From Charles Gave of GaveKal
Gold As A ‘Deflation’ Hedge
Economists have had many market puzzles to ponder in this era of monetary excess, going back to Alan Greenspan’s long bond “conundrum” nearly a decade ago. The latest market conundrum is gold: why did it begin rallying on news that US liquidity growth would be slowing (the taper), and why has it remained strong despite weak global CPI prints and flagging broad money growth the world over. This is particularly hard to understand for Organization for Economic Co-operation and Development investors, who think of gold as an inflation hedge. But it is less counterintuitive for the emerging markets.
To explain, let us for simplicity’s sake divide the world into two categories: 1) those countries which have foreign exchange controls; and 2) those which do not. The first category will be comprised mostly of emerging economies, the second mostly of developed economies.
If you are a rich person in one of the countries with capital-account restrictions, it can be difficult to diversify your assets abroad. In quite a few of these countries, even if one cannot for example buy a US government bond, one can buy gold, often produced locally. So gold becomes the substitute for international assets in a diversified portfolio.
Since the monetary history of quite a few of these countries is checkered at best (hyperinflation, defaults, taxes on capital flows, devaluations, etc), gold becomes the best available hedge against bad policy, as well as against a bear market in the local stock market. And it works—see the chart of Brazil as an example.
Of course, emerging markets are often as vulnerable to the vicissitudes of foreign capital flows as they are to domestic policy. Fed policy risk offers another motive for gold-hoarding in emerging markets (EM). If US monetary policy adds to the volatility of EM exchange rates, then residents need to hedge against this—and, as mentioned, their hedging options are limited. This is how we get the bizarre situation where holding gold protects against devaluation and growth/deflationary pressures in the emerging markets.
Gold will keep rising as long as US policy is exporting volatility—we see no imminent change in this situation under Janet Yellen’s Federal Reserve.
As the French economist Frederic Bastiat told us long ago, with any economic policy, there is what we see, and what we don’t see. The markets are looking for the effects of Fed policy in key US data points, like the employment figures. Yet the exchange rates of economies that now make up a significant portion of the global growth pie—Brazil, Indonesia, India, China, etc—are also quite relevant to the future of the financial markets in the developed world.