The Relationship Between Financial Assets, Time And Gold

geoffrey_fouvreyWe have released several articles and reports from Global Gold Switzerland, written by Claudio Grass (managing director). They have been very much appreciated based on the number of readers and their comments. See for instance Physical gold – Antidote against the global debt crisis or The Truth About The COMEX. The content of these articles has also been food for discussions. One of those readers was Geoffrey Fouvry, founder of the website The Duration Report. Mr. Fouvry has been working in the hedge fund industry for 13 years as analyst, head of research and portfolio manager. He has had several discussions with Claudio Grass which resulted in a unique view of how the concept of time is related to financial assets and in particular gold.

On a daily basis financial assets and commodities are measurable with the same yardstick which is say US dollars. This measurability in dollars in both cases is misleading and obscures the fact that they are indeed totally different. Their relationship to time is what sets them apart. The idea of duration and the difference between a present good and a financial asset are the most important concepts to understand for people wondering what Gold allocations are all about.

The concept of duration can be illustrated in the following way:

Assume for argument´s sake that NASA finds out that a meteorite will fall in 10 months on the earth killing everybody. This would be indeed a terrible fate; however we are not here to speculate about the likelihood of such an event (which is extremely remote) nor is it our goal to scare everyone into believing that “the end is near”. We will just use the example to illustrate the situation of a huge contraction in time horizon, or contraction in duration. How would financial assets behave in such situation? A treasury bond is a stream of future cash flows. Treasury bonds would only pay the next coupon and after that there would be no other future stream of cash flows. The treasuries price would plunge evidently; generally all financial assets with long duration (high growth stocks with little current cash flows) would equally plunge in price initially (1).

What would happen to present goods, i.e. consumable commodities which are perishable for example? Let us take the example of wheat. The farmer would have enough wheat in his silo for his family for the next 10 months and would have little incentive to prepare for the next harvest. In that case in the next few months the stock of wheat would dwindle to zero since people would still consume for the next ten months while no farmer would work the land and replenish the inventories. This would occur until the last grain of wheat is auctioned at an insanely high price.

So in this huge duration contraction, financial assets (future promises of cash flows) would plunge and consumable present goods which have a present consumption value and whose value is not derived from any future stream of cash flows would go up a lot in price. This example illustrates why commodities and financial assets usually have large relative price moves when there is a contraction of duration.  Students of the Dow-Gold ratio would recognize the situation of a very low Dow-Gold ratio. In the meteorite example this ratio would go extremely low but even more so against a consumable commodities basket.

Precarious conditions typically result in discounting the future cash flows at very high nominal rates. Those very high nominal rates can also be high in real terms during debt deflation contraction. Those high nominal rates might not be so high in real terms when debt destruction takes the form of a high level of inflation. Either way financial assets are a function of nominal rates discounting in both cases. In both a debt deflation situation (1929-1931) and a very high inflation (1980), the nominal market rates drive P/E multiples on the stock indexes to very low levels.The difference is that debt deflation destruction hurts stocks more than debt, while debt destruction through inflation hurts debt more than equities. In those situations, the duration contraction and precarious conditions make people prefer the present goods as opposed to the promises of future cash flows. Time preferences and duration contraction/extension along with changes in long term nominal market rates are what set financial assets and Gold on the opposite sides of the weighing pendulum scale.

Precarious conditions can come from different sources.

We can count two of those conditions with a monetary origin, a third one can be exogenous (meteorite, earth quake), and a fourth one is manmade (war). Some additional ones are purely due to perception and psychology and unique to a sector or company. This last category typically makes for great stock picking situations when a “precarious situation” is only a perceived/psychological one and not real. When this perceived precarious condition or “scare” subsides, the performance is usually very good. Finally all those conditions can interfere with one another. Exogenous shocks and war can interact with monetary conditions to create a very large duration contraction.

What is debt and what is GDP? What does “we have too much debt to GDP” mean?

The debt of someone is the financial asset of someone else (future cash flow promises). GDP is the circulation of present goods right now, which include goods and services, commodities. Those present goods have little price sensitivity to a moderate change in interest rates and inflation and those are not a stream of future cash flows unlike US treasuries. We can now rephrase the statement in the following way: We have too many financial assets (Debt, but equities too) in nominal terms in relation to nominal GDP (goods services and commodities). In that case it is not very sound to be overweight the asset class (financial assets) which is in nominal terms too abundant. The ratio of Debt to GDP can be restored by bankruptcies (numerator, i.e. debt and financial assets) or we can inflate the nominal prices of everything included in the GDP (denominator i.e. GDP or present goods). The Central banks today are attempting the second solution through money printing after a brief and relatively limited amount of the first resolution a few years ago (bankruptcies).

While the inflation numbers are probably doctored, the inflation in the general prices level has not been very large yet. For the financial specialists trained in the XIX century banking school, this is to be expected. Initially money printing will go into financial assets as described by the great monetary thinkers of the banking school (Fullarton) and will only start to move into the real economy when the nominal long term interest rates start to rise and change direction (Thomas Tooke). In future posts we will explore the relationship between rising interest rates and price levels and why money printing initially creates a financial assets rally while at the same setting the stage for future and continuous P/E contraction as soon as long term interest rates change direction.

Conclusion

When there are too many financial assets (Debt) to GDP (present goods), market participants need exposure to present goods (soft commodities, precious metals) and should be careful about stocks which rely on leveraged consumption. Duration contraction can happen with a credit crunch (refinancing rate shooting up brutally – bankruptcies 1929-1931 or briefly in 2008-2009 –) or with higher and higher rates because of higher and higher inflation (stagflation 1966-1981). Both processes destroy debt. The second is slower and more insidious, but ultimately both are a situation where precarious conditions make market participants discount the future cash flows at very high rates.  We are in a duration contraction (negative duration) environment, we had a glimpse of the first type in 2009, but we are now at the very beginning of the second type of duration contraction (rising long term rates and inflation). Both are a form of resolution to the excess of debt to GDP. Mr Ray Dalio has mentioned several times that the US was facing a beautiful deleveraging just like Great Britain post World War II. During that period, Britain avoided hyperinflation and also avoided debt deflation (US 1930s style), so in that sense it was beautiful. However post World War II, Britain was saddled with higher and higher inflation and higher and higher long bond rates until it had to be bailed out by the end of the 1960s. This beautiful deleveraging avoided the worst, but was not good at all for British financial assets market, bonds and earnings multiples, and meant a very weak British pound over time.

(1) The stock prices could rise thereafter because the meteorite wouldl ikely trigger hyperinflation, but in real terms they would nonethless plunge overall.

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