Gold – preparing for the next move

Friday, March 22, 2019
By Paul Martin

MARCH 22, 2019

Note: this article is not and must not be construed as investment advice. It is analysis based purely on economic theory and empirical evidence.

The global economic outlook is deteriorating. Government borrowing in the deficit countries will therefore escalate. US Treasury TIC data confirms foreigners have already begun to liquidate dollar assets, adding to the US Government’s future funding difficulties. The next wave of monetary inflation, required to fund budget deficits and keep banks solvent, will not prevent financial assets suffering a severe bear market, because the scale of monetary dilution will be so large that the purchasing power of the dollar and other currencies will be undermined. Failing fiat currencies suggest the dollar-based financial order is coming to an end. But with few exceptions, investors own nothing but fiat-currency dependent investments. The only portfolio protection from these potential dangers is to embrace sound money – gold.

The global economy is at a cross-road, with international trade stalling and undermining domestic economies. Some central banks, notably the European Central Bank, the Bank of Japan and the Bank of England were still reflating their economies by supressing interest rates, and the ECB had only stopped quantitative easing in December. The Fed and the Peoples’ Bank of China had been tightening in 2018. The PBOC quickly went into stimulation mode in November, and the Fed has put monetary tightening and interest rates on hold, pending further developments.

It is very likely this new downturn will be substantial. The coincidence of the top of the credit cycle with trade protectionism last occurred in 1929, and the subsequent depression was devastating. The reason we should be worried today is stalling trade disrupts the capital flows that fund budget deficits, particularly in America where savers do not have the free capital to invest in government bonds. Worse still, foreigners are now not only no longer investing in dollars and dollar-denominated debt, but they are suddenly withdrawing funds. According to the most recent US Treasury TIC data, in December and January these outflows totalled $257.2bn.[i] At this rate, not only will the US Treasury need to fund a deficit likely to exceed a trillion dollars in fiscal 2019, but the US markets will need to absorb substantial sales from foreigners as well.

In short, America is going to face a funding crisis. To have this funding problem coinciding with the ending of credit expansion at the top of the credit cycle is a lethal combination, as yet unrecognised as the most important factor behind both American and global economic prospects. The problem is bound to emerge in coming months.

While today’s trade protectionism is less vicious than the Smoot-Hawley Tariff Act, America’s drawn-out trade threats today are similarly destabilising. The top of the credit cycle in 1929 was orthodox; its principal effect had been to fuel a speculative stock market frenzy in 1927-29.

This time, the credit bubble is proportionately far larger, and its implosion threatens to be even more violent. Governments everywhere are up to their necks in debt, as are consumers. Personal savings in America, the UK and in some EU nations are practically non-existent. The potential for a credit, economic and systemic crisis is therefore considerably greater today than it was ninety years ago.

Bearing in mind the Dow fell just under 90% from its 1929 peak, the comparison with these empirical facts suggests we might experience no less than a virtual collapse in financial asset values. However, there is an important difference between then and now: during the Wall Street crash, the dollar was on a gold standard. In other words, the price-effect of the depression was reflected in the rising purchasing power of gold. This time, no fiat currency is gold-backed, so a major credit, economic and systemic crisis will be reflected in a falling purchasing power of fiat currencies.

The finances of any government whose unbacked currency is the national pricing medium are central to determining future general price levels. Just taking the US dollar for example, the government’s debt to GDP ratio is over 100% (in 1929 it was less than 40%). At the peak of the cycle, the government should have a revenue surplus reflecting underlying full employment and the peak of tax revenues. In 1929, the surplus was 0.7% of estimated GDP; today it is a deficit of 5.5% of GDP. In 1929, the government had minimal legislated welfare commitments, the net present value of which was therefore trivial. The deficits that arose in the 1930s were due to falling tax revenues and voluntary government schemes enacted by Presidents Hoover and Roosevelt. Today, the present value of future welfare commitments is staggering, and estimates for the US alone range up to $220 trillion, before adjusting for future currency debasement.[ii]

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