Shift in Investor Sentiment

In the past quarter, gold has performed unusually well in all major currencies, suggesting that a shift has taken place in investor sentiment. We believe the shift reflects the growing fact of inflation, not the kind that can be measured on the supermarket shelves [yet] but rather the inflation of money supply and liquidity that depreciates the perceived future value of fiat money... in other words, currency debasement.  

For most of this year, the threat of systemic collapse has been receding while inflation has been perceived as a far-in-the-future problem. This view has favored equities and corporate debt which have performed admirably for most of the year. We have been pleasantly surprised that gold has held up so well when paper assets have strengthened markedly. Equities in particular have been supported by the consensus view that a mildly deflationary environment will ensure that central banks continue to pursue a loose policy of low interest rates and increasing liquidity with no threat of rising price inflation to worry about.

But holes are now appearing in the moderate deflationary hypothesis. Deflationists ranging from the Federal Reserve to Nouriel Roubini and Paul Krugman argue that the output gap (underutilized capacity in the form of the unemployed and idled factories) depresses prices and is therefore deflationary. As we have noted in past commentaries, the output gap is an elegant theory without supporting facts - there is no correlation between inflation and capacity utilization. Try telling Icelanders that they are not experiencing 11% price inflation while their GDP has declined by 8.5%. The issue is money supply, which does correlate with inflation, albeit with a lag. Deflationists also argue that commercial banks are sitting on huge excess reserves while also reducing their lending... a deflationary development because it reduces the money supply by reversing the banks' traditional money multiplier effect. This is a sound argument except for the fact that the world is currently awash in cheap liquidity which is funding huge trading volumes and overt speculation in many asset classes. In our view, the role of commercial bank lending in money creation is no longer as significant as it once was.

Where is all this inflationary liquidity coming from? First, from central bank reserves which now stand at an astounding US$7.3 trillion and growing at an annual rate of 24%. About 62.8% of the total is held in US dollar securities with the remainder in euros, yen and gold. At one time, these reserves rarely left the vault but now they are being mobilized to fund stimulus programs and investments by sovereign wealth funds. Central banks have become net purchasers of gold, reversing a trend that goes back to 1968, to protect their reserves from fiat currency debasement. Recently, India and Sri Lanka have joined China and Russia as purchasers of gold.

A second source of liquidity is international institutions such as the IMF, newly funded via issuance of Special Drawing Rights totaling US$500 billion to bail out nations facing financial crises. These funds are working their way into the system.

A third source of liquidity is direct monetization of assets by central banks (known as quantitative easing), a policy which bypasses the commercial banking system and injects cash directly into the economy via government spending (if the assets purchased are Treasuries) or into the hands of private holders. In the US, these injections will soon total US$1.75 trillion.

A fourth source of liquidity is the purchase of Treasuries by commercial banks using the excess reserves provided to them by the central banks. This is quantitative easing by another path (QEII). In the US, bank holdings of government securities increased at a 16.2% rate in the second quarter to US$941 billion, the fastest growth in nearly ten years.

Finally, Treasury issuances worldwide have increased dramatically. Treasuries have nearly as much 'moneyness' as cash-they are widely accepted, generally very liquid and highly rated by credit agencies. In the past twelve months, the US Treasury has printed US$1.9 trillion in new liabilities which are being used by investors to lever other investments. If this amount was backed by savings, it would not be a problem. But printing government liabilities in excess of savings, which nearly every major government is now doing, is the essence of inflationary debasement. The new debt is used to cover public expenses and to fund consumption, not invested in productive enterprise that could generate repayment.

Not surprisingly, the latest data from the St. Louis Federal Reserve suggests that the velocity of money is now turning up.

For those who believe in paper currencies, perhaps the most troubling development is the growing use of the US dollar as the primary funding currency for the carry trade. Dollars are being borrowed and shorted to provide funds for the purchase of higher yielding investments in other currencies. There are many good reasons why the US dollar has been chosen including the Federal Reserve's promise to maintain exceptionally low interest rates for an extended period, growing fiscal deficits, slower economic growth and a Congress that seems willing to intervene in the private sector without limits and without warning. Carry trade funding increases the size of the pool of dollars available for transactions- another source of cheap liquidity. But when the carry trade funding currency is also the world's reserve currency, special problems arise. The dollar is used as settlement for international trade and for the pricing of commodities. Excess dollar balances have to be absorbed and the dollar has to be supported by other central banks who must print their own currency to buy the dollar and relieve the upward pressure on their own currencies. The result is greater monetary inflation and increasing instability in foreign exchange markets. No major nation appears to want a strengthening currency.

All of these factors lie behind the increasing attractiveness of gold. The global money supply probably totals US$30 trillion and it is growing rapidly. The world stock market has a current value of around US$40 trillion while the bond market is north of US$80 trillion and also growing rapidly. Against this, we have a global gold supply that is today valued at approximately US$5 trillion. Where do you think your savings are safest? Investors are increasingly answering that question by reaching for gold. In our view, the gold price has much higher to go.  

Excerpt from the Report to Shareholders, November 12, 2009

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