The Gold Market: Time to Buckle Up?

The Gold Market: Time to Buckle Up?

Is the gold market now approaching its moment of truth? The mainstream continues to ignore the relentless rise of the gold price, proclaiming each new high to be a 'bubble' top, noting again and again that gold has no real use, cannot be eaten and pays no dividend or interest. But in our view, beneath the surface, confidence in the current monetary order is being eaten away by the twin cancers of rising debt and reckless monetary expansion. Are we approaching a major market dislocation which fundamentally changes the perceived value of gold?  

The banking and credit crisis of 2008 is morphing into a sovereign debt and fiat currency crisis. Governments and central banks have expanded their balance sheets to mitigate the consequences of the credit collapse. In keeping with our dearly-held maxim that 'there is no problem that government can't make worse', we believe that the misplaced attempts to resolve the last crisis are, once again, creating a bigger one. In our view, enormous tensions are building within the global financial system, tensions which are more dangerous than the forces which coalesced to create the panic of 2008. Once again, the markets do not appear to be discounting these possibilities, thereby increasing the risk of a major market dislocation.

To date, gold has performed roughly in parallel with base metals and other commodities. Our sense is that gold is now moving towards a divergence from commodities, reflecting increased fears of serial sovereign defaults, renewed concerns about the health of the banking sector and growing distrust of fiat currencies as stores of value. Although the U.S. remains at the epicenter of these developments, every major economy and currency is contributing to the growing instability as developed countries increase their already unmanageable debt levels and developing countries inflate their currencies to support the dollar and maintain 'favorable' trade imbalances.

There are, in our view, three key assumptions that underpin the continuity of the existing monetary system: (1) a self-sustaining economic recovery is in progress; (2) governments will be able to return to fiscal balance via a combination of austerity and growth; and (3) central banks will be able to tighten monetary policy without major mishap and before price inflation spirals out of control. Our assessment is that each of these assumptions is false and each will be disproved over the next 12 months, creating the conditions for a highly dynamic gold market.

No Self-Sustaining Recovery

In the U.S., economic bulls, who appear to form a large majority, point to official data such as the GDP, a lower unemployment rate, miniscule core inflation and various diffusion and leading indices to paint a picture of recovery. By now, even the most resolute bulls must know that government data is suspect...that the GDP is only up in real terms because it is calculated using the lowest possible inflation measure, that the unemployment rate is down because discouraged workers are leaving the workforce, that the infamous birth/death model is "creating" thousands of hypothetical jobs in the housing sector, that core inflation has nothing to do with real consumers and so on.

Of course there is some evidence of growth... how could there not be with the amount of stimulus that has been thrown at the economy! The wonder is that reported growth is not better. Generously assume a 3% real growth rate for the U.S. economy. That's a return of only US$450 billion a year from $2 trillion in additional deficit spending to date and the current US$900 billion annualized increase in the Federal Reserve's balance sheet. For more than a decade, the U.S. Federal Reserve has unsuccessfully attempted to make easy money a substitute for the accumulation of savings and investment. What happens when this level of stimulus is reduced? How does an economy with net negative savings (because of huge government deficit spending) generate real growth? Borrowing to support consumption, which is what federal government stimulus has done, does not create a sustainable recovery but it does add to the debt-drag, a major head-wind for future growth.

U.S. households are now receiving more cash handouts from the federal government than they are paying in taxes for the first time since the Great Depression. Fully 59% of all Americans now receive money from the federal government in one form or another. There are now about 7.5 million fewer jobs in America than there were in 2007 and the average length of unemployment has hit an all-time record of 39 weeks. These are not the indications of an economy in recovery. If you think that the U.S. is not representative of the world economy, think again. 'Better off' Canada reports that 30% of households cannot pay their bills and 38% have no savings. As for the super-growth economies like China, how much of their reported expansion is real and how much is cash-induced unproductive activity funded by 17-20% annual increases in M2 money supply and a banking system that does not always expect repayment? Relying on China as the world's economic engine seems risky at best.

