What Could Go Wrong For Stocks — And Right For Gold — In 2014?

Are investors too bullish on the stock market’s prospects for 2014 and too bearish for gold’s? It would certainly seem that way based on the near unanimity of analyst consensus. Most institutional analysts have published bullish forecasts for equities in 2014 and a bearish, or at least cautionary, outlook for gold. The favorable forecast for stocks and bearish gold outlook is based on the assumption that deflation remains at bay for the coming year.

But what if analyst expectations are disappointed and deflation rears its ugly head? That is precisely the scenario we’ll discuss here. For if deflation returns at some point this year it would easily upset the status quo for both asset categories.

Not without reason economists have recently turned their attention to the specter of deflation. Christine Lagarde, managing directly of the International Monetary Fund, last week stated her concern for a possible revival of deflation. “If inflation is the genie, then deflation is the ogre that must be fought decisively,” she said. Lagarde’s comment came out of left field considering that most economists have assumed that inflation, not deflation, is the new watchword. Could it be that Lagarde is more perceptive than most economists? Does she know something that most of us don’t?

This sudden return of the “d-word” to the limelight is actually quite timely. In view of the upcoming 60-year Kress cycle bottom in September, the long-term cycle of deflation is currently in its final “hard down” phase. And while it would be easy to sneer at a miniscule eight months, a lot can go wrong in eight months (as the events of the last few years have shown).

The Financial Times has astutely observed that “it is hard to remember a period, other than in the months immediately following the financial crash of 2008, when core and headline inflation has been so low in so many different economies.” This in spite of the record levels of liquidity that central banks have foisted upon financial markets. The fact that inflation hasn’t become a problem is due solely to the undercurrent of deflation courtesy of the long-term deflationary cycle that is scheduled to bottom late this year.

With a growing number of economists becoming aware of a potential deflationary event in 2014, central banks have been even more vigilant. The ECB is expected to expand its balance sheet even more this year in response to the decline in the euro zone’s core inflation rate. Dr. Ed Yardeni highlighted the potential risk of a deflationary revival in a recent blog posting. He noted that initially deflation might actually be bullish for stocks, even causing a “melt-up” since central bankers would respond to it be injecting more liquidity in the system.

He added that if deflation prevails, however, a melt-up would most likely be followed by a melt-down, which in turn would worsen the deflation. “In general,” he wrote, “falling consumer prices would be bad for corporate earnings.”

As for gold, many analysts erroneously assume that gold can only benefit from inflation. Samuel Kress maintained that gold performs best as a safe haven investment during two phases of the 60-year inflation/deflation cycle: the final "hyper-inflationary" phase of the cycle (e.g. late 1970s) and the final "hyper-deflationary" phase (e.g. the last 10 years or so). With deflation comes investor uncertainty, which in turn causes them to search for financial safe havens. Gold and bonds are the two most obvious choices in the minds of most investors in times of uncertainty. Indeed, as the last 10-15 years have shown that both gold and Treasuries benefit more from deflation than from inflation.

What could go wrong for equities in 2014? A revival of deflation could easily emanate from a credit crisis in China. China’s stock market is reflecting the growing debt problem in China. Below is a chart showing the Shanghai Composite index. A debt-laden and slower growing China could have repercussions on the global economy, including the U.S. economic and equity market outlook, for 2014. Should China’s problems begin to weigh on the U.S. and Europe, a gradual return to the safe havens of gold and Treasuries could emerge later in the year.

Also worth noting is that despite its internal economic problems, China’s gold demand has shown a dramatic increase in the past year. Even more demand is expected heading into the start of the Chinese lunar New Year on Jan. 31. Bloomberg reports that contracts traded on the Shanghai Gold Exchange jumped to a one-week high on Monday. Last year, the Chinese imported an estimated 1,000 tons of gold, which more than offset the decline in gold-backed ETF holdings, according to Sharps Pixley.

If China’s voracious appetite for gold continues in 2014, even in the face of a slowing economy on the home front, it could add even more impetus to a turnaround for the yellow metal later this year. Moreover, a palpable slowdown in China would eventually be felt in the U.S. and would give investors pause to reconsider gold as an investment safe haven as financial market volatility increases.

It’s worth mentioning that Bank of America Merrill Lynch strategist David Hauner has noted that commodity prices are back to the “ominous” highs of 2008 in South Africa and Turkey. He believes this divergence “will have a significant impact on growth and inflation in 2014: weak pricing power means that higher commodity prices act as a tax on demand, slowing down growth and thus ultimately reigning in current account deficits and inflation.”

Incidentally, take a look at the iShares MSCI Turkey ETF (TUR) which reflects the stock market situation in that corner of the globe. This provides us with a simple overview of the tenuous economic situation in the Middle East region.

South Africa’s stock market isn’t too far behind Turkey’s in terms of global underperformance (below).

In his latest research report, Hauner observed concerning China that the country’s “rebalancing is a closely connected disinflationary factor.” He added that consumer prices in Europe, the Middle East and Africa “are highly correlated with China’s with a lag of a few months. In fact, the betas to China and to commodities are themselves highly correlated, likely as demand in China is the key factor driving both.”

He concludes that the sharp drop in China's headline inflation from 3.2% to 2.5% “is likely to have a dampening effect” on consumer prices in Europe, the Middle East and Africa in the coming months.

In other words, Hauner’s analysis loosely corresponds with mine that a pick-up in deflationary pressure is possible further into 2014, which in turn could increase financial market volatility and possibly lead to gold’s return to favor among investors.

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