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Gold, Crypto, Commodities & Inflation
written by : William F Bryant The current economic environment, decisions by the Fed and massive “stimulus” packages that have been passed by government have brought the focus of alternative assets for investment to the forefront of most every strategist’s newsletter. These alternatives are familiar to most these days whether up on investment news or not, gold and cryptocurrencies. But to be clear, I do not think you can classify these entities as investments, they are more aptly hedges. Investments would generally be considered as assets that would grow in value, equities, or have a guaranteed payment, bonds. Hedges offset changes in price. This is an important distinction as is the way price is viewed. Before getting into the gold, crypto and fiat there are certain things that must be defined as they are too often glossed over or misunderstood.
Price is often mistaken for value, but that is not the full picture. The price, while comprised of supply and demand matchings and influential components of perceived benefits, is also affected by the economic environment. The economic environment is both economic and monetary policy decisions, consumer behavior, cycles and also inflation. A good example of this is a home. The value one puts into owning a home could be qualitatively generalized to be steady, but the price to own a home has changed dramatically. Does a homeowner get more out of a home now then 10, 20 or 30 years ago? Have the reasons to own a home changed? What has changed is the aforementioned economic environment, many times over. I would then surmise that price is a weighted, relative representation of value during a period of time. Now, let’s address inflation. Inflation is, strictly, the expansion of the supply of money. This expansion is done through the creation of credit. Inflation is not the increase in prices; read above. Inflation is a contributing component and therefore can not be the defined as an increase in prices if there are additional, more influential components involved in pricing. If you are wondering about the creation of credit, when the government declares it utilizes deficit spending, this is the creation of credit offered up by the willingness of other countries to purchase the debt, albeit being defined as a bond and not a loan. The effects of inflation are most easily visualized in an open market auction, before which, all bidders are given a relative to income determined increase in spending allowance. The price will most, likely not increase by the full amount of any one bidder’s allowance, but the price will increase above the price that would have been reached had there been no allowance increase. Stepping outside the general retail consumer marketplace, where might an auction and price increases due to inflation be seen first-hand; commodities. I have always enjoyed commodities and commodities’ markets. Perhaps it was growing up in a farming community and listening to Paul Harvey and the farm report or perhaps it was the derivatives and math involved, but one thing is certain, I can not discuss gold and cryptos without covering commodities. Commodities are the upstream in the supply chain. Commodities are the raw materials that go into production, metals, precious metals, energy and crops. It is also why these are the ‘canary in the coalmine’ indicators as to what prices are going to be flowing downstream. The way prices are tagged to commodities are of primary interest in this commentary. [Recall prices as the relative numerical representation of value in a given economic time period. Prices are heavily determined on the demand and supply matching component on a market, but let’s not forget how these are influenced and consider additional aspects of seasonality, tariffs and quotas. However, because these are influencing factors of supply and demand, I will simply state supply and demand without exhaustive mentioning of all influential factors.] Commodities and commodity traders generally watch for supply changes to anticipate future price changes. This is because demand is fairly predictable in terms of elasticity in a stable economic environment at the level of raw materials. Of course, we have now seen first hand what a sudden, comprehensive market demand drop will do to prices causing immediate oversupply, followed by segmented market demand upticks and supply chain buckling in an unstable economic environment, but focus on stability for a moment. In a stable environment inflation is of concerning interest as a price changing influencer. It is the Fed’s credo to push up prices 2% YoY. While this 2% is at the pricing of selected goods the consumer is exposed to, the 2% will be proportionally represented throughout the supply chain all the way back to the raw materials. So, as inflation is influential in price increases, the same amount of raw materials costs more to purchase in a given future time period and given economic environment regardless of demand and supply changes. In other words, commodity prices also move relative to a weighted inflation factor. [I will insert a comment on debasement and total money supply. There is absolutely a relationship between total money available in an economy, total supply of goods and prices. This implies that if the total money supply is doubled, presumably relative to some factor like income, and the total supply of goods does not increase, then prices will increase. Alternatively, the purchasing power of the money is reduced or debased. The increase of the supply of money and debasement are two sides of the same coin, given that the money is representative of something of value, say productivity.] If you were able to anticipate future price increases you may purchase the goods now to avoid paying more later. If you believed all prices were going to rise and the rise may be semi-permanent then you may desire to purchase substantially more of a good or goods and hope to use them to leverage the rise in prices by using or selling them off over time. Ideally you would purchase a good or commodity whose supply and demand is inelastic to price changes and has no substitutes, but it must also keep over time and have a small cost of carry. This good or commodity would not grow as an investment, it is a hedge against inflation and loss of purchasing power. Its price would adjust and be reflective of the value of the asset in terms of the currency in a specific time period and economic environment; note this is exactly what happens to commodities though some are more sensitive to whispers of supply changes than others. This is the power of, and warning inherent in, certain commodities. Similar reasoning and methodology is involved in the usage of copper, but rather than hedge inflation it suggests investment