In a global economy witnessing passive consumer inflation, sluggish wage growth and falling commodity prices, some market observers have voiced their concern about the potential for deflation in developed markets.
Last month, gold dipped below $1 200/oz, before recovering marginally, as inflation hedges lost favour among investors fearing low growth and lacklustre monetary policies, which could yield deflation in the world’s most advanced economies.
With monetary policy remaining weak, market expectations for inflation have remained lacklustre, and a slowdown in emerging markets has accelerated the trend.
Prices for a large basket of commodities have continued to slide in recent months, with the Dow Jones Commodity Index falling more than 9% so far this year, after prices peaked late in June.
During recent industry events, some analysts were decisively bearish on the yellow metal’s recent performance and the price outlook, arguing that exaggerated inflation fears that occurred shortly after the financial crisis caused artificial demand, which has proven unsustainable in more recent years.
Certain analysts are blaming a rapid increase in natural gas and oil reserves, combined with insipid demand from China, as its middle class fails to accelerate spending on consumable goods. Meanwhile, in a recent study, The Economist noted that raw materials might be on a path to erase gains that caused commodity prices to triple between 2000 and 2011.
At the same time, technological improvements and innovation in hydraulic fracturing have made energy cheaper and more plentiful, which, in turn, has lowered concerns about an inflationary spiral caused by diminishing resources. With less demand for commodities, traders are finding less justification to buy gold as an inflation hedge, particularly as the metal has seen continued price declines since its 2011 peak.
Despite commodity prices slowly rising west of the Atlantic, more economists are predicting deflation in the European Union (EU), as monetary policy remains relatively tight. EU Central Bank president Mario Draghi recently attempted to cause prices to rise by starting a US Federal Reserve-style quantitative easing programme, but the plan was met with strong resistance, especially from German politicians.
Further, unlike the US fiscal cliff, which was largely defused by Congressional action, the US monetary cliff – which will be reached if US inflation rates turn negative – cannot be easily circumvented. Over the past two years, US, EU and Chinese inflation rates have drifted steadily lower, and Japan’s “end deflation” initiatives have produced only modest relief from 15 years of deflation.
Once an economy slips into deflation, the risk of falling into a self-reinforcing deflationary spiral rises. And, as deflation increases, investment, spending, lending, and employment growth suffer. Because the US is the largest economy in the world, US deflation could be exported to the rest of the world.
The Federal Reserve is set to end its economic stimulus programme this month, bringing to an end the controversial five-year-old scheme, despite analysts saying there are signs that the US economy is still in trouble, prompting certain investors to once more hedge in tangibles such as gold and real estate.
“Recent years were kind of like the perfect storm – anything and everything that could go wrong went wrong,” Regal Point Capital Management chief investment officer Vijay Marolia tells Mining Weekly.
He argues that precious metals are still the ultimate holders of value and a currency on their own. Marolia further believes that what the public is told by governments about inflation does not always ring true. “We are often told that inflation is a natural phenomenon, but, in reality, deflation is natural. Productivity and learning, in fact, create a downward movement in prices if it is a free market,” he says.
Marolia maintains that deflation is often misunderstood and that, as long as deflation is not sudden and extreme, it is the natural way things happen. Cellphones, for instance, get cheaper as they are produced in greater volumes. “Deflation should not be scary – inflation should be scary – we are like the proverbial toad in boiling water. It’s not making a strong enough impact to cause us to change our behaviour or view,” he says.
Marolia believes that the impact of deflation on the mining industry would make life difficult for companies with a lot of debt on their balance sheets. From a consumer standpoint, however, people are not likely to complain when prices come down; however, Marolia stresses that almost everybody has debt, especially in the developed world, and that deflation would make it increasingly difficult to pay it back, resulting, inevitably, in even more debt being written off.
Marolia further points out that the current spot price of precious metals is making things difficult for producers, as it creates a market where forced sellers are making excellent targets for buyers. However, at this point, he believes “it is time to pay the piper”.
Many project start-ups that were feasible at higher prices are now being shelved in the lower-price environment. China is slowing down, which bodes ominously for materials that ultimately originate from the mining industry.
Marolia adds that miners are also being forced to better disclose the true cost of mining. “There has been a lot of emphasis on how to best disclose capital costs and operating costs, but if anything, the trough has to end somewhere,” he says.
It would not make sense for certain projects to continue if the price continues to slide but, eventually, it will take out supply. “I don’t see how gold and silver can trend lower for much longer, without causing disruptions in supply,” he says.
The mining industry has seen significant cost inflation over the past five to ten years, when the global economy was storming forward, compounded by a higher consumer price index (CPI). However, KPMG Canadian mining leader Lee Hodgkinson tells Mining Weekly that some of that pressure on costs had come off in recent months, as many projects have been shelved.
He notes that, despite deflation being most likely to occur in the more mature jurisdictions that may not predominately rely on mining, deflation would most likely have a positive impact on the costs to extract minerals. Conversely, inflation could obviously impact negatively on operating costs.
“It’s the relationship between inflation and commodity prices that would probably be key for mining companies and their margins,” he says.
Hodgkinson noted that inflation’s impact on prices could be significantly mitigated if rising costs are tied in with deflation of a country’s currency, while US-dollar denominated prices hold steady.
“I don’t think we need to focus on CPI, which is not that relevant to the mining industry, but rather specific input costs such as oil, consumables and labour,” he says.
Author of the Mercenary Geologist website, Mickey Fulp, agrees, telling Mining Weekly in Toronto that, in real terms, commodity prices have remained flat in recent times. “The US dollar rose by about 5% in the last several months and gold was off by about 10%; even oil is down to near a year low despite all the geopolitical turmoil,” he says.
In light of many companies cancelling and shelving projects in recent months, prices for materials and supplies have declined owing to supply/demand dynamics. “Lead times are down and, now that businesses have suffered a bit, it makes sense that prices for materials and intellectual capital have also come down,” he says.
However, Fulp argues that the cost of goods is still comparatively high. “I’m surprised that oil is costing in the low $90s per barrel right now, because all mining activities and materials movements use oil.”
He adds that there is no overly positive economic news coming from the US. While it is looking better, economic growth is still tepid. Nonetheless, with the world economy still sideways, the US dollar has again become the safe haven of choice for investors. Despite being off a bit lately, the Canadian dollar has also maintained its value against the dollar.
“The view is that North America is the place of stability and potential growth. Personally I think the US dollar has gotten ahead of itself, but we’ll have to wait and see about that,” he notes.
Fulp stresses that it is always a good time to build a mine in a cyclical downturn, with the hope of hitting a commodity up-cycle by the time production gets going.
“Demand remains strong. Despite China slowing down, the US is again growing faster, so we have a constant demand for commodities – I don’t see that ending,” he says.
Fulp notes that about a quarter of the world population is today still living without electricity. “We have 7.2-billion people on this planet and everybody wants a better lifestyle. Couple to this the expectation that by 2050 there’s going to be 9.5-billion people on this planet, the future is boding incredibly well for the commodities industry as a whole,” he says, referring to the inevitable cyclical upswing and the higher commodity prices that brings.
Further, the fact that the mining industry has gone through this past difficult time has translated to it not discovering new deposits. For instance, the gold sector is expected to see declining output over the next three to four years, as opposed to the increases in output over the last three years.
“That bodes well for the gold price,” Fulp says, noting that better commodities prices across the board will be the single most important factor that would once more spur the mining industry back to life.