Wednesday, December 28, 2005

Gold, inflation and decrease in the value of currency

The recent run up in gold prices to above 500 U.S Dollars has caused a stir in the financial markets. Is the run up an indicator of stronger inflation in the coming year or is this a trend because of the strong growth in the emerging markets and transfer of petro dollars to Russia and middle east?Let us consider the first question - i.e., of inflation. Inflation is already running at multi year highs - the U.S I bond currently yields 6.83%.

Many companies are expected to pass on the increased costs to the consumers next year - Kimberly Clark has said that the tissue prices will be upped by 6% starting in January 06 as noted in the link below., the above price increases are already factored into the gold prices and the run up in November is the one that is posing the question - "is the runup in gold price a harbinger of greater inflation and stagflation?".

Economist wrote an article which basically debunked the theory of gold prices being the harginger of more inflation. The economist article compares and is able to correlate the increase in price of precious metals price to that of gold. of the reasons being touted for the increase in the price of gold is the gold ETFs GLD and IAU. Both these ETFs have low expense ratios and it is easy for investors to buy and sell gold like stocks through these ETFs. One doesnt have to go through the normal time consuming and expensive procedure to procure, secure and sell the precious metal. Investors have ploughed in about four billion dollars into these ETFs increasing the demand for gold bullion.

The recent article in supports this theory. The other reason for the strong demand for gold is the increase of wealth in emerging markets. As an example, in India the economy has been growing at a very fast clip ( 7-8% ) and is expected to keep growing that way for some years to come. The salaries have been growing even faster at the rate of 13-14% a year. This has resulted in a boom in all sorts of markets starting from the stock market to the use of consumer products such as cars. The trend is similar in other markets such as China, Russia and Brazil.

The only conundrum for this theory is that the stock prices of gold mining companies havent kept pace with the price of gold. The gold mining stocks GG, ABX, NEM and PDG havent kept pace with the price of gold. It is easy to conjecture that if the price of gold is to increase, the price of the gold mining stocks should also increase. The only reason this wouldnt happen is if the demand for gold is primarily from emerging markets. The currencies in emerging market countries are not freely convertible and it is not possible for individuals to buy the gold mining stocks. After all, gold is the real thing when compared to gold stocks.The International Monetary Fund (IMF) has published its forecast for next year's global growth at 4.2%.

The IMF forecast can be read here. though economic forecasting is a bit like fortune telling and it doesnt account for unexpected events such as terrorist attacks, natural disasters; there is significant momentum in the current cycle and it is unlikely that the U.S economic growth will slow down significantly in 2006. As I have published in the earlier blog on S&P 500, it is likely that the SP500 will do fine next year.We are seeing a global increase in wealth that is making more money chase the same goods. The demand from emerging markets will keep increasing. This has already shown itself in the increased demand for oil. Real estate is dearer all around the world now than was the case a few years back. The growth and demand from emerging markets will keep increasing.What is more likely is the growflation scenario - where we see growth and some inflation. It isnt going to matter what currency you own, everything is likely become dearer in the next couple of years. It is also likely that an average person's net worth will also increase significantly if the above scenario holds good.

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