What's Going on in the Gold Market? Summer 2011

What's Going on in the Gold Market?

In our last report in early May, we suggested that investors buckle up in preparation for a run in the gold price. Events have unfolded as expected. Gold has now established its own path as the premier vehicle for the preservation of wealth independent of currencies and other asset classes (whether commodities, equities or bonds). The decision in early August by the Swiss and Japanese central banks to intervene in the markets to weaken their currencies has served notice that strong currency alternatives to gold will not be tolerated. And gold is once again the preferred reserve asset of the world's central banks: South Korea, Thailand and Kazakhstan joined the ranks of buyers in the last 30 days.  

Our anticipation of a gold price surge was based on the assessment that markets were about to overturn three of their most cherished assumptions: (1) that there was a sustainable economic recovery in the developed economies, particularly the U.S.; (2) that western countries would be able to return to fiscal balance without default; and (3) that central banks would be able to rein in the excess liquidity they have created through enormous expansion of their balance sheets. The real facts are now working their way into the consciousness of investors...that there is no sustainable recovery, no resolution of the sovereign debt crisis without default and the certainty of additional quantitative easing from central banks. We believe these perceptions will shape markets for the next several years. In our view, gold will maintain its upward trajectory until these perceptions change.

Default is the only option

The central issue in the western economies remains debt. Excess public and private debt incurred to support unsustainable levels of consumption (rather than productive, wealth-generating investment) is now choking growth by impairing balance sheets and claiming too large a share of income. Current sovereign debt levels can never be repaid. Government unfunded liabilities add a further enormous future burden. Default is the only option, accompanied by a substantial reduction in the western world's standard of living as well as a shift in political philosophies from nanny state redistribution to private sector investment. Too many resources and too much time have been wasted on wrong priorities. The world economy must now go through a period of consolidation in which the poor choices made over the past 30 years are paid for. In this slow-to-no-growth environment, sovereign debtors will not be able to outgrow their liabilities.

In past economic recessions, the problem was an excess of private debt which was painfully but quickly resolved through the process of bankruptcies, write-downs and reorganizations, whether corporate or personal. This time around, thanks to the theory that governments and central banks should act to avoid the painful cleansing of economic recessions and financial dislocations, the debt loads got much bigger as a percentage of GDP. The answer to every problem was more liquidity, more cheap credit, which amounted to a central bank license to speculate without fear. Financial institutions engaged in 'innovation' which increased leverage and reduced intelligent oversight. The 'bust', when it finally came, was of monumental proportions. Rather than let it play out in a massive deflationary spiral of debt repudiation, governments and central banks nationalized the liabilities. The financial system was bailed out, private debts were taken onto the public books, sovereign debt was issued in enormous quantities and central bank balance sheets were sent skyward. A potential deflationary spiral was temporarily halted by a deluge of newly printed money and financial instruments. A problem of debt was met by more of the same. A very big problem is now bigger and there is no longer a larger balance sheet to pass it on to.

Underneath every economic crisis is a failed economic theory. In this case, the failure is Keynesian. How many times have you heard financial commentators remind you that consumption is 70% of the economy and that economic slowdowns require loose monetary conditions to stimulate demand, because end demand is what drives economic growth. This thinking is our greatest bankruptcy. As the U.S. example demonstrates, consumption drives imports (not growth) and cheap credit drives speculation (not investment).

Savings finance capital investment, ultimately leading to the build out of a country's productive and competitive capacity that generates job and wage growth. Consider how savings have funded the development of countries such as Chile, Brazil and a number of Asian economies, evidence of just how powerful incentivizing savings can be for an economy. But since the early 1980s, the substitute for savings in the U.S. was credit. The savings rate ultimately fell to zero (where it remains, as government deficits more than offset increases in corporate and personal savings). Loose monetary policy facilitated the largest credit expansion on record.  Proliferation of credit led to a strange form of GDP 'growth' in the U.S. over the last 12 years which generated no net addition to jobs. The current employment crisis began long ago with the failure to save and invest in factories, education and infrastructure. To make things worse, the banking sector has "consumed" valuable public assets in the current cycle by shifting its bad debts to the taxpayer. Meanwhile, tax policy and low interest rates continue to favor consumption over savings.

It only remains to be seen if inevitable default will come by way of repudiating debt or destroying its value in nominal currency terms. We believe the near unanimous choice for the developed countries will be default by currency debasement...making the debt worth less. The unprecedented August 9 announcement by the Federal Reserve promising to freeze short term interest rates at zero for the next two years could not be a clearer signal on where central banks are headed. In this process, currency will cede its function of storing wealth to gold. We believe those who have their savings and pensions in the dollar-euro-yen-denominated world will suffer huge losses in real terms.

The intractability of the current crisis is well illustrated by the recent debt ceiling debate in Washington. The first casualty of this debate was language. The 'cuts' included in the new legislation are not cuts...they are small reductions in the rate of increase in federal government expenditure and most of that will only take place later this decade. After months of rancorous disagreement, the result was to postpone any real cuts. The direct consequence is that S&P downgraded U.S. treasury debt.

