Inflation, Stagflation and Asset price

I was thinking about the effect of inflation on equity prices. Therefore I studied the Dow chart adjusted for consumer price inflation. The results confirmed my long held belief that in a fiat currency system asset prices may not correct nominally but in real terms the correction in asset price can be severe. Let us look at the given chart of Dow. In this chart we can see Dow (RED) v/s Inflation adjusted Dow (blue)

Constant Dollar DJIA v/s DJIA

Let's zoom in and see the chart form the period of 2000 - 2011. We can see even though the Dow made a new high in 2008 in constant dollar dow only made a double top and at current price when nominal dow is down by 21% from the top Inflation adjusted dow is down by more than 27%. And that too in a decade where inflation was under control due to globalization.

2000 -2011

In the coming decade I expect inflation to be higher as governments will try to inflate their way out of debt. The next chart will give us an idea about how severe correction can be in real term when inflation is high. The given chart shows Dow v/s inflation adjusted down from 1964 to 1981. We can see that Dow stayed in a range between this period and in nominal terms the index was flat but if we adjust for inflation Dow went down from 500 levels to less than 180 levels which indicates a loss of 74% in buying power.

1964- 1981

The next chart shows Dow and Inflation adjusted Dow form 1925- 1981. We can see that by the end of 1981, the purchasing power of Dow has reverted back to 1950. It had lost 25 years without giving any real returns.

1925 -1982

Let us look at the given chart where we can see Dow priced in Gold. We can see that at max we could buy 40 ounce of gold per unit of Dow in 2000 and at the minimum we could buy 1.5 ounce of gold per unit of Dow. Currently we can buy 6.5 ounce of gold per unit of Dow. If this ratio is going to go back to its previous lows either Dow will have to fall or gold will have to rise or both will happen. I think it is quite feasible that Dow may correct upto 5000 levels and gold go up to 3500 USD levels. And just like 1970's the current decade is conducive for stagflation.

Dow priced in Gold

In the next chart I have presented gold price adjusted for Inflation. Today although gold is trading at 1750 USD per ounce much higher than 700 USD per ounce high of 1979, adjusted for inflation Gold had just reached its previous top where one ounce of gold can barely buy 8 units of consumption basket. If we believe that the coming decade is of stagflation than inflation and Gold may both move up.

Inflation Adjusted price of Gold

The last chart is that of Yuan. We can see that in last week Yuan have rapidly appreciated against USD. As we all know that Yuan is a tightly controlled by PBOC. The increase in the pace of appreciation shows that the communist party is ready to accept to risk losing export competitiveness but they want to slow down the accumulation of USD assets. This will prove to be an important turning point for global economy with lot of unintended consequence. It’s a big unknown as to what would be US 10 yield if china slows or stops buying US treasuries. If US yield raises dramatically it may prove to be catastrophic for the global economy.

Yuan - USD chart

I would suggest reader to go through recent report by Russel Napier "The great reset" will give you more insight into how central bankers throughout the world have/will shift their focus from buying US treasuries which will result into rising US treasury yield. I believe that US treasury have been into falling since last 30 years and the trend is about to get reversed in next few years.

Some Thoughts on US sovereign downgrade

There have been lot of fuss on US sovereign downgrade. I have two points to add to it. If markets believe that a default in real terms should also constitute a default then US rating downgrade is more than warranted. After all there is no way a US can pay its 14 trillion debt in real terms. It will use inflation and currency devaluation to default in real terms while still paying back in nominal terms.

Secondly, whether sovereign ratings relative or absolute. If ratings are relative to other countries then US is still arguably the strongest sovereign and therefore should be AAA rated. But if the ratings are absolute than US warrants a downgrade.