The Gold Market

The Gold Market

It sometimes seems to us that no investment attracts more negative commentary than gold. In the past six months, investors have been treated to yet another round of high-profile analyses declaring that the gold bull market is dead. Since these analysts are not on record as having predicted the gold market's consecutive 10 year bull run and its gain of more than 600%, why would anyone listen to them? But investors do listen to this nonsense and so it needs to be addressed.  

Let’s be clear that short-term chart patterns are not going to tell you if the gold price has peaked. For the gold bull market to die, we believe the dollar has to reverse its multi-year downtrend; the dollar actually has to increase its purchasing power and its reliability as a store of value, rendering gold unnecessary as an investment. A reversal in the fortunes of the dollar requires a revolution in US fiscal management, a sea-change in monetary policy and an enormously painful reset of America’s mind-boggling sovereign and consumer debt load. No doubt these things will occur at some point and then we will need to consider the end of the gold bull market. But not any time soon.

Gold is not up because it is a speculative darling. It is up because fiat currencies and the securities denominated in them are down in real terms; the alternatives are losing value measured against real things. Or as Jim Grant says (and we have been saying for at least as long), gold is a reciprocal of confidence in the world’s fiscal and monetary authorities and there is no bull market in this form of confidence.  In other words, gold is up by default, a long, slow, drawn-out default in the alternatives which, in our view, will last for many more years.

Misconceptions du jour

In 2012, gold has been laboring to overcome two misconceptions: the US economy is in recovery (which means that the Federal Reserve will begin to reverse its accommodative policies); and the European debt crisis is resolved, at least for the next several years. Both are illusions.

The economic bulls point to such factors as 'slow but steady' job growth, consumer deleveraging in the real estate market and a rebound in vehicle sales as evidence that the economic recovery has underlying strength. But the latest numbers are not supportive. Consumers are once again depleting their savings to increase spending at a faster rate than growth in income. The deleveraging which is absolutely required to reduce the burden of unmanageable debt has been postponed, providing an illusion of renewed prosperity. The facts: subprime is back, supporting the car market.  At one time, you only needed a pulse to buy a house in America. Now, that's all you need for a new truck. Nothing has been learned. We are still trying to re-inflate the credit bubble with more cheap credit and pretending that this is how sustainable recoveries are made. Mortgage debt is down largely due to write-offs on defaults, not pay-downs, leaving behind a smaller pool of homeowners who are still frozen in place by far too much debt. Foreclosures are on the rise again.

But the proof of a deepening recession is in the employment numbers. John Hussman's April 9, 2012 newsletter is a good place to start. He notes that since the recession officially ended in June 2009, total non-farm payrolls in the US have grown by 1.84 million jobs. However, employment of workers 55 years of age and over has increased by 2.96 million jobs while employment among workers under age 55 has actually contracted by 1.12 million jobs. This is not the message you hear from the White House.

Hussman writes: "The over-55 cohort has suffered an assault on its financial security: a difficult trifecta that includes the loss of interest income, the loss of portfolio value, and the loss of home equity. All of these have combined to provoke a delay in retirement plans and a need for these individuals to re-enter the labor force...In short, what we've observed in the employment figures is not recovery, but desperation...and explains why real disposable income has grown by only 0.3% over the past year." And what is to become of an unemployed generation of young people saddled with $1 trillion in student loans?

This was not a normal recession and it has not ended. In our view, the economy is not bouncing back. We will not return to the 'normal' of 10 years ago because that 'normal' was really an enormous debt bubble of historic proportions which will not be repeated in our lifetimes.

Does this look like a sustainable recovery?

• There are 242 million working-age Americans and 100 million of them are not working. The Federal government reports that only 13 million of these people are actually unemployed. There are more than 2 million fewer Americans working full time today than there were 10 years ago.

• Prior to 2008, US deficits never exceeded 4% of GDP but now they exceed 9%. This unsustainable spending gives the illusion of an economic recovery but not the savings and investment needed for real growth.

• The US Federal Government borrowed $1.3 trillion last year, 36 cents for every dollar it spent. The Federal Reserve last year purchased 61% of total net Treasury issuance. (Source: The Center for Financial Stability). Washington is living on printed money.

• The average annual deficit from 2000 through 2008 was $190 billion. Since 2008, the annual deficit has averaged $1.3 trillion.

• The US national debt increased $5.6 trillion in the last three and a half years. It took 211 years to accumulate the first $5.6 trillion of debt.

• The national debt will reach at least $20 trillion by 2015. If interest rates normalized to the same level they were in 2007 (5%), annual interest expense would be $1 trillion or 45% of current tax revenue. Interest rates cannot be allowed to rise and therefore more quantitative easing is inevitable.

The logical consequence of this fiscal nightmare is a future funding crisis for Washington. In the March 29 edition of Barron's online, Randall W. Forsyth reports on comments by Stephanie Pomboy, head of MacroMavens advisory. Noting that Uncle Sam is currently borrowing some $1.1 trillion a year of which foreign creditors are buying just $286 billion, Pomboy says "I'm no mathematician, but that seems to leave $800 billion of 'slack' (of which the Fed graciously absorbed $650 billion last year). Barring a desire to pay the government 1% after inflation, there is NO profit-oriented or even preservation-of-capital-oriented buyer for Treasuries," she writes. "For the life of me, I can't understand why NOBODY is talking about this???!!!"

