Gold prices have plunged. But those that are holding the yellow metal needn’t worry. Soon, you might be able to buy gold for double, even triple today’s price.
Let me explain.
Central banks around the world have one thing in common: they like to print money. Since 2008, the U.S. Federal Reserve has increased money supply by 67%, or more than $5.0 trillion. The European Central Bank (ECB) also joined the game, starting its 1.1 trillion euro quantitative easing program earlier this year.
Note that I am not telling you to buy gold. I am merely saying that for any investor, managing risk is necessary. In market conditions like this, gold provides a great hedge, not only to stock market downturns, but also to the monetary crisis that part of the world is already experiencing now.
The recent downturn in gold prices reflects more of a change in sentiment rather than fundamentals. There is a good reason for the change—the returns in the stock market were too high. And the reason for a bloated stock market was in part due to the Federal Reserve’s massive quantitative easing program. Moreover, near zero interest rates also pumped up the markets. When investors see no return in bank deposits, they put their money in stocks and bonds.
The current situation is like this: a lot of money has been poured into the economy, but a large part was absorbed in asset markets, so we have historical highs in asset prices but not that much inflation. Once the Fed starts to raise interest rates, and they are expected to do so later this year, we are going to see how markets react.
Another big worry is when inflation will come. Despite Greece’s problem and China’s slowdown, deflationary pressures are not likely to last. This is because the amount of money that has been printed by the Fed and the amount of money the ECB is still printing will translate into price inflation. I have said this many times: when more money is chasing the same basket of goods, each good in the basket is going to command a higher price.
What’s in it for gold? Well, what we are about to experience is the flaw of the fiat money system—the declining value of paper currency. Gold cannot be printed or created out of thin air. It might not have given you astronomical returns like the stock market did, but it will also not evaporate like public companies’ market value. The shiny metal sits there, at your house or in a vault. It is not anyone’s liability, and no one can default on the gold at your hand. Gold is, in itself, an investment that all too many investors have ignored.
As billionaire investor Ray Dalio says, “If you don’t own gold, there is no sensible reason other than you don’t know history or you don’t know the economics of it.”
Too Comfortable with Low Interest Rates
What I am worried about is that we are getting too comfortable with low interest rates. Over the past several years, businesses in the U.S. were able to fund their operations and expansions at record low interest rates. This makes us question whether the growth (which has been quite lackluster) we see has been artificial as a result of the low interest rates, and how much of that growth will remain once interest rates resume to normality.
It was not just our businesses that got too comfortable with low interest rates; the government enjoyed it too. Government debt has piled up, with interest payments increasing from $515.0 billion in 2008 to $636.1 billion in 2014. If interest rates double, the interest payment on government debt alone would top $1.0 trillion! (Source: Federal Reserve Bank of St. Louis, last accessed July 9, 2015.)
As we can imagine, the upcoming rate hike will make it more difficult for companies to finance their operations, and add more of an interest payment burden to the U.S. government budget. How will company earnings change? And how will the U.S. government raise more money for the interest payments?
Companies’ financials are likely to deteriorate. The government would either cut their spending or raise taxes. Or, the government could issue more debt to make the payments on current debt. Sound familiar? A Mediterranean country was doing just that.
Once the downturn in business financials and government credibility kicks in, markets would finally see the fundamentals, causing the asset price bubble to burst. At that point, expect a huge rush to owning hard assets like gold.