Some people are saying that the yellow metal is losing its shine. They have a point, as gold prices have plunged quite dramatically during the past few years. However, we shouldn’t be too fixated on the current gold prices. They are a result of emotional trading, extreme speculation, and possible manipulation. Looking ahead, the fundamentals of gold will eventually be priced in.
Let’s look at inflation first. The money printing by the Federal Reserve was at unprecedented levels. Since the Great Recession started in 2008, the Fed has increased money supply by 67%, or more than $5.0 trillion!
Intuition suggests that when more money is chasing the same basket of goods, each good is going to command a higher price. But why don’t we see it happening?
Well, there are three reasons.
The first reason comes from the official measure of inflation—the consumer price index (CPI). You see, the CPI puts significant weight on gas and housing costs, and those two are not growing that much these days: gas prices have stayed low since last summer, and there is a limit as to how much rent can go up each year. CPI numbers are dragged down by gas and housing. But if you look at core CPI (which excludes food and energy), you’ll see that inflation is more substantial.
The second reason is that a lot of the newly-printed money has not really gone into the real economy. The first stop for that money was the asset market, as that was the whole point of quantitative easing. What ended up happening was a huge boom in asset prices—the stock and bond markets soared to all-time highs. Since March 2009, the S&P 500 has climbed a dramatic 208.8%!
The third reason is simple: people did not have more money to spend. Despite the improvements in headline numbers, the reality in the U.S. labor market is quite disappointing. According to the most recent jobs report, the participation rate dropped to 62.6% in June, the lowest since 1977!
Moreover, the U.S. economy is gaining part-time jobs but losing full-time jobs. In June, there were 6.5 million workers who wanted to work full time, but could only work part time due to the lack of full-time jobs. (Source: Bureau of Labor Statistics, July 2, 2015.) Many part-time jobs do not pay enough to make ends meet. The gloomy U.S. labor market has put constraints on people’s disposable income. Without improvements in disposable income, consumers cannot increase spending on goods and services (other than taking on debt). That is another reason why inflation has been slow.
So what does it mean for gold?
Basically, there are two scenarios that could happen: the real economy either grows, or does not grow. In both cases, gold will shine. Here’s why:
Scenario #1: The Real Economy Grows
If economic growth finally picks up, what we’ll see is improvement in people’s disposable income. And that would lead to more consumption, which is good for the U.S. economy as two-thirds of its gross domestic product (GDP) comes from consumer spending. The problem it brings is that all this growth in consumer spending is going to drive up prices—i.e. inflation kicks in, and the purchasing power of paper currency will decline. When that happens, expect your real wealth to deteriorate. For centuries, gold has been used to store wealth during inflationary and hyperinflationary periods. This time, inflation could be huge (go back to look at the amount of money that has been printed), and gold will prove its value when that happens.
Scenario #2: The Real Economy Fails to Grow
Given what is happening around the world, there is a strong chance that growth will not pick up in the near future. The reason is simple: China’s stock market just crashed; its economy is slowing down; there is huge uncertainty in Europe; and uncertainty is also at substantial levels in the Middle East. As many U.S. companies have business overseas, the slowing down in foreign markets is going to put constraints on their earnings growth. When corporations report these earnings, markets will finally get a chance to see the fundamentals. A stock market correction, or even a crash, could follow.
How does this affect gold? Well, just look at China’s recent stock market crash. As share prices tumble, investors have been pulling funds out of the stock market and putting them into the gold market: in the first four trading days in July, settlement volume on the Shanghai Gold Exchange increased by sixfold to 597 metric tons. (Source: Ifeng, July 9, 2015.) On the U.S. side, gold served investors well during the stock market crash in 2008.
The key takeaway is this: under either circumstance, gold will protect investors. Indeed, that is what gold has always been—a great hedge. With the world economy being what it is today, savvy investors have gold in their portfolios.