paths. Most commodities have a ‘use by’ date. Commodities spoil, rot, rust, erode, require unique distribution and storage methods and can simply be awkward. Some have considerable lead-time, some require continuous supply as stoppage is all but impossible and some require immediate processing due to an extremely short life span. You might recognize these traits as reasons speculators make use of futures or options contracts and why smoothly running supply chains are so important. But, in terms and times of inflation worries, the more risk adverse take to the adage, “if you don’t hold it, you don’t own it”. Holding and owning is huge step toward risk mitigation. This is why factories attempt to stock raw material to smooth out production due to anticipated supply changes (Huawei and chips), but it is no less effective if large swings in inflation are expected and added contract risk may not be acceptable. This writing is, of course, leading to a commentary on gold and cryptocurrencies, but I wanted to explain commodities in terms of how the pricing reacts to the additional factor of inflation, it is why any commodity could be a hedge against inflation. Commodity prices all rise in times of inflation. Recall, price is a relative measure of value during a specific time period and reflective of the economic environment. Most commodities, however, have many previously mentioned issues as an asset hedge with the notable exception of precious metals. In fact, I maintain that one of the most appealing factors to the usage of gold as money was that gold does not change over time, it is the least reactive noble metal and in pure form does not corrode or tarnish. Historically, empires were built on commodities and empires flourished from their trade. Commodities were the only real representation of wealth because raw materials are essential for productivity and productivity is essential to grow an economy. Rising from a bartering system of assets, it was understood that a medium of exchange was beneficial since most raw materials had all the issues, again, previously mentioned. A medium of exchange and a well-oiled financial system also proves to increase economic productive potential. But, technically, anything could serve as a medium of exchange, even wooden spoons; what was needed for exchange was money. Unbeknownst to many, money is not the paper cash carried in your wallet. Money actually has generally accepted characteristics that make it money. Money must be accepted as a medium of exchange, it must be able to serve as a unit of account and it must serve as a store of value, which implies a degree of scarcity. Interestingly, only commodities actually serve all three functions. Of course, commodities serve these functions to varying degrees. All can be measured to a unit, though some more easily than others. The same can be said for exchangeability. Finally, when a fiat currency, or debased currency, introduces inflation factors to pricing, the commodities will keep their value relative to the inflation and supply, demand concepts and therefore hold as a store of value. Immediately, you should be focused on the ease of debasement and find that the easier the medium of exchange is to debase, the less like money it is as the ease of debasement puts pressure on the medium’s ability to be a unit of account and its ability to be a store of value. The beneficial characteristics that commodities possess made them an ideal candidate for money and, perhaps most importantly, were trusted by the people. Obviously at first, metals and coinage were used. It was quickly discovered that certain metals oxidize and corrode in a short period of time and this was, itself, a cost to creating a medium of exchange. And then there was gold (and in a bimetallic currency system, silver). Used because of its longevity, malleability and its commodity characteristics meeting the requirements to be money. Using commodities as money actually works as a price stabilizer and productivity rewarder. There are times that there will be variability but these are easily recognized and smoothed out over time. The primary issue with commodities as money is found within the government and financial institutions. When an entity can only spend relative to what it holds, this acts as a restraint. It keeps governments in check and without rampant credit (and debt) prevents both governments and financial institutions from running amok. This should be recognized as the source of inflation, the increasing of the money supply, and the very issue which commodities were suggested as a solution in the first place. The relationship should then make sense. [I want to make an additional comment about government debasement of gold coinage. When government “needed” more money, living beyond its means, it minted coins with less gold. This created more coinage in circulation and stretched the amount of gold the government had in its coffers. This event debased the amount of gold in each coin, but also increase the money supply. Prices in the market increased, but because of the awareness of gold content in the coinage I would posit that there was an inverse relation to price and amount of gold in the coins. If a 1 oz gold coin once bought a horse, but the coin was debased to 1/5 of an ounce of gold that same horse would cost 5 of those same coins. The idea is that it was never the coins that mattered, only the gold. Fast forward to a concerted effort to prevent people from understanding how much of a metal went into a coin or even the understanding of its relativity to productivity.] Enter cryptocurrencies. I am going to be brief in this section because little needs to be said if you understand money. The power of crypto is in the blockchain technology. This technology has revolutionized supply chains and ledger security. Cryptocurrency is not, in and of itself, money. At best, it can be representative of a quantity of exchange that has real value by being backed by an asset, otherwise all you have is fiat all over again or a medium that does not meet the expectations to be called money. This is a similar concept to coinage, except that the coinage is digital rather than physical. For those that mention Bitcoin, and do not understand that Bitcoin may be the worst representation of the cryptocurrencies, then you may not understand the concept of inflation and money. Or worse, you do. If the entire value of something is based upon total money pooled together divided by coins outstanding and yet has no linking to anything other price factor, it is a closed-end mutual fund that holds no assets. It may, actually, be considered as a barometer for the flow of the monetary supply increases through the economy. Technology does not change the necessary qualities that define an asset or money. |
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