The U.S. financial system is another source of deflation as banks struggle to recapitalize and purge their illiquid backlog of derivatives tied to housing and other opaque securities. Banks are now lending less – also a deflationary event. If less credit is flowing, then the economy can’t grow.

Of course, prices for just about everything are soaring over the last 12 months.

The government’s official CPI numbers don’t tell the whole story. Consumers are paying much more for goods and services today compared to last year and, in some cases, more than double for items like gasoline and certain foods. Yet, the official CPI is just 5% over the last five months through June.

The bull market in gold is sitting pretty. Investors, policy-makers and consumers are scrambling to decipher how to arrest rising inflation while in some industrialized countries central banks can’t aggressively hike lending rates because deflation has already gripped housing and bank credit. It’s an awfully delicate macroeconomic landscape.

Inflation and deflation now co-exist for the first time since 2001. I’m not sure which economic evil will win this war but one thing is for sure; if given a choice, the Federal Reserve and other central banks would much rather allow inflation to grow than deflation or an environment of accelerating falling prices. This, in fact, has been the sad history of all paper money; over the next 12-24 months I suspect the Fed and its international counterparts will aggressively print credit because deflation is seriously threatening the global economy as millions of consumers witness a purge in asset values. Inflation is the lesser evil and central banks recognize this.

Gold anyone?

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