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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.
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