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  The Rise Of Gold, China, And The Economic Barbarians At The Gate
 
  2016-06-10
 

 

Summary

Gold has risen by 18% over the last six months and there are signs it will continue to rise in value and there is no clear indication as to why.

China's unsustainable growth and impending meltdown has the failure to derail global economic growth.

Growing distrust between governments and their constituents is undermining the value of fiat currencies.

Rising geopolitical uncertainty and economic volatility coupled with gold not being correlated to stocks and bonds makes it an appealing asset class in an uncertain world.

With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people. - FA Hayek

Gold (GLDIAU) has long held a special place in the portfolio of many investors with the lustrous yellow metal perceived to be the best safe-haven asset and store of value in uncertain times. Recent global economic and market volatility has caused gold to spike by 18% over the last six months with signs of further appreciation on the horizon. This has triggered considerable interest in the yellow metal, which many believe is the ideal investment to offset the risks associated with fiat currencies, historically low and even negative interest rates, growing geopolitical uncertainty and economic instability.

In fact, there are signs that the greatest threats to fiat currencies, market stability, and socioeconomic cohesion have reemerged, and these have the potential to derail the fragile economic recovery in the U.S. and even cause the global economy to sink.

In the past, I have been particularly harsh on the value of gold as an asset class, with it having been one of the poorest performing and most volatile asset classes over the last 50 years. But one thing it has proven time and time again throughout history is that in times of absolute social and economic disintegration, it retains its value and provides a clear hedge against uncertainty. And this raises the question for investors everywhere, are we facing a global economic doomsday with the barbarians at the gate readying for the metaphorical sacking of Rome?

 

 

Genseric Sacking Rome

The barbarian at the gate

Globalism and the rise of global socioeconomic interdependence have created an ever more complex, interlinked, and increasingly dependent global system, where an economic tsunami can sweep through with ease.

You only need to look at the global financial crisis to see how the U.S. housing meltdown swept transformed into a financial crisis and swept across the globe as the cascading failure of financial markets brought the global economy to its knees.

The potential for this phenomenon to occur again remains ever present with fears of yet another global financial collapse rearing its ugly head yet again when commodities sharply collapsed in 2015. And now there are signs of yet another barbarian at the global economic gate.

Not only are there fears of an economic hard-landing in China, which could easily derail fragile global economic growth but the country is once again building a tremendous debt bubble as it creates ever more overcapacity and stockpiles surplus resources. This has created a debt bubble of epic proportions that if it collapsed could trigger a massive debt tsunami that would sack the global economy and create a financial crisis that would dwarf the GFC.

Interestingly, the possibility of a global economic meltdown triggered by China is very real.

You only need to turn to Brazil, an economy that is a mere sixth of the size of China's, to see the danger of the policies implemented by Beijing.

When caught up in the heady days of being one of the BRICS and one of the fastest growing economies in Latin America and in fact globally, Brazil's government fought to continue this momentum. And it did so by introducing policies that artificially boosted investment and suppressed consumption, which led to a rapid buildup of growth and large trade surpluses.

 

Nonetheless, in the end, these policies created structural imbalances that are not unraveling as Brazil faces its worst economic crisis ever.

Beijing has been following the same path, the only difference is and this is a very big difference is that China is the largest market for commodities globally and over the last decade has become the engine of global economic growth. For 2015, China was responsible for generating over 16% of global GDP, or more than a fifth of Brazil, and that trend is set to continue for some time yet even with its rate of economic growth slowing.

So when China's economy hurts, the global economy also feels the pain.

Like Brazil, China's growth model is unsustainable because of Beijing's obsession with propping up ailing state enterprises with copious amounts of debt in order to generate employment, driving economic stimulus through infrastructure investment and devaluing the Yuan to boost demand for manufacturing demand for exports. This approach to economic management, as witnessed with Brazil, is not sustainable and is priming China for a massive fall.

China has taken the concept of excessive capacity during the boom years to a new level.

Stockpiles of commodities are everywhere as is unnecessary infrastructure, while shells of unfinished high-rise buildings dominate the skylines of many cities.

 

You only need to turn to steel to see this. The global steel industry is caught in a protracted crisis with a massive global steel glut devastating global prices, yet China is pumping out steel with steel output in March hitting record levels. And it continues to stockpile steel and its core components including iron ore and coking coal despite significant global overcapacity.

 

The same is occurring with a range of other commodities as well, including copper and nickel.

Why is this occurring?

Beijing is determined to keep unemployment high in order to reduce internal dissent and with the steel industry being a key national employer, it has no option but to prop up unprofitable steel enterprises. The same is being witnessed with iron ore and coal mining as Beijing battles to boost employment and curtail rising internal dissent.

Michael Pettis, a former Wall Street trader and professor of finance at Beijing University's Guanghua School of Management who called the collapse in commodities as early as 2012, called China's growth model as unsustainable.

Morgan Stanley (NYSE:MShas weighed in with this gem:

We are concerned about the deteriorating quality of the cyclical improvement, as it has been mainly a government-led recovery in investment growth - especially infrastructure and property.

Without a doubt, just like Brazil, China is heading towards economic failure with it being focused on using debt to boost capacity and generating economic activity, with little regard for sustainability.

In fact, I will leave the last word with Morgan Stanley:

The cyclical improvement doesn't solve the structural problems of high debt, excess capacity, and persistent disinflationary pressures...

When China's economy finally collapses, the global impact will be massive, triggering a major deflationary cycle and economic contraction that will be impossible for central banks to manage.

