The USA is slipping into stagflation

The Fed appears to be failing in both of its mandates. It is possible that we will see a second wave of inflation in the coming months.

By Laurent Maurel

Gold vs. bonds

A year ago I wrote that physical gold had become a more reliable option than government bonds.

The central banks' buying spree has cemented gold's status as a currency reserve. According to the Bank of America, gold has now overtaken the euro and has become the world's second-largest currency reserve after the US dollar, accounting for 16% of total reserves.

How could government bonds lose their historic role as a safe haven for investment portfolios?

The World Gold Council recently published a post explaining why gold will become the ultimate defensive asset in 2024, replacing bonds.

The most important graphic of this study, published on page 3, illustrates the contribution of the two asset classes to the overall risk, i.e. equities and bonds:

Bonds as a risk

The purple part of the chart shows the percentage contribution of bonds to the overall portfolio risk. We see that this risk contribution increases significantly over time, especially after 2014, with significant highs of just under 40% in 2020 and 2023. In recent years, the risk contribution of bonds has fluctuated very widely and has been negative at times (i.e. bonds reduce the overall portfolio risk), especially before 2014.

In recent years, the general upward trend indicates that bonds are becoming an increasingly greater source of risk. Not only do they no longer provide protection for the portfolio – they actually increase the overall risk!

The blue line shows the correlation between bonds and Swiss stocks over three years. This correlation, shown on the right-hand axis, fluctuates between positive and negative values. If the correlation is negative, bonds and stocks move in the opposite direction, which should theoretically reduce the overall risk of the portfolio.

60/40 Portfolio

In recent years, however, the correlation has become positive. This means that bonds and stocks move in the same direction, increasing the overall risk of the portfolio.

A classic 60/40 portfolio no longer succeeds in mitigating market risks – on the contrary, it exacerbates them.

Gold is currently outperforming the 60/40 portfolio and investors are waking up to this new reality. As I explained in a post published two weeks ago, gold is about to cross an important threshold relative to the “classic” 60/40 portfolio:

The move away from government bonds by investors can also be explained by the development of US interest rates. In 2023, the interest rate on 10-year US Treasuries broke its downward trend:

The TLT, an ETF for long-term US government bonds, has begun a revival in 2024 with high trading volumes – but this remains far too timid:

stagflation

The clear end of long-term trends in the US Treasury market has changed the perception of this asset class. Inflation has changed the tide in the US bond market.

Doubts about the United States' ability to repay its debts in a currency that has retained its value are growing as the country slides further into stagflation (a recession coupled with inflation). The Fed appears to be failing in its two mandates. Its battle against inflation has not been won and it is possible that we will see a second wave of inflation in the coming months.

Recession also seems to be looming on the horizon.

The inverted yield curve, a recession indicator we have discussed repeatedly in these posts, signals the official start of an economic downturn in the coming weeks:

The number of job openings confirms that the economy in the USA is slowing down more than expected:

Struggling US economy

But it was the latest ISM statistics in particular that spooked the markets this week.

Activity in the American manufacturing sector has now declined for the fifth month in a row and the ISM Purchasing Managers Index has fallen to 47.2 points.

This means that the purchasing managers' index fell short of expectations, as 47.5 points had been forecast for last month.

The index for new orders has now fallen to 44.6 points from 47.4 points in July, marking the third monthly decline in a row.

Production has fallen 21 times in the last 22 months, extending the second longest production decline in history.

The most important figures among these statistics are the inventory data:

Inventories have exploded on a regular basis, while consumption, the last engine of growth in the United States, has experienced a sudden slump.

Return of inflation

What is particularly worrying is that the decline in economic activity is accompanied by renewed price increases. While an increase in inventories should theoretically lead to a fall in the price level, we are currently observing the opposite.

The price index climbed to 54 points, up from 52.9 points in July, marking the first consecutive monthly increase.

Demand collapses, inventories grow (due to unsold products), and prices rise (due to higher labor and transportation costs). This is basically the definition of stagflation!

This is the Fed's nightmare, but also the nightmare of the most vulnerable consumers who are already struggling to pay off their debts:

Against the backdrop of stagflation, a new credit default cycle has begun in the United States:Given the stagflation and the beginning of a new cycle of credit defaults in the US, gold can logically attract new buyers.

Source: Goldbroker

LAURENT MAUREL in precious metals and mining analyst. An engineer by training, he has worked in various sectors (telecommunications, software engineering, astrophysics …) in Canada, the United States, Germany and France.

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