Developed Countries Cannot Return to Fiscal Balance

If economic growth does not accelerate, there is no way to avoid serial sovereign debt defaults, in our opinion. The enormous blow-out in spreads for Greek debt speaks for itself and Credit Default Swap markets are telling us that Greece is not alone. But the super-critical fiscal situation is unfolding in Washington, home of the world's reserve currency. The media debate has focused on President Obama's deficit reduction plan versus that of Paul Ryan, Republican Chairman of the House Budget Committee, as well as the theatrics of whether or not the debt ceiling will be raised in time to avoid a default. The real issue, it seems to us, is that even the more radical and aggressive Ryan plan falls well short of solving America's fiscal imbalance even assuming  optimistic economic projections, a continuation of  current historically-low interest rates and dramatic cuts to Medicare and Medicaid which are likely to prove politically difficult to achieve.

The Ryan plan claims to cut spending by US$5.8 trillion over 10 years but it does not actually cut spending at all...it cuts the projected spending increases in the Congressional Budget Office's estimates. The CBO estimates that federal spending will grow 4.6% compounded annually for an average of $205 billion a year. Ryan would reduce this to 2.7% compounded annually or about US$110 billion a year, racking up another US$5.1 trillion in red ink over the next 10 years and taking Treasury debt from US$14.3 trillion today to more than US$20 trillion by 2021. Last November's election results and the tea party's triumphs have accomplished nothing. At best, the sovereign fiscal situation will remain a destabilizing issue for many years to come. In the U.S., we expect to see continued monetization of debt and further weakening of the dollar, amounting to de facto default. This is no longer a radical position. Bill Gross, manager of the world's largest bond fund, writes in his April Investment Outlook that "if the USA were a corporation, then it would have a negative net worth of $35-40 trillion...as pointed out by Mary Meeker and endorsed by such luminaries as Paul Volcker and Michael Bloomberg..." Gross expects default "deceptively" via a declining dollar.

Central Banks Cannot (Really) Tighten

Finally, we have the continuing expectation that central banks will be willing and able to tighten policy and take back the excess money they have printed once the economy is stronger and inflation becomes a threat. As noted above, we are not bullish on real economic growth. Central banks will therefore be under pressure to look tough while avoiding any real contraction in their balance sheets. The master here is the People's Bank of China which regularly raises reserve requirements and increases short term interest rates while maintaining a dollar peg which guarantees high ongoing rates of monetary expansion. China's trade objectives trump monetary stability just as they also do in Japan, Brazil, Indonesia and a host of other countries where the demand for physical gold is also rising, not surprisingly.

The critical player is, once again, in Washington, home to the world's central bank, the one that is exporting money-printing to the rest of the globe. Its $600 billion QE2 monetary easing program ends in June, 2011. Bill Gross estimates that so far this year, the Fed has accounted for 70% of the Treasury market, effectively monetizing the federal budget deficit during this period. He asks who will replace the Fed and buy Treasuries when QE2 comes to an end. Not him. He announced at the end of February that his fund, PIMCO, was no longer a holder of Treasuries. We expect to see QE3 before Christmas. It will be brought on to provide a needed bid for the bond market and to shore up the equity markets which rely far more on excess liquidity than on earnings to levitate at current levels. Governor Bernanke has told us in no uncertain terms that the performance of stocks is now a key factor in Fed policy.

Nor can the Fed simply increase interest rates as the markets expect. There is a great deal of difference between raising rates by contracting the money base (currency in public hands and commercial bank reserves held at the Fed) and raising rates while leaving the money base at its current enormously inflated size. If rates are increased without a huge reduction in the money base, excess money will flow into the economy, money that is currently being held as unproductive cash because interest rates are so low. Raising rates will reduce the preference for holding cash, increasing its 'velocity' with major inflationary consequences. Dr. John Hussman has calculated that a .25% increase in the T-Bill rate would require a complete unwinding of QE2 to avoid a severe inflationary outcome (see his April 11, 2011 commentary). Recent statements by Fed Governor Charles Plosser clearly agree with this assessment. What would be the impact on the economy and investor confidence of a US$600 billion contraction in base money? If the Fed cannot increase rates, what are the implications for the dollar and gold?

A Volatile Year

For those who have owned gold and gold stocks, the last decade has been challenging but rewarding. We expect this trend to continue and accelerate in what is likely to be a volatile 2011. Our aim this year at Seabridge is to provide our shareholders with a larger share of the gains we have made in the value of our assets.

‍