Inflation or Deflation: Gold Will Be King

By Clive Maund

From August 2007 when the world passed the tipping point it has been in the grip of massive deflationary forces that have already ravaged portfolios and pension plans and resulted in millions losing their jobs. This deflationary implosion had become structurally inevitable and it was only ever a question of when, rather than if, it occurred. It had to happen because debt and debt financed activities had ballooned to unsustainable levels. The wilful obstruction of the necessary corrective forces of recession over many years and the continued expansion of this huge debt bubble to unprecedented extremes via what is called financial engineering, in particular derivatives, led to it becoming critically unstable, so that when it burst a disastrous cascading deleveraging process set in. As we know, the event or crisis which burst the bubble was the sub-prime mortgage debacle.

Instead of accepting the deflationary implosion as the necessary price to be paid for years of excess, and something essential for eventual renewed growth from a firm foundation in the future, politicians and governments around the world, unable or unwilling to face up to the economic pain and probable political instability that would result, have been and are trying to obstruct the contraction through enormous ramping of the money supply in many countries and propping up defunct entities that according to the laws of economics and capitalism itself should be allowed to fall by the wayside. This is creating a highly anomalous situation where massive and ultimately unstoppable deflationary forces are colliding with an outright and reckless attempt to block them through means of massive reliquification. Because of the enormity of the debts and the scale of deleveraging necessary to purge the system, they can only delay or temporarily mitigate the forces of contraction, and that is probably all they are trying to do with the intention of further lining their pockets before they head for the hills. However, their continued efforts to obstruct these forces by means of the very profligacy and fiscal abuse that created the monstrous bubble in the first place, will lead to an even more catastrophic collapse later on. Their immediate solution to the crisis is to create blizzards of new money out of nowhere to throw at it and to drop interest rates to zero, in a desperate effort to stir up economic activity and to retard the compounding of already hopelessly out-of-control levels of debt. Many individuals and companies and even states and countries are in no fit state to take up the offer of cheap money, and have no reason to with demand having fallen off a cliff. Thus we face a situation where many asset values are likely to continue to collapse even while the air is filled with clouds of confetti money - you could call it super stagflation. The value of most debt must collapse towards zero, only in this way can individuals and companies be rid of its suffocating and paralysing influence, which is inhibiting their ability to generate demand within the economy. This means that the holders of debt instruments across the board are going to see the value of these investments shrivel towards zero over time. This will, of course, include the holders of US Treasuries and the holders of US dollar denominated assets in general.

Over the past two months we have witnessed a big recovery in world stockmarkets, that has been fuelled by the widespread perception that the global economy has "hit bottom" or is close to doing so, and that world governments have essentially bought their way out of trouble and beaten back deflationary forces by means of their massive money creation - politely referred to as quantitative easing. This fantasy has been played up by the media, who are in most instances an arm of government, but as we have just stated, the deflationary forces can only be exhausted once the imbalances giving rise to them have been corrected - and this will only be achieved once the massive debt overhang has been unwound, and this doesn't mean marking debt to model, it means being realistic and marking it to market, which in the case of most debt means marking it to a big round 0. The crisis will end when we have arrived at this point and we are clearly a long way from it yet.

Thus, it looks likely that we will witness another downblast of deleveraging before before much longer, and it will probably take several such downwaves perhaps over the space of years to finally purge the system, just as in the time of The Great Depression, and the recent buffoonery of massive money creation will only exacerbate the crisis. As we witnessed last year, the collateral damage that is inflicted during a phase of rapid deleveraging can be very heavy as forced sellers indiscriminately dump everything over the side, regardless of its intrinsic merits. Therefore we should not rationalize that because something has sound fundamentals it will be immune. We are well aware of this risk and expect the oil sector to get taken down hard should another wave of heavy selling in the broad stockmarket develop as expected, which is why we dumped the oil sector at the peak a week ago . Precious Metals stocks may well suffer too, and we will mechanically exit most PM stock positions, which we scaled back a week ago, in the event of the current uptrends in the PM stock indices failing. However, this time around we cannot be so sure, for gold, which held up remarkably well during last year's carnage, could rise as it continues in the direction of being "the only game in town", and is given added impetus by the watering down of currencies worldwide. For a while we could see gold going up and gold stocks dropping at the same time during an acute selloff phase, before rebounding strongly. The US government has good reason to want to see another wave of deleveraging as it would serve to channel funds into the dollar again to buy Treasuries, like last year, although not to the extent that they would hope for, as this time round the rally in both the dollar and Treasuries is likely to be much more muted as more players realize that both are living on borrowed time, especially as the growing risk of holding Treasuries has in the recent past been highlighted by the Fed stepping in to monetize them to plug a threatening shortfall in demand, a sign of growing desperation. Once this late flight into the dollar and Treasuries has run its course, they are very likely to collapse. At this point gold and silver, the physical supply of which is already acutely thin, will go through the roof.

It is because of this risk of another wave of deleveraging setting in that we have been rather circumspect in recommending Precious Metals stocks in the recent past, especially the big index driven stocks. Certainly the fundamentals for the sector are very positive with the outlook for gold getting better and better with each passing month - the massive increases in the global money supply not only to finance bailouts etc but also to support burgeoning deficits guarantees strong inflation in the future, and the supply of physical gold and silver is getting ever tighter, creating the conditions that are at some point are likely to lead to an explosive advance. In addition, mining costs have dropped considerably, especially as a result of last year's big drop in the price of oil. However, if the expected inflation is preceded by another bout of deleveraging, as looks likely, then Precious Metals stocks could be taken down temporarily along with most everything else, although this time gold is likely to hold up better and perhaps even rise. This is why we have been lightening positions as the PM stock indices approached the top of their current intermediate uptrend channel and stand ready to take evasive action or protect positions with options should this uptrend fail. If it does and we see another plunge it will be viewed as an outstanding opportunity to take positions across the sector for what promises to be an exceptionally powerful recovery and uptrend. Selected strong juniors have been recommended in the recent past on the site that have the capacity to make strong gains over a short time horizon.

In conclusion, this is a very tricky time for investors with the battle on between the forces of inflation and deflation. Because of the highly unusual combination of enormous debt that must unwind with rapid expansion of the money supply, we are likely to see extreme stagflation involving economic contraction, sometimes involving heavy and destructive bouts of deleveraging, accompanied by eventual high inflation that could morph into hyperinflation. With Treasuries and other government paper becoming less and less attractive and more and more dangerous, investors seeking to preserve their capital will turn increasingly to gold. Gold will be king.

With acknowledgements to whoever created the pictures used in this article.