Inflation, Gold, and Cash
A look a long-term risk-off asset notions
Wednesday, 12 January, 2022
Published irregularly, as conditions dictate.
Today’s full CPI print comes in at 7.1234% YoY inflation (not the 7% the BLS erroneously rounds this already-diluted index down to) which is above last month’s 6.8805% YoY inflation (which BLS rounds to 6.8%). This is utterly damning to the economy, indicating an imminent recession being > 5% YoY, which historically has been as reliable as an inverted yield curve but more timely:
The NY Fed’s Underlying Inflation Gauge, a better measure than the Core CPI, calls major turns in CPI, is still heading up:
Hence, we would expect today’s full CPI print of +7.1234% YoY to not be the ultimate top.
Historically, when real (inflation-adjusted) earnings go negative, it has been the kiss of death for post-WWII markets, from the ‘87 crash where real earnings went briefly negative in August and September of 87, to t he 2000 and 2008 crash, we’re negative again, both on real, 12-month rolling actual earnings and the chronically optimistic forward earnings metrics:
And for the sake of a deeper history:
Recall that the current CPI full measure has undergone two major revisions ,both of which have worked to dampen the calculation, one in the the 1990s, another in the 1980s. With the Shadow Stats pre-1980 number as a guide, which is roughly at least 7% higher, we would be looking at real earnings, YoY in the above chart, somewhere in the vicinity of -11% approximately.
The notion of strong current earnings is completely diminished, and then some, when viewed under the lens of “real” YoY earnings.
With the caveats about the modern-day, more diluted CPI, let’s examine what it would cost today to buy what $1 bought on May 1, 1968 ($8.15 today, according to CPI over the interim)
Examined reciprocally, what is the value of one dollar on May 1, 1968 ($0.1227) ?:
Now let’s examine the value of $1 on May 1, 1968, adjusted for YoY CPI (“inflation”) if it were also invested over the interim in 90-day T-bills:
That $1 of May 1, 1968 would be worth about $1.29 in terms of 1968 dollar purchasing power. In other words, you would have more purchasing power per May 1, 1968 dollar today, after inflation and 90 T-bill interest. However, roughly 1/5 of the of the purchasing power would have evaporated since the Global Financial Crisis of 2008, and the steepest drop having occurred over the past ten months.
Once again, the problem is real returns. The question is whether such negative real returns are sustainable and if so, for how long? Indefinitely?
Let’s consider our model using employment and inflation to predict 90 day rates. We developed this model in the late 1990s using both the unemployment rate and the inflation rate to model where 90-day T-bill rates should be, and it has not been tweaked since, so the past 25 years or so are all roughly “out of sample.”
Though the model has gotten out-of-sync from time-to-time with actual 90-day T-bill rates given the Fed’s effect on the short end, the direction of rates resolves in the direction predicted by the model, which is currently decidedly and strongly up.
The Fed has no choice but to either raise rates aggressively or begin draining liquidity aggressively, or both, pleasant, mollifying chit-chat by the Chairman notwithstanding. Consider that historically, when the 2 year note minus fed funds gets beyond 50 basis points, what happens. When Fed Funds are 50 bps or more below the 2 year, the Discount rate is hiked and vice versa. Fed Funds are about 80-85 bps below the 2 year, and hiking can occur before March even. The history of this relationship is exhibited below:
I expect rates to be raised aggressively in 2022, and liquidity to be drained via reserve requirement adjustments. Unfortunately, the short end of the yield curve is where i believe you want to be, despite the likely loss there (a smaller loss being better than a larger loss, until long rates re-assert) if not outright short stock indexes as well.
Gold, unfortunately, has historically been a terrible hedge against equity market drops. Let’s examine the history of Gold, post May 1, 1968, in terms of inflation-adjusted price for gold to today’s price:
Note that this is the third time since 1968 that inflation-adjusted gold has exceeded $2,000 / oz. Has it retained it’s relative purchasing power? The argument can me made that currently, it has. But would that argument have held up say, from 1979 to 2000? From 2013 to 2019?
Was gold a good hedge against a declining equities market in 2001-2002? in 2008?
At best, real gold seems to have an independent correlation to equities, and has, over the long haul fared quite well against inflation.
What about crypto then? Digital gold?
Those who know me know I don’t care to venture into arguments where the other party cannot be won over. Some arguments are just head-butting, and to be avoided. I try to avoid these both in communication with others, as well as garnering an opinion, myself, personally. For example, for me to harbor a political opinion can only cloud my data-driven market judgement, at best.
Crypto is akin to a religious argument at present, one I care not to wade into, and frankly, care not to trade. I just don’t know the space well enough for that (at this time).
I will present the following, however. I believe people invest based on three possible criteria (although the criteria have different tax implications and liquidity concerns, which the investor is willing to assume):
Intrinsic value. People convert their cash into an item because it has value , that is, it can be converted back into cash and that it is “worth” the amount of cash for it; that is, a reasonable person would pay them the same thing, if not a little more, for the same amount of the resource they are converting their cash into. These are often “hard” assets, oil, metals, real estate, patents, and collectibles. This can also occur in the form of abstractions including patents, or the value of education, or even such as derivative products to price.
Income stream producing. Here, not only is the concern for how much income can be produced, but how long it can be produced for, and often the investor dichotomizes this income as a separate concern from the principal amount and its safety.
Someone will pay more for this tomorrow (the “Chain letter” criterion).
Usually, someone invests in something based on more than one criterion. For example, a bed and breakfast business that comes with property satisfies criteria 1 and 2. Almost always, criterion 3 is implicit in an investment (save for many fixed income products held to maturity). I find gold satisfies criterion 1, and, for most purchasers, criterion 3.
Further, I think we are in an era where most investments are overloaded on criterion 3, absent the first 2, if not entirely, certainly to a significant degree.