4.7% US inflation: buy gold, sell US treasury bonds!

The complacent reaction to last week's US inflation figures from the financial markets was incredible. They had expected worse, so what they got was OK. Never mind that at the same time US consumer sentiment and industrial output came in well below expectations.

Let us look at those inflation figures a moment. The September rise in US inflation of 1.2% was the biggest rise in 25 years; the annual inflation figure of 4.7% the worst since 1991; and the 12% surge in energy inflation was the highest since 1957.

Economists drew comfort that inflation outside the energy sector was still very low. But are these guys not able to spot a trend when it is staring them in the face? Inflation is up, and it is up very substantially.

Inflation hits T-bonds

What does this mean for investors? Well, for one thing the holders of US treasury bonds are losing money because inflation is now eroding their capital faster than the interest earned on the bonds.

It is also clear that higher energy costs are going to have two other immediate effects: lower consumer spending and higher energy costs for manufacturers and everyone else. The former hits demand and the latter cost of supply and the net impact has to be lower profits, ergo inflation will be bad for equity prices.

Now where does that leave money to go? The 1970s were the last time that investors experienced such an inflationary environment. In the 1970s holding cash actually outperformed equities but commodities were the place to be, and specifically oil and precious metals.

Commentators like Jim Rogers, whose book 'Hot Commodities' is a persuasive read, demonstrate how commodity prices are inversely related to equity markets. He shows that in the past commodities have continued to rise in price even when GDP is in decline.

Gold shines

Now with gold prices up 15% or so this year against a flat line for major US equity markets, this historical precedent seems to be holding true.

Arab investors in the 1970s were among the biggest buyers of gold, perhaps instinctively trusting the security of gold in troubled, inflationary financial conditions. The same class of investors is also believed to have been a big buyer this year, and could well have got it right again.

Certainly a rush to buy equities in this environment is reminiscent of the enthusiasm of lemmings for self-destruction.