Diagnosing Inflation

Since the 2008 crisis, gold bugs and other commodities investors have been announcing to the public that the dollar is doomed and metals are the only smart play in this troubled economy. While investors are noticing signs in the economy that are similar to inflation, the economics do not support the claim. As pointed out in both Inflation — the elephant in the room and Inflation or deflation: Yes, there is a very real chance that we could see inflation in the future, however we do not predict inflation being an economic problem in the next 6 months. We wanted to take some time and analyze why some investors fear inflation in the short-term and try to put those fears to rest.

Commodities are overbought

Following 2008, gold was a hot investment on fears that the Fed’s Quantitative Easing policies would destroy the value of the USD. Along with precious metals, investors looked to other commodities such as agricultural goods and energy products such as oil, natural gas, etc. Food prices, especially corn, are very high right now, but that is due to a function of supply and demand more than inflation. Corn is not only a sought after agricultural good for consumers, but it also feeds livestock and is consumed in ethanol production. Due to increased demand and a lackluster growing season, corn has jumped in price, thus making it more expensive to feed livestock resulting in higher meat prices. Transportation costs have also risen, making it more expensive to deliver food products to their final destination, resulting in higher prices. Remember, inflation is not the only factor that can cause commodity prices to spike; supply and demand can as well.

This gold buying frenzy that has occurred in the last 5 years has resulted in the XAU (gold mining stock index) and Bullion ratio, which historically sits at around 5, to jump to over 10.5 in recent weeks. We believe that this indicator will come back in to balance, but for this to happen gold prices need to drop substantially, gold mining stocks need to rally, or some combination of the two. We believe the latter is the more likely case.

The strength of the USD

Despite all of the doom-and-gloomers out there, the USD has slowly crept up to a 2 year high based on outlooks for future manufacturing in the US. Typically, the price of gold and the value of the USD vary inversely. We believe that the value of the USD has justifiable economics substantiating its growth, while gold may simply be overbought. In short, a strong Dollar hurts the inflation argument.

No borrowing means no inflation

Inflation is defined as growth in money supply exceeding economic growth. Few people realize it but growing the money supply is healthy for a growing economy. If economic activity is increasing but money supply is not, the value of your domestic currency becomes so strong that no foreign nations can afford to buy your products, and manufacturers are forced to sell goods for less than the cost of production in order to remain competitive, which leads to deflation, which leads to recessions. This is the major flaw with the argument for a Gold Standard. If a nation were to use a precious metal such as gold for currency, they would only be able to grow their monetary base as fast as they could mine the mineral. While this makes excessive currency creation nearly impossible, it also makes necessary growth to the money supply absolutely impossible. For reference, look at the US economy pre-Federal Reserve; before 1913. The US averaged a depression every 7-10 years, partially due to this inability to grow the money supply as needed. In short, tying domestic currency to a tangible asset constrains economic growth.

As we have previously written, to have inflation we must have 2 factors; volume and velocity. After QE1 and QE2, we have the volume, but money is simply not turning over in the economy. Furthermore, corporations are sitting on trillions in cash and are unlikely to borrow until they see a tangible bottom in interest rates. Once rates begin to rise and borrowing ramps up, inflation may be a valid argument, but not yet.

Considering the observable factors in our domestic economy, we completely understand why the inflation argument is being made, however the fundamentals do not support this theory. If circumstances were to change, we could possibly see substantial inflation, but not in the short-term. While it is important to recognize the symptoms of inflation, it is far more important to properly diagnose it and adjust your portfolio accordingly.

Ben Treece is a partner with Treece Investment Advisory Corp (www.TreeceInvestments.com) and licensed with FINRA (www.Finra.org) through Treece Financial Services Corp. The above information is the opinion of Ben Treece and should not be construed as investment advice or used without outside verification.
« Back to the blog.