Transcription
This line that you see here, moving up and down, shows us one of the most important relationships in financial markets. It is the performance of the US stock market measured against the price of gold. And we've just seen it plunge down to the lowest level in over 5 years. This is potentially marking the beginning of a generational transfer of wealth that is going to be taking place over the coming years. The people who take advantage of this will come out significantly wealthier.
We can look at the stock market measured in gold prices over the last 100 years and see that there's been multiple large moves down in this ratio. Most of these have been associated with some kind of systemic financial crisis, like the Great Depression, the dotcom bust, and the 2008 financial crisis, or with periods where inflation was out of control, like during the Great Stagflation of the 1970s.
In fact, most people believe that gold prices only rise when inflation is running out of control. For instance, when gold prices rose from $35 an ounce all the way to $670 an ounce in the 1970s, that was indeed a direct result of out-of-control levels of inflation in the United States. By the time gold peaked in 1980, inflation hit 15%, which means that prices of everyday consumer goods were rising each year by 15%—completely unsustainable levels. And gold in the 1970s was indeed acting as a hedge against these high levels of inflation.
But fast forward to today, and the picture is quite a bit different. Gold prices have been going on a meteoric rise, but the official US inflation rate data has been steadily moving lower. In fact, if we zoom out to the early 2000s, we see that gold experienced a substantial rise in its prices without any big wave of inflation like in the 1970s. The root cause of gold's rise today is something very different to what we had in the 1970s. But arguably, it's something that's potentially a lot more dangerous and could have an even larger impact on people's lives.
Instead of comparing the price of gold to inflation, let's compare it to the level of US government debt. This line here shows us the ratio of government debt to GDP. So, it's a way for us to know how good or bad of a shape the US government's financial situation is. And as we can see, gold prices have been intimately correlated to how bad the government's financial situation is.
As trust in the US government's financial situation diminishes, that means that trust in US Treasury bonds diminishes. Now, both gold and US Treasury bonds are financial assets, and both have the goal and objective of being a safe haven asset, or in other words, the goal of keeping their value. The size of the US government treasury bond market stands at $27 trillion while gold's market cap stands at $22 trillion. So here we understand why, as trust in treasury bonds diminishes, that has been directly benefiting gold's rise since the early 2000s. It is a direct result of the government debt crisis that has been unfolding for decades.
Now the question is, how bad is all of this going to get, and what does it mean for the stock market? This right here is the official projection from the Congressional Budget Office of the debt to GDP ratio over the next few decades. Most official government and third-party projections suggest that the government's financial situation is going to keep on getting worse. This is due primarily to long-term structural issues like an aging population, which is going to increase spending on social security and health benefits, but also rising costs on interest payments as well as taxes that are generally too low to keep up with all of this spending. Clearly, this isn't a very sustainable situation and could possibly end quite badly.
So, we're going to look at four potential scenarios for how all of this could play out, and then I'm going to highlight which one is the most likely under the current administration.
Scenario A, austerity. Here, the government would aim to cut back on its spending in a significant way. But, as we just mentioned, it's unclear how feasible this actually is due to the many structural long-term forces that are pushing government spending higher. But if somehow the government is actually able to do this, that would increase confidence in the government's budget, likely leading gold prices lower. But on the flip side, it would cause economic growth to slow down because of lower government spending. The US government has been running a deficit of $2 trillion per year since 2020, which has given a significant artificial boost to economic growth over this time period. All of a sudden, removing this deficit spending would lead to lower levels of growth. So in scenario A, we would see both lower gold prices and lower stock prices. Now while the current administration has talked about higher levels of government efficiency, it has not talked about making deep cuts to government spending, which does make this austerity scenario quite unlikely right now.
Scenario B, the government decides to increase taxes in a substantial way in order to keep up with its spending. This would, of course, be extremely unpopular and would likely damage economic growth significantly as it would directly reduce the purchasing power of the average American. It would cool down concerns regarding the government's budget and so stop gold from rising so aggressively. So the impact of this scenario would be very similar to scenario A where both gold and stocks would be likely moving lower in this scenario. Now, as far as we know, this is probably the least likely scenario with the current administration. If anything, Donald Trump has talked about reducing taxes, certainly not raising them.
Scenario C, the government doesn't do anything about it. This has more or less been the government's philosophy for the last 5 years. Now, this would allow the government to keep on spending without needing to raise taxes. So, at first, it would avoid any damage to economic growth, which could mean that the stock market can keep rising over the next few years. Now, this would come at the cost of a higher debt to GDP ratio as trust in the government's debt would decline, which could have very significant long-term side effects. In this scenario, government bond yields would be forced higher, which means that interest rates around the whole economy would go up. Mortgage rates would go up, reducing access to housing. Corporate debt interest rates would go up, which would reduce access to financing. And so, all of this would eventually slow economic growth. In this scenario, gold would likely rise as trust in government debt declines and the stock market would probably stay more resilient than in the other scenarios, at least in the near term, but would probably run into a wall down the line.
Now, the final scenario, scenario D, is an aggressive tariff policy. Tariffs are basically another form of taxes. So, the overall impact of tariffs is actually very similar to option B. They could help the government's budget as they would increase revenue, but they would very likely lead to slower economic growth if implemented in a significant way. This is why economists have been raising their estimated probability of a recession ever since Donald Trump's April 2nd Liberation Day tariff announcement.
So, out of these four scenarios, we think the most likely outcome is a mix between C and D. It remains unclear exactly how big the tariffs are going to be. And so naturally, it's unclear how much they will actually help with the government's budget. And it's also unclear how much of a negative impact they will have on growth.
You might be thinking, what's the takeaway for stocks and gold? We think gold is a must-have in any long-term investment portfolio in the current macroeconomic context. It is a hedge against the unfolding government debt crisis and it has a good chance of continuing to outperform the stock market as long as the government debt hasn't been solved, which doesn't look imminent. But gold has already witnessed an incredible move up, and we actually think that in the short term this isn't a great place to be betting long on gold. This is why we actually closed all of our long trades on gold very recently on our website. We had exposure to two gold mining companies, WPM and AEM. We also had exposure to a leveraged gold ETF that we just closed for a 50% gain. Now, could gold continue moving higher in the short term? Of course, it could, but we're now going on the sidelines here, and we'll be looking to get back in once price has had a chance to consolidate a little bit.
When it comes to the stock market, we also believe it should be part of any long-term investment portfolio. And the recent correction in stocks has been an opportunity to dollar-cost average down into long-term positions. In the near term, however, we think the news from tariffs could still take some time to get digested by the market and possibly cause some choppy price action over the coming weeks. We're constantly scouting the market for trading opportunities, and we've already been able to lock in some pretty incredible profits just over the month of April. You can check out the results of all of our closed trades for 2024 on our homepage and join our