Are
investors too bullish on the stock market’s prospects for 2014 and too bearish
for gold’s? It would certainly seem that
way based on the near unanimity of analyst consensus. Most institutional analysts have published
bullish forecasts for equities in 2014 and a bearish, or at least cautionary,
outlook for gold. The favorable forecast
for stocks and bearish gold outlook is based on the assumption that deflation
remains at bay for the coming year.
But
what if analyst expectations are disappointed and deflation rears its ugly
head? That is precisely the scenario
we’ll discuss here. For if deflation
returns at some point this year it would easily upset the status quo for both
asset categories.
Not
without reason economists have recently turned their attention to the specter
of deflation. Christine Lagarde,
managing directly of the International Monetary Fund, last week stated her
concern for a possible revival of deflation.
“If inflation is the genie, then deflation is the ogre that must be
fought decisively,” she said. Lagarde’s
comment came out of left field considering that most economists have assumed
that inflation, not deflation, is the new watchword. Could it be that Lagarde is more perceptive
than most economists? Does she know
something that most of us don’t?
This
sudden return of the “d-word” to the limelight is actually quite timely. In view of the upcoming 60-year Kress cycle
bottom in September, the long-term cycle of deflation is currently in its final
“hard down” phase. And while it would be
easy to sneer at a miniscule eight months, a lot can go wrong in eight months
(as the events of the last few years have shown).
The
Financial Times has astutely observed that “it is hard to remember a period,
other than in the months immediately following the financial crash of 2008,
when core and headline inflation has been so low in so many different
economies.” This in spite of the record
levels of liquidity that central banks have foisted upon financial
markets. The fact that inflation hasn’t
become a problem is due solely to the undercurrent of deflation courtesy of the
long-term deflationary cycle that is scheduled to bottom late this year.
With
a growing number of economists becoming aware of a potential deflationary event
in 2014, central banks have been even more vigilant. The ECB is expected to expand its balance
sheet even more this year in response to the decline in the euro zone’s core
inflation rate. Dr. Ed Yardeni
highlighted the potential risk of a deflationary revival in a recent blog
posting. He noted that initially
deflation might actually be bullish for stocks, even causing a “melt-up” since
central bankers would respond to it be injecting more liquidity in the
system.
He
added that if deflation prevails, however, a melt-up would most likely be
followed by a melt-down, which in turn would worsen the deflation. “In general,”
he wrote, “falling consumer prices would be bad for corporate earnings.”
As
for gold, many analysts erroneously assume that gold can only benefit from
inflation. Samuel Kress maintained that gold performs best as a safe
haven investment during two phases of the 60-year inflation/deflation cycle:
the final "hyper-inflationary" phase of the cycle (e.g. late 1970s)
and the final "hyper-deflationary" phase (e.g. the last 10 years or
so). With deflation comes investor uncertainty, which in turn causes them
to search for financial safe havens. Gold and bonds are the two most obvious
choices in the minds of most investors in times of uncertainty. Indeed, as the last 10-15
years have shown that both gold and Treasuries benefit more from deflation than
from inflation.
What
could go wrong for equities in 2014? A
revival of deflation could easily emanate from a credit crisis in China. China’s stock
market is reflecting the growing debt problem in China. Below is a chart showing the Shanghai
Composite index. A debt-laden and slower
growing China could have repercussions on the global economy, including the
U.S. economic and equity market outlook, for 2014. Should China’s problems begin to weigh on the
U.S. and Europe, a gradual return to the safe havens of gold and Treasuries
could emerge later in the year.
Also worth noting is that despite its internal economic
problems, China’s gold demand has shown a dramatic increase in the past
year. Even more demand is expected
heading into the start of the Chinese lunar New Year on Jan. 31. Bloomberg reports that contracts traded on
the Shanghai Gold Exchange jumped to a one-week high on Monday. Last year, the Chinese imported an estimated
1,000 tons of gold, which more than offset the decline in gold-backed ETF
holdings, according to Sharps Pixley.
If China’s voracious appetite for gold continues in 2014,
even in the face of a slowing economy on the home front, it could add even more
impetus to a turnaround for the yellow metal later this year. Moreover, a palpable slowdown in China would
eventually be felt in the U.S. and would give investors pause to reconsider
gold as an investment safe haven as financial market volatility increases.
It’s worth mentioning that Bank of America
Merrill Lynch strategist David Hauner has noted that commodity prices are back
to the “ominous” highs of 2008 in South Africa and Turkey. He believes this divergence “will have a
significant impact on growth and inflation in 2014: weak pricing power means
that higher commodity prices act as a tax on demand, slowing down growth and
thus ultimately reigning in current account deficits and inflation.”
Incidentally, take a look at the iShares MSCI
Turkey ETF (TUR) which reflects the stock market situation in that corner of
the globe. This provides us with a
simple overview of the tenuous economic situation in the Middle East region.
South Africa’s stock market isn’t too far behind
Turkey’s in terms of global underperformance (below).
In his latest research report, Hauner observed
concerning China that the country’s “rebalancing is a closely connected
disinflationary factor.” He added that
consumer prices in Europe, the Middle East and Africa “are highly correlated
with China’s with a lag of a few months. In fact, the betas to China and to
commodities are themselves highly correlated, likely as demand in China is the
key factor driving both.”
He concludes that the sharp drop in China's
headline inflation from 3.2% to 2.5% “is likely to have a dampening effect” on
consumer prices in Europe, the Middle East and Africa in the coming
months.
In other words, Hauner’s analysis loosely
corresponds with mine that a pick-up in deflationary pressure is possible
further into 2014, which in turn could increase financial market volatility and
possibly lead to gold’s return to favor among investors.
