Is the balloon going up?

I was taken to task recently for admitting – as if it were a crime – to owning some gold. Gold, I was told, doesn’t produce any income which is the raison d’ for holding any investment; valuation thereof being a “simple” discounted cash flow calculation. It is also easy for the price to be manipulated and, historically, governments have made it illegal for individuals to own the stuff.

The last purchase was nearly a year ago at a price of $875. Today gold goes for $1128 an ounce and even in sterling terms that’s a 21% increase so the barbs of criticism haven’t even “scratched the surface”. At the time gold bullion merchants had nothing on the shelves and demand was frenetic. The one thing I did take from my economics teacher was that if demand exceeds supply, price goes up. It did; eventually. There was no clear chart signal and to my chagrin the price spiked down briefly to $800; so yet another mental note to check with the “angels” before rushing in…

So I was asked, “Why are you still holding it now?” Well it has a lot to do with inflationary perceptions and the fact that paper cash is backed by nothing other than a government’s promise…More years ago than either of us care to remember my dear friend David Fuller opined that when governments are in trouble they will always inflate their way out. Inflation reduces the value of debt and it becomes easier to service, so whilst they publicly declare inflation to be the Antichrist, they secretly desire to have some, but not too much of it or you end up in trouble of Zimbabwean proportions.

Right now there is an equal chance of deflation, with its own set of problems (see Japan), as there is of inflation, but with the world awash with liquidity it has to go somewhere. The economic recovery is nascent, to say the least, so we are seeing another chapter in the asset price inflation story ie stock markets are going up again. If the recovery does continue then we will start to see inflation unless the central banks are very adept, a difficult skill when you are basing your policy decisions on hindsight.

Higher interest rates eventually kill the beast as Paul Volcker, the Fed chairman before Greenspan proved. But such is economic fragility at the moment that the goose may well get it in the neck as well. At this point stagflation (declining economic output and high inflation) arrives and your currency becomes worth almost as much as the paper it is printed on.

In this scenario the worst investment to hold is likely to be government bonds. Again my old friend supply and demand gives us a clue. Massive issuance to pay the bill for earlier policy errors, lukewarm demand and Q.E.D. the price goes down. So if this balloon does go up where to turn? I’ll give you some clues. It’s shiny and worth its weight…