With the economy weakening, outstanding debt will accelerate due to lower tax revenues and higher support payments under existing programs. In its already frightening deficit projections, the Congressional Budget Office assumes completely unrealistic rates of increase for economic growth, revenues and expenses. The most recent CBO budget projections (January, 2011) assume that over the next five years (2011-2016) U.S. government revenue will grow at a compound annual rate of 11.4%, expenses by 3.9% and real GDP by an astounding 3.2%...compounded annually. These are the numbers on which both parties negotiated the debt ceiling deal. Those deficit projections are therefore about to get much more frightening, to the point where they will overwhelm the policy stances of both parties. In our view, we will either see massive real cuts in both entitlements and defense spending as well as significant increases in taxes or a much lower dollar with consumer price inflation that will take your breath away. We expect inflation.

QE as far as the eye can see

U.S. monetary policy will be even more aggressive in the months ahead. QE3 is inevitable. It is notable that within days of the end of QE2, equity markets fell, just as they did when QE1 came to a close. Since the Federal Reserve has made it clear that it is targeting equity markets, enough new money will be printed to turn the markets around and ensure a higher level of general price inflation, thus implementing the next stage of default by debasement. Huge dollar swap lines will likely be reinstated to meet the liquidity requirements of the world's financial system and to ensure the safety of America's money market funds which have much of their assets in European bank paper. It is curious to imagine how a Tea Party-dominated Congress will respond to the Fed.

Europe, of course, has its own set of problems. The Euro Zone (EZ) has dithered its way into the contradictory policies of forcing austerity on its weakest member countries (the so-called PIIGS) while simultaneously loading them up with additional debt they cannot repay from the European Financial Stability Facility (EFSF) to avoid near-term default. The EFSF is an emerging European Treasury Department, a fiscal authority financed and run by Germany to match the EZ monetary authority which is the European Central Bank (ECB). The EFSF is expecting to be empowered to issue bonds backed by the 17 economies of the EZ and then lend these funds to member states at interest rates well below the market rates that these states would otherwise borrow at, if they have access to markets at all. The borrowers are required to enact specific austerity programs in order to qualify for the loans. Austerity is meant to bring debt-to-GDP ratios down in the long term but it risks driving these countries into deeper recession which only makes them more insolvent. Where is the logic in lending more money to insolvent debtors?

This kick-the-can policy may yet be overturned. The EFSF -- which is expected to be the bailout fund for the latest Greek rescue -- needs to be approved this September by all the parliaments that participate in the EZ.  Opposition to this plan is growing in the north. Even if it is approved, the EFSF is not of sufficient size to bail out Spain and Italy, should they require it, and the bond and CDS markets for these countries have suggested that they might indeed be next. The EFSF is essentially a method for conferring Germany's credit rating to the indigent southern EZ members. But Germany's debt-to-GDP ratio is already at 82.3% (98.6% for the U.S.) and its economy is considerably smaller than Italy and Spain combined. Demands on the EFSF may well be a bridge too far for the overburdened Germans.

The European Central Bank is equally odd. It has hiked interest rates as growth has slowed in order to project an image of probity but meanwhile has bought the bonds of the PIIGS and accepted downgraded PIIGS debt at par from commercial banks to save them from ruin. In early August, to address the seizing up of inter-bank credit markets, the ECB advised that its previously announced suspension of bond purchases and special lending programs to banks had never really happened and that all-but-free six-month money was available to banks for the asking. This announcement was then followed quickly by another...to buy Italian and Spanish bonds aggressively. We do not see these purchases being sterilized. The ECB does not call this QE. We do.

The ECB's balance sheet is more impaired than that of the U.S. Federal Reserve and its current leverage is estimated to be well above 100 to one (55 to one for the Fed). A small write-down of Greek debt would probably require it to seek fresh capital. Therefore, defaults and write downs must be avoided. The large European commercial banks which the ECB backstops are extremely undercapitalized compared to their American counterparts as they rely almost exclusively on short-term funding. The 90 biggest banks in Europe collectively face an estimated Euro5.4 trillion in principal loans coming due over the next 24 months. We believe this debt can only be rolled over if the ECB backs these banks and there are no sovereign or major commercial bank defaults in the EZ. Meanwhile, deposits flee PIIGS commercial banks and European bank stocks have collapsed.

We believe that the ultimate decision, perhaps only weeks away, will be to monetize the sovereign debt of the PIIGS on a very large scale in order to preserve the Euro Zone. We believe the totals will eclipse by far the Fed's QE 1&2. Formal default for a member country is not an option under the EZ charter and would give rise to an enormously complex series of problems.

Not the return of 2008

Is this 2008 all over again? Investors are asking this question as markets tumble. Will we once again see the U.S. dollar scream higher amid fears of deflation and a liquidity crunch while everything else collapses? We do not think so. Confidence in the U.S. dollar has surely been shaken and there are no comparably deep and liquid currency markets to replace it as a safe haven. In 2008, markets did not know how the authorities would respond to the crisis (remember Lehman Brothers and the failed TARP vote in Congress) or whether the means existed to flood the world with liquidity. Now it is known. In 2008, gold recovered its losses and closed up on the year. This time around, we expect it will continue upward and outperform all alternatives including the dollar as the monetary authorities predictably respond to panic with massive money creation more quickly and more precisely than three years ago. It has already begun. There will be no Lehman moment this time. The next challenge will not be deflation but its opposite, and we believe gold will reach levels that cannot easily be imagined.

Will gold equities finally begin to follow the gold price and separate from other equities? We think this may in fact prove to be an important inflection point for gold stocks. Institutional investors are hugely underweight gold in their portfolios. We believe that they may now find undervalued gold shares to be irresistibly attractive.

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