Gold, Inflation and Stock Market Returns

Gold price hit an all-time intraday high of $1266.50 per troy ounce even as stock markets around the globe continued their recent upward journey. This is one of the two scenarios I had said were possible in the markets; the other of course being a rising stock market with falling gold prices. Unfortunately, the former is what is happening right now and that, to me, is not good news. Many have written about the equity markets being driven by liquidity, there is an even more interesting way to look at it.

The S&P 500 index closed at 893.04 on June 22nd 2009 while gold closed at a price of $920.6 per troy ounce. That would peg the index at being worth about 0.97 ounces of gold on that day. A year later on June 18th 2010, the index had risen over 25% to close at 1117.51. However, gold had far surpassed that by rising a massing 36.5% to close at $1257.2. The index, measured in gold now stands at 0.88 ounces of gold. So even though the index has risen, the investor has been left poorer. My interpretation is a little different though. I'd say that the entire (or substantial) rise in the index has been driven by liquidity provided by the various central banks, primarily the US Fed and the ECB as has been most of the rise in gold. However, the excess 11% rise in gold price is probably a good measure of the fear for further inflation, or rather currency devaluation which the easy money policy is pointing towards. How much further gold will rise depends on how far the fears will be exaggerated and how long the central banks take to start increasing interest rates. I will only feel confident about any real recovery when the momentum in gold slows down and the S&P 500 recovers to somewhere over 1 ounce of gold.

In India, the story works a little differently. While interest rates in India are also being kept fairly low, gold in INR terms hasn't appreciated as much because of the contrarian effect of FII money inflow which keeps the rupee bouyant and gold prices a little in check. The increased liquidity is showing up elsewhere though, with food inflation staying stubbornly over 10% for over 2 years now. Right until the middle of 2009, the Government refused to admit to inflation at all with persistent reports of low inflation citing the wholesale price index which was close to zero for much of this period. When food inflation was finally recognized as a problem, it was attributed mainly to supply side problems citing low output in the previous year. Towards the end of 2009 and early 2010, the supply side problems had supposedly eased but food inflation doggedly continues above the 10% mark with the actual number for April 2010 standing at 14.8%. While this has led to increased speculation that the RBI shall move to increase interest rates soon, Governor D. Subbarao has maintained a stance that interest rates will not be hiked immediately as "other measures" have been taken to control liquidity in the market. My concern remains that even though liquidity may have been mopped up by issuance of Government bonds to finance the deficit, the deficit spending itself is a crucial source of the persistent inflation, not least being the spending under the National Rural Employment Guarantee Scheme.

While central bank madness continues in Europe and in the US, I think quick steps need to be taken to increase interest rates even at the risk of slower economic recovery in India. Even though we depend on western demand to a certain extent, I think prudent monetary and fiscal policy can make India the preferred destination for external capital and hence can sustain our recovery even with higher interest rates domestically. On the other hand, economic recovery at the cost of skyrocketing food prices does not bode well for the internal security of the country. Any increase in economic activity can quickly be offset by social unrest if food inflation is not checked soon.