Peter J. Cooper’s Weblog

The Royal Bank of Scotland has given gold a 25 per cent weighting in its latest Autopilot capital guaranteed deposit account targeted at expatriate customers. Performance is weighted equally across four sectors: emerging equities, developed equities, property and gold.

The role of gold in this new account is bound to raise eyebrows and comes as the bank is warning customers to expect turmoil in equity and credit markets over the next three months, an unusal statement for the second largest UK bank. The new fund will track performance of the four sectors when rising and divert to cash when a falling trend is identified.

Investors around the world are seeking to protect their assets from inflation yet in many cases these assets are suffering from deflation. It is a painful and expensive dilemma. How can inflation and deflation exist at the same time? Are they not supposed to be like matter and anti-matter, and not bedfellows?

Is it not bizarre for British citizens that the price of food, petrol, essential services and rents are spiraling upwards, while the value of their beloved homes is falling like a stone? Even in the Emirates stock market prices are weak while consumer prices are spiraling upwards, although real estate here still remains the best hedge against inflation at present.

The answer to the inflation versus deflation conundrum is that the two are part of the same phenomenon: the expansion of the money supply above levels of real economic growth.

It is easiest to explain this in practice with reference to the US situation. The Federal Reserve has been pursuing a low interest rate monetary policy off-and-on for more than a decade. This fanned the dot-com boom and bust of the IT sector in the late 1990s. Then the US housing bubble followed on the back of the low interest rates to bail out that bust.

Now the housing bubble has burst and the Fed is again applying low interest rates, this time to rescue the injudicious lending practices of the financial sector and to put a floor under falling house prices.

The problem now is that the financial sector is raising mortgage rates and keeping the profits from low interest rates to repair its own tattered balance sheet. Indeed, banks are not keen to lend to a sector that has just gone bust, and are instead providing money directly and indirectly for commodity speculation.

This is driving up the cost of oil, food, metals and an entire range of commodities. Even in China the government is no longer able to afford energy price subsidies and last week hiked prices at gas stations by 17 per cent. We still have the knock-on, secondary impact to come on consumer price inflation.

The so-called second-round effects of this primary inflation are two-fold. First, manufacturers face a surge in raw material costs and have to pass this on in final prices, whether they are making cars in Luton or ships in Shanghai. Secondly, workers rebel against rising prices and demand higher wages as they see manufacturers hiking their prices.

At the same time, companies find their profits under pressure. Many are in competitive markets and are not able to pass on rising costs fast enough to offset the impact on profit margins. And as profits are squeezed then the market capitalization of such companies on stock markets will fall, and share prices suffer deflation.

So in a curious cycle we can see inflation of house prices resulting in a deflationary bust that causes a policy response that leads to inflation in consumer prices which causes a further deflation of asset prices. In the case of housing, consumer price inflation reduces disposable income available for financing the purchase of homes and induces a deflationary downward spiral, the opposite of a real estate boom.

Where does this leave investors? If you sit on cash then inflation will erode the spending power of your money. If you invest in deflating assets then you are losing money.

What you require in this environment is a way to protect the value of your money. It is only going down in value because the central banks are printing more and more money in a necessary but vain attempt to shore up asset prices, at least in nominal terms. The answer is to convert to a currency which is not subject to an inflating money supply. It will then rise in value while other currencies sink, and will still be available when asset prices bottom out and look a good buy again.

Step forward precious metals as the only true money and repository of value. The supply of gold and silver is relatively fixed, and only inflating by the amount of annual production which is around two per cent of total available supply.

But hold on a minute. Prices of any commodity are determined by two essential factors: supply and demand; and speculative flows of money. If asset markets weaken further and investors gradually abandon them – or all suddenly jump for the exit door in another Wall Street crash – then the relative attractiveness of gold and silver will become apparent.

There are also considerable short positions in gold and silver which would amplify the price movement in the event of a sudden shift of money into precious metals. Therefore gold and silver are not only likely to prove highly defensive assets in an inflationary environment for general prices, and a deflationary one for stocks and real estate.

A big price spike like that seen in the late 1970s is perfectly likely. How high could prices of precious metals go? The Schroder Alternative Solutions Gold and Metals Fund launched last week predicted $5,000 an ounce for gold in the next few years.

Silver has arguably greater potential for price gains, with the largest short position and tightest supply situation and could top $100 from $17 an ounce today. That is why more and more smart money is choosing precious metals as an asset class. The cycle will later turn and real estate and shares recover their appeal once a recession has beaten inflation. But that is a several years away and not yet even on the horizon.