Gold - A Perfect Storm For 2019

The objective is to impede China’s technological development. It was tolerated when China, to steal a line from Masefield’s Cargoes, was the world’s supplier “…of firewood, iron-ware and cheap tin trays”. But China is moving on, creating a sophisticated economy with a technological capability that is arguably overtaking that of America. The battle for technological supremacy came out into the open with the detention on 1 December in Vancouver of Meng Wanzhou, the CFO of Huawei. Huawei is China’s leading developer of 5G mobile technology, installing sophisticated equipment around the world. 5G’s capability will make internet broadband redundant and will become widely available from next year.

Ms. Meng’s arrest represents such an escalation of deteriorating relations between China and America that many assume it was ordered by rogue elements in America’s deep state. Maybe. But these things are difficult to reverse: does America tell the Canadian authorities to just let her go? It would uncharacteristic for America to admit a mistake, and it would probably need President Trump to personally intervene. This is difficult for him because application of the law is not in his hands.

If Ms. Meng is not released, we will enter 2019 with the Chinese publicly insulted. They will realize, if they haven’t already, that ultimately there can be no accommodation with America. Fighting tariffs with more tariffs is a policy that will achieve nothing and damage China’s own economy.

It, therefore, becomes a matter of time when, and not if, China deploys financial weapons of its own. These will be targeted at the US’s obvious weaknesses, including her dependency on China for maintaining and increasing holdings in US Government debt. The increasingly compelling use of physical gold to both protect the yuan from attack in the foreign exchanges and limit the rise of yuan interest rates would serve to insulate China from the fall-out of a collapsing dollar.

The economic outlook, and the effect on the dollar

For market historians, the economic situation rhymes strongly with 1929, when the Smoot-Hawley Tariff Act was being debated. Eighty-nine years ago, the first round of votes in Congress was passed on 30 October, and Wall Street fell heavily that month in anticipation of the result. Following the G20 meeting two weeks ago, where it was vainly hoped there would be progress in the tariff negotiations between the US and China, markets fell heavily, reminding market historians of the 1929 precedent.

When President Hoover stated his intention to sign Smoot-Hawley into law on 16 June 1930, Wall Street crashed again. The lesson for today is that equity markets are likely to crash again if Trump continues with his tariff policies. Smoot-Hawley raised import tariffs on over 20,000 imported raw materials and goods, increasing the average tariff rate from 38% to over 60%. The difference today is that instead of tariffs being used only for protectionism, they are being targeted specifically against China. 

There will be two likely consequences. The first is the undermining of financial markets, which in the 1930s led to the virtual collapse of the US banking system and the global depression. And secondly, there is the escalation of a wider financial war raging between China and the US. These two factors are potentially very serious, with stock markets already on shaky ground. 

This is not the uppermost reason for market weakness in investors’ minds, who worry about the economic outlook more generally. The conventional credit cycle features rising interest rates as a consequence of earlier monetary expansion and the exposure of malinvestments. Markets discount the phases of the credit cycle when they become apparent to far-sighted investors, and only indirectly contribute to the collapse itself. But when valuations have become wildly optimistic, the fall in markets becomes a crisis on its own, contributing to the collapse in business that follows. This was the point taken up by Irving Fisher in the wake of the 1929-32 bear market.

In any event, the global economy appears to be at or close to the end of its expansionary phase, and is heading for recession, or worse. As well as the potential impact from an unanchored reserve currency, price inflation in the US will be boosted by Trump’s tariffs, which amount to additional consumer taxes. Price inflation pressures will then call for further rises in interest rates, while economic prospects will point to easing monetary conditions.

We have yet to see how this will be resolved. A further problem is that an economic downturn will increase government welfare commitments and therefore borrowing requirements. Bond yields will tend to rise and therefore borrowing costs, driving spendthrift governments into a debt-trap, just when price inflation is likely to demand higher interest rates. The most likely outcome will be further losses of fiat currencies’ purchasing power.

The 1930s depression saw a rising purchasing power for the dollar, with all commodity and consumer prices declining. The dollar was on a gold standard, and prices were effectively measured in gold, the dollar acting as a gold substitute. This is no longer true, and the purchasing power of the dollar, along with all other fiat currencies will at best remain stable measured against consumer products, or more likely will decline. In other words, a severe recession which looks increasingly likely on cyclical grounds will lead to higher gold prices, irrespective of fiat currency interest rates.

The gold-fiat relationship and monetary inflation.

According to the World Gold Council, central bank gold reserves total 33,757 tonnes, worth $1.357 trillion at current prices. Global fiat money is estimated to total about $90 trillion, which suggests there’s 66 times as much in global cash and bank deposits as there is gold to back it.[iii]

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Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated. The article is for general information ...

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