The US government is addicted to its exorbitant privilege of printing the world's reserve currency and shipping it abroad for goods and services. It is a privilege that has been supported by foreign central banks buying US debt for the better part of the last 30 years and it works as long as exporting countries take the dollars and reinvest them in US capital markets. This may now be changing as Pomboy notes. Foreigners have lost interest in US Treasuries. China, the largest foreign holder of US dollars, reduced its purchases in the past year and Japan, the second largest holder, actually repatriated funds. If the Fed is also not there to buy Treasuries and fund the federal deficit, who is? That's a question Bill Gross of Pimco, the world's largest bond fund, has been asking. He expects more quantitative easing soon, as do we. A much weaker dollar lies ahead, in our opinion.

Does this look like a Greek rescue?

While investors contemplate a difficult time ahead for Spain and Italy, the real and pressing issue in the Euro Zone is...Greece. You thought it was fixed? Read on. The continuing saga of the second Greek 'bailout' provides the evidence as to why you should not trust statements from the European Union (EU). Yes, senior officials have declared the European debt crisis to be over, with their example being Greek. It is not over.

"The Second Economic Adjustment Programme for Greece, March 2012", a 195-page official document from the European Commission which describes the terms and conditions for the latest Greek bailout, contains this exact quote: "Disbursements to Greece by the EFSF and the IMF will still be conditional on compliance with conditionality". (p45, PDF version)

The first disbursement to Greece under this new arrangement was made on March 20, 2012. Disbursements are paid quarterly which means that June 20 is the date of the next disbursement. Greece was originally supposed to receive E74 billion in the first tranche (p46) but it received just E7.5 billion. To meet its cash obligations to the tiny minority of private sovereign creditors who, under the original terms of their bond purchase, were entitled to full payment under the March bond swap, the Greek government reportedly drained the accounts of the country's largest universities and regional hospitals held at the Bank of Greece -- an amount estimated by one source to total some E1.4 billion. These institutions are now effectively insolvent. The next bond swap for E450 million (issue XS0147393861) is due and payable in cash on May 15. Attempts to settle this issue for less have reportedly been rejected.

Of the E7.4 billion it received in the first tranche, a Greek government official stated that Greece would use this money to pay E4.66 billion to the European Central Bank and other Euro Zone national central banks for the capital amount of a three-year bond that expired in late March. This left E2.74 billion for the Greek government to live on for the next three months. If you believe the 1% deficit forecast for 2012 (complete nonsense on p89), Greece has a shortfall of E1.25 billion per month which consumes what remains of the first disbursement from the EU & IMF. But, alas, there are E5.2 billion in Treasury bills due in April and May. How is this sustainable? (See "Greek Government Robbed Public Iinstitutions to Complete Bond Swap" and "Crunch Time for Greece").

The most amazing aspect of this second Greek bailout is that the country's debt has INCREASED. Private holders of Greek debt were forced to take E105 billion in write-offs but with the addition of the new loan of E130 billion, gross debt has increased E25 billion. The total debt of Greece (sovereign, municipal, corporate and bank) has increased from E912 billion to E937 billion. Borrowing your way out of insolvency is never easy. With a collapsing economy and surging unemployment, more loans will surely be required.

If the EU cannot rescue tiny Greece, how can it save Spain or Italy? Greece may well prove to be the catalyst for the bursting of the global sovereign finance bubble just as Lehman was for the banks in 2008. How much bond market confidence has been lost by the fact that the European Central Bank and other EU institutions did not take a write-down on their Greek debt?

This is what real inflation looks like

In our view, Gold's highest and best use is as a store of wealth especially when compared to fiat currencies and financial assets. The physical gold supply is growing at about 1.5% per year and really can't expand any faster. Michael Pollaro estimates that money supply for the US, Europe and Japan combined is now increasing at nearly 10% annually with infinite upside from there.

Traditional measurements of money supply probably understate the problem. According to the March 30, 2012 edition of the Artemis Capital Management newsletter, "the pace of global monetary stimulus has been astounding reaching almost $9 trillion in total expansion over the past three and a half years in the greatest period of fiat money creation in human history. Let me put these numbers into perspective. Collectively global central banks have created enough fiat money (over the past three and a half years) to buy every person on earth a 55" wide-screen 3D television."

But the best evidence of inflation is the growth in US dollar-denominated claims...the supply of debt-based financial assets. Let's look at US Total Credit Market Debt. In 1980, it was $4.7 trillion. Today, US Total Credit Market Debt is $57.3 trillion, an increase of 1,119%. All of this debt is somebody's asset and sits on the books of lenders and investors. Meanwhile, the US gold reserve (282 million ounces) has increased in value by about 100% to $465 billion over the same period. It would now take a gold price of more than $203,000 per ounce for the US gold reserve to provide 100% coverage of total US debt.

We do not know how much confidence investors in US credit markets will lose and how much insurance coverage they will demand. The risks must seem rather low to them at present and there are ways to hedge other than gold...like Credit Default Swaps which are issued in vast and unregulated quantities by banks and hedge funds. But debt has grown three times faster than the economy which must service and back this debt. Too much debt has gone to support consumption and non-productive investment. Credit creation is faltering when it must continue to grow rapidly just to roll over existing debt and keep the game going. The conclusion, in our view, is default either by repudiating the debt or eroding its value through monetary debasement.

We believe credit expansion is the inflation that gold must eventually backstop in the event of a collapse of confidence in the financial system. The question is, what are the owners of $57.3 trillion in debt-based 'assets' willing to pay for the one asset that backs itself, cannot be printed and cannot default?  And where do you think central banks will deploy their US$10 trillion in rapidly growing reserves when each of them is attempting to devalue the currencies they issue? (Hint: a growing number are now buying gold).

Keep your exposure to gold

As we see it, the world's fiscal and monetary authorities have done nothing to earn your confidence. Should you trust them with your savings? Do you think their paper, issued in ever greater amounts, is a safe place to be? The dollar has steadily lost value for more than a hundred years. That's what a bear market really looks like. By comparison, gold looks pretty good to us.

‍