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Gold, commodity prices, emerging markets and the US dollar

Dec 01, 2014

Gold has been on a tear today!

Lower oil prices are deflationary on the surface only. Lower oil prices are a big stimulus to the economy. People start to drive more and spend more when they save money at the gas pump. Air fares go down and one travels more. Food prices go down and one ends up buying the more expensive cuts of meat and perhaps a more expensive bottle of wine. Consumption is a much bigger driver of inflation compared with reduction in energy costs. Consumptions spread throughout the economic system. It  is the same amount of money that is being transmitted from energy savings to the rest of the economy, but its impact on markets and equity prices is disproportionate.

Consumption turns companies that may be otherwise on the verge of bankruptcy into viable businesses. This is the basic principle of economics. A little stimulus can go a long way when it is applied correctly. The value of projects and human capital that are viable are exponentially greater than when one is at the edge of despair.

The rally in Gold today perhaps reflecting the onset of inflation. Gold has jumped by 4.50% at the time of writing. Other commodities are likely to follow in the near future if the Gold rally takes hold.

Almost everyone, including their mothers, is bullish on the dollar because they all believe that the US economy is doing well. Lower oil prices may put some spanners into the shale gas projects. But even more significantly, the strong dollar itself acts as a break on US competitiveness. Analysts draw the conclusions from history that a strong dollar is bad for emerging markets. That is if emerging markets have a lot of debt or become politically isolated. Exporters in emerging markets are usually clamouring for weaker local currencies. The whole basis for the Japan recovery relies on devaluation of the JPY with the aim of pushing up inflation.

There is a case to be made that a Goldilocks scenario is developing in the global economy. Interest rates can stay low because of low inflation expectations. But stimulus is coming from lower energy costs, which is the primary locomotive for everything we consume. Stimulus is also coming from the ECB and BOJ and low yields on government bonds in all developed markets and now the prospect that emerging markets will lower rates.

The main concerns are with oil producing countries. The Middle East countries are not going to run out of money any time soon. Canada isn’t exactly poor. Russian, Brazil, Mexico are going to manage because low energy costs present an opportunity as well as a risk. The big growth economies, China, India, Indonesia, Thailand and all of Europe benefit. European consumers needed a shot in the arm. Lower energy prices this winter is likely to keep them warm and put them in a good mood to spend.

In conclusion we maybe in the last phase of the downturn in commodity prices. If growth and confidence does revive in the rest of the world, then there is no reason for the US dollar to keep rising.

A very strong dollar is not in anyone’s interest if it has the impact of curtailing growth in emerging economies – the main engines of growth and inflation.

Of course, given that current volatility is at lows and bond prices are at their peaks the downside risks for the markets may come from other factors. Signs of inflation may cause a selloff in the bond markets sooner than desired.

Risks have to be monitored, measured and managed. Whatever one thinks can turn out to be wrong. But what works often is a systematic approach to risk management.