The US central bank (Fed) is about to raise its interest rates further. The outlook for even higher yields has become quite a concern for investors. “Because if and when interest rates keep edging up, the ongoing boom can be expected to come to a shrieking halt, running the severe risk of turning into a bust. This is neither an unwarranted nor exaggerated worry – as we no doubt live in times of boom and bust,” explains a market report from the precious metals’ firm Degussa.
The reason is that central banks, in close cooperation with commercial banks, issue new money through credit expansion, which artificially lowers market interest rates to below their “natural level”. The newly injected money brings about an economic up- swing (“boom”). It makes investment and consumption, propelled by easy credit, go up. Financial asset prices increase, giving people the illusion of great prosperity.
Furthermore, the relentless increase in the quantity of money brings up prices and thus erodes the purchasing power of money. Sometimes the inflationary impact manifests in rising consumer goods pr ices, sometimes in asset prices such as stock, bond, housing, and real estate prices. In other words: Today’s monetary system (you may call it unbacked paper or fiat money system ) is chronically inflationary.
But Degussa’s analysts think that sooner or later the inflationary boom brought about and held up by monetary distortions on a grand scale, will collapse and turn into bust.
However, unfortunately for most investors, there is no sure way to know when the crisis is going to happen. We do not have a rule or ma thematical for- mula according to which the duration of the boom can be estimated or the timing of the subsequent bust computed.
A key question for the investor is, therefore , how to deal with the boom – and – bust – cycle.
If the timing of the boom turning into b ust is unpredictable, it makes little sense for the investor to devote attention to market timing strategies. For instance, if you invest in stocks of great companies, and succeed in buying them at a decent price, there are plenty of good reasons to hold on to these stocks even through a phase of bust.
A great company will weather the storm. Its stock price may take a hit, but its earning power will not suffer permanently. And it is the latter that matters for the long – term oriented investor: A firm’s return on equity capital is what determines its stock price in the long- run (over five or more years). That said, Degussa’s report says that “if you are invested in great companies, you do not have to bother with trying to forecast the timing of the boom turning bus.”
The even more pressing question is, however: Will the approaching bust be short – lived and temporary, or is it going to deal a heavy blow to the economic and financial system? Again, most of us will probably find it pretty hard to come up with a reliable answer. However, sound economics may provide some helpful considerations, allowing the investor to deal with these questions in a sensible way.
The longer the fiat money fueled boom goes on, the higher the economies’ debt level relative to GDP becomes. The more stretched valuation levels in stock and housing markets become, the higher the probability that something will go wrong and that the boom will turn into bust – a kind of bust that may well become life – threatening to the current economic and financial structure.
Of course, significant productivity gains may well improve the economies’ debt sustainability and thereby prolong an ongoing boom, postponing the bust. Without them, however, the probability that the boom will sooner rather than later come to an end increases. In other words, in the current phase of the business cycle, with central banks trying to escape their ultra-expansionary policies, the probability of something going wrong is increasing.
Degussa points that it is here where gold comes into play. As they explain, from the investor’s viewpoint, gold can be considered a sound currency, as the “ultimate means of payment”.
Gold has unquestionably proven to be a sound currency in the long – run, having “outperformed” the US dollar (and other fiat currencies). Looking ahead, however, gold has another property which appears to be highly attractive from a savvy investor’s point of view.
Gold serves as an insurance against the vagaries of fiat money. Its purchasing power cannot be eroded by central bank policies. The yellow metal also protects against payment defaults (which bank deposits and short – term government bonds do not offer). And if the investor succeeds in purchasing it at a decent price, gold can even be viewed as insurance with an upward price potential in times of severe market stress. According to experts, that said, their argument has come full circle.
If the boom continues, gold as part of the investor’s liquid assets may well perform less favourable than stocks of great companies, for example. However, the investor should be aware of the fact that gold does not compete directly with stocks but with unbacked currencies such as, for instance, the US dollar, euro, Japanese yen, and Swiss franc.
Under current monetary policies, which are unlikely to bring inflation-adjusted (real) interest rates back into positive territory, gold appears to be in a favour a- ble position to outperform unbacked paper currencies in terms of keeping and even in creasing its purchasing power over the medium – to long – term. Especially so as gold does not seem to be expensive at the current price.
In case of emergency, when the boom turns into bust, gold protects the inve s- tor against currency debasement and payment defaults. It also entails the chance of an increase in price in times of financial market stress, which would allow the investor to exchange highly priced gold against attractive assets (such as stocks of great companies) that trade at suppressed prices, thereby helping to enhance the investor’s portfolio return