Already, in the wake of the global financial crisis, central banks have pushed monetary policy to its utmost limits for very little gain, with artificially low rates and quantitative easing inflating asset prices and doing little to benefit the real economy. This means that the policy cupboard will be bare for the next financial crisis, potentially creating the deepest financial crisis ever known to the modern globally interdependent economy.

 

Such an apocalyptic economic meltdown would certainly leave gold as one of the few acceptable asset classes for investors with it being the only true store of value.

More than likely gold would return to the heady heights of the 2011 gold bull market. While this may be one of the greatest threats to the global economy and growth assets such as stocks and real estate, it isn't the only one.

The usual suspects

The appeal of gold as an investment has risen in recent months, historically low interest rates coupled with negative real rates in a range of economies make gold an attractive investment.

In any deflationary environment, gold is an attractive investment because it is perceived to be the ultimate store of value. So while growth assets such as stocks and real estate fall in value, gold retains its value, increasing its popularity among investors. Even in times of moderate to negligible deflation, gold is a popular investment because its value is negatively correlated to that of growth assets, which typically increase in volatility and fall during these periods.

Then you have the element of growing distrust among people who have lost faith in central banks, government, and the value of volatile fiat currencies.

Much of this is fueled by dissatisfaction over the outcome of quantitative easing, the losses experienced during the global financial crisis which can be directly attributed to the excess of Wall Street that triggered the crisis, the willingness of government to use taxpayer funds to bailout the perpetrators and the failure of Fed policy including QE to deliver any real benefit to the average Joe.

This is illustrated by the success Presidential campaign of Donald Trump, a populist who has captured followers who are disenfranchised with mainstream politics, remote bureaucracies and the tangled world of corporatized capitalism, where it seems the average guy always loses out.

The increasing breakdown in trust between governments' and their constituent populations is magnifying the volatility felt in markets and is a long-term headwind that is undermining the value of fiat currencies. This makes gold an important addition to any portfolio.

 

It was William F. Rickenbacker who famously stated:

Gold would have value if for no other reason than that it enables a citizen to fashion his financial escape from the state.

Don't forget, we now live in a multi-polar world where geopolitical tensions exist everywhere:

  • There are China's ongoing disputed claims to islands in the South China Sea, which has triggered rising tensions with its neighbors.
  • An assertive Russia focused on extending its influence into Eastern Europe and blunting that of Nato and the European Union.
  • The smoldering separatist conflict in the Ukraine which has prompted the intervention of Russia.
  • The war in Syria which has created the biggest refugee crisis in Europe since the Second World War.
  • Global terrorism and the emergence of Daesh and Al Qaeda as globally disruptive forces.
  • The ongoing civil war in Libya with Daesh now a major player; the civil war in Yemen.
  • The ongoing proxy war between Saudi Arabia and Iran for control leadership of the Arab world and control of the Middle-East.

In fact, oil has increasingly become an economic weapon of war, with the Saudis and their Gulf State Allies using oil as means of achieving their national, political, and economic goals.

Then there is the rise of an increasingly assertive form of nationalism across a range of emerging markets and the failure of the emerging markets growth model.

It is this last point which is of growing concern because it is also helping to feed the economic uncertainty surrounding the outlook for the global economy with emerging markets responsible for 57% of global GDP.

The slump in commodities continues to place considerable pressure on emerging markets with the majority of those economies caught in the extractive trap and highly reliant upon the production and export of commodities to drive economic growth. Of greater concern is that the fragile U.S. economic recovery is incapable of picking up the slack left by the decline in growth among emerging economies.

This is placing considerable pressure on the global economy, being a key reason for the failure of QE in the Eurozone and Japan and the negative interest rate environments that now exist in those countries.

 

The end result is that these even greater deflationary pressures coupled with global economic uncertainty, growing geopolitical volatility and the breakdown of trust between governments and their people make gold an appealing investment.

According to Irwin A. Schiff:

All of the government's monetary, economic and political power, as well as its extensive propaganda machinery, will be enlisted in a constant battle to drive down the price of gold - but in the absence of any fundamental change in the nation's monetary, fiscal, and economic direction, simply regard any major retreat in the price of gold as an unexpected buying opportunity.

My problem with gold

While I have often decried the value of gold as an investment, especially because of its poor performance and volatility in recent years, there are signs that it is going to perform quite strongly for the foreseeable future. My biggest problem with gold has been that it has no utility and its value is essentially imputed from a perceptual framework where people and investors have been conditioned over time to believe that gold is a store of value.

It has also been one of the most volatile and worst performing asset classes over the last 50 years, with it being outperformed both by stocks as measured by the performance of the S&P 500 (NYSEARCA:SPY) and 10 Year Treasury Bills (NYSEARCA:IEF).

In fact, where gold has only returned 4.72% over that period with a standard deviation of just under 20%, the S&P 500 has returned 8% and 10 Year Treasuries 7.6% with standard deviations of 16.5% and 8.8% respectively.

Nonetheless, neither stocks nor treasuries will perform well in an economic environment that is facing significant disruptions because of deflationary pressures, rising geopolitical uncertainty and failing economic growth. Then there are the issues around the disconnect between governments and their constituents and the increasing erosion of trust, which is triggering upheavals in a range of countries globally.

 

I will leave the final thoughts with renowned hedge fund manager Ray Dalio:

If you don't own gold... there is no sensible reason other than you don't know history or you don't know the economics of it...

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I/we have extensive investments in physical gold bullion and antique gold coins.

 
 
 
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