By David Hunter
Casey Research
Gold and the Upcoming Deflation Cycle
Gold has been in a secular bull market since 2001, when it began rising from a low of $250. It had been in a bear market for the prior two decades after peaking out at $880 in 1980. Disinflation and the end of the Cold War dampened gold’s appeal through the 1980s and 1990s, as did the strong returns generated by bonds and stocks.
Then 9/11 happened, followed by the Iraq and Afghanistan wars. Once again investors began looking at gold as a potential beneficiary of increasing world strife. We started to see both money and credit expand, and investors began considering the implications this could have for future inflation. Gold soared to $1,900 in 2011, and one analyst after another predicted ever-higher prices for gold—$2,500, $3,000, $5,000, and higher.
That marked the high-water mark for gold. It has been down ever since. In the past three years, gold has fallen 37% from 1,900 to its current price near $1,200. The selloff has certainly frustrated the gold bulls, who thought the Fed’s $3 trillion of QE would have propelled inflation and gold prices much higher by now.
Gold had a great 10-year run and was overdue for a correction. Many investors bought into the inflation scenario, and when it didn’t materialize, began to liquidate their gold holdings. Once the uptrend broke and momentum clearly shifted to the downside, more and more gold investors bailed. I think the dominant factor driving gold lower these past two years has been the unwinding of the inflation trade.
Gold is still in a secular bull market and much higher highs lie ahead. It could reach $5,000 or even $10,000 by the end of the decade. However, right now it’s in a cyclical bear market—one with significant further downside risk just ahead.
Deflation
Throughout this recovery cycle, the consensus on Wall Street has been that it’s only a matter of time until inflation rears its ugly head. Most assumed that after three decades of disinflation—when inflation fell from near 20% down to 1%—the odds favored a reversal of the trend. The prevailing view was that the Fed would do everything it could to ensure that the economy didn’t slip into deflation. The expansion of the Fed’s balance sheet by over $3 trillion led analysts to assume that a new inflation cycle was inevitable, and likely coming sooner rather than later.
The problem for gold is that not only has inflation failed to surge during this cycle, it has actually declined over the past five years. Globally, we are now closer to a deflationary cycle than at any time in the past 80 years. And the dollar’s recent sharp rise is putting more downward pressure on prices here in the US.
There are still plenty of inflationists hanging on to their gold positions. They believe inflation will heat up soon and that the dollar will lose its reserve currency status in the near future. My guess is that even these “strong hands” holders of gold will have their convictions tested in the next few months as the dollar soars and gold trades well south of $1,000. I suspect many will finally throw in the towel when they see deflation. Capitulation by this most resolute group of gold investors should set the bottom and usher in the next big bull cycle.
So here we sit, with gold around $1,200, well off its high of $1,900, but also still well above the 2001 low of $250. In some respects, I’m surprised that gold has remained this high, given how wrong the inflation thesis has been. If someone told me in 2001 that in 13 years, inflation would be 1-2% and heading lower and that the price of gold would be up almost fivefold, I would have characterized that scenario as highly unlikely.
Amazingly, gold ran up from $250 to $1,900 primarily based on an inflation premise that has yet to pan out. The dollar did experience a big decline over that time, which certainly played a significant role. But in hindsight, the gold rally was overdone. Ever since I turned bearish on gold in 2012 at $1,800, I have been targeting $800-$1,000 as a potential bottom. Given my expectations of a deflationary bust and a dollar rally that takes the index to 100, gold could even fall below $800 for a short period.
Gold’s final leg down will be all about deflation, and most investors are not prepared for it. Most gold investors remain focused on inflation. Those who do mention deflation seem to think it’s rather benign, just a step removed from disinflation. Their understanding is based on what has occurred in Japan and more recently, Europe. The deflation in both cases has been mild and gradual, and to date has not had a game-changing impact. Some have even suggested that deflation could be positive because consumers would be able to buy things cheaper.
It has been 80 years since this country experienced widespread deflation, so it’s understandable that most investors have little comprehension of the implications. Wall Street doesn’t even get it. Deflation is more than just a little price weakness—especially when it comes in the form of a bust, as I expect to be the case. Not only will consumer prices drop sharply, incomes, revenues, and asset prices will plummet too.
I expect the global deflationary bust to be short and sharp. I think it will cause significant involuntary liquidation and some major bank failures. Equity markets around the world will decline by more than 50%, and commodity prices will fall sharply. Bond spreads will widen dramatically, and the junk bond market will implode.
I don’t foresee a depression, although it will certainly feel like one while we’re in it. The best comparison is 2008-‘09, except the coming downturn will likely be worse. It will be what 2008-‘09 would have been if not for TARP.
Still, I expect the bust to be contained within 2015, because we know exactly how central bankers will respond.
The Inevitable Response
Policymakers have but one tool that they can deploy quickly enough to counteract a free-falling global financial system: massive Quantitative Easing.
The coming global financial crisis will be unlike any in history. The credit crisis in 2008 was a precursor; this one will be worse, and the global financial system will be at risk of spinning out of control. Janet Yellen and her fellow central bankers will respond with panic, shoveling money into the system at a magnitude far beyond what we have seen in this cycle to date. I expect $10-$15 trillion in additional QE from the Fed, and for the other central banks of the world to do the same proportionally. They will do whatever it takes to stem the free-fall. Fiscal policy will play a role, but that response will be slower and come later.
Simply put, policymakers have spent the last five years attempting to manage the deleveraging of the massively overleveraged global economy. They’re reaching the limits of what they can do. It was unrealistic to think they could successfully deleverage the system without creating serious dislocations. They had no choice but to try.
The recent volatility in the currency and commodity markets suggests that policymakers have run out of room. They’ve reached the point where a policy fix in one place exacerbates problems elsewhere. In spite of their best efforts, the global financial system is more leveraged than ever, and the global economy is losing steam. Officials have made some major policy errors, and the world is edging ever closer to a deflationary bust.
I am quite certain the stock market has seen its highs, and I expect the unwind to be swift and steep. Commodities will also fall sharply in the weeks and months ahead. Oil prices will likely fall below $50 and natural gas could drop to $2. Copper prices could decline by half.
Gold is further along in its cyclical decline and thus nearer its bottom. It has begun the final leg of its decline and could find a bottom by late this year or early next. A great buying opportunity lies ahead for the precious metals, as they will be the leaders of the next market cycle.
However, for now, investors should focus on the risks. A short, sharp deflation cycle is coming, and it will be a game-changer.