Avid readers of The van Eyk View and our other publications know all too well the importance we give to inflation regimes as predictors of future returns.
In fact, in the Interactive Asset Allocation Model recently made available on our online research portal iRate, the likelihood attributed to each of four different inflation scenarios (Functional or disinflation, Inflation, Deflation, and Stagflation) is a key input to strategic asset allocation decisions.
The one question we (and all economists, central bankers, and other pundits around the world) have struggled with for the past few years is whether deflationary or inflationary forces will eventually prevail. The Great Recession has spread from the US to Europe and more recently to emerging markets.
Outlooks for growth are diminishing everywhere and it stands to reason that if this trend isn’t reversed, deflation may soon take hold. On the other hand, central banks have used every play in (and off) the book to avoid deflation.
The US and the EU have lowered interest rates to zero or near-zero levels. In the past few weeks the Federal Reserve and the European Central Bank announced new rounds of quantitative easing, which combined with their previous actions (QE1, QE2, LTROs etc) and various forms of government stimulus – not just in the US and Europe but in China as well – amount to an unprecedented flooding of liquidity into the financial system. Or in other words, the perfect storm for future high inflation.
While the price of gold is often used as a barometer of inflation fears, a little known fact is that silver is often more sensitive to changes in inflation or deflation. The use of silver is roughly equally split between industrial and monetary uses. As a monetary metal, silver will (very much like gold) appreciate when global sentiment shifts toward expectations of higher inflation, as investors look for ways to shield their capital.
At the same time, since above-ground inventories of silver are relatively low and demand for silver in the industry is significant, it is also considered a particularly volatile metal. Therefore, the process of silver price appreciation (or depreciation) is accelerated, when compared to gold’s. Chart 1 tracks inflation (as measured by the US CPI) and the ratio of the silver price to the gold price over time.
A technical analysis of the chart shows that on three distinct occasions over the past 20 years, the breaking of long-term trendlines in the silver/gold ratio was followed by major shifts in inflation.
Chart 2 focuses on the latest data for the silver/gold ratio, and shows a clear breakout of the trend line to the upside.
As a stand-alone indicator, we wouldn’t give disproportionate attention to the technical analysis of the silver/gold ratio, but it happens to be supported by some mainstream economic data. The S&P GSCI Index of commodities has risen close to 20% from its lows in mid-June, a fact often overlooked in Australia where we have focused on the recent slide in iron ore prices.
It is evidently too early to assert that inflation has won its tug of war with deflation, but it seems that the printing of money in the US and Europe has initiated of phase of reflation. It remains to be seen whether this trend will last, and more importantly, whether it will result in inflation or stagflation.
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