Submitted by Trey Reik via Sprott Asset Management, [6]
Few assets command more disparate investment motivations than gold. Most investors hold opinions of gold’s merits, usually with surprising conviction. Some view gold as an inflation hedge, others as a deflation hedge. During times of financial stress, some view gold as an asset to own, while others might view gold as an asset to short, because of gold’s historically inverse relation with the safe-harbor U.S. dollar. Many view gold as the ultimate “risk off” asset, and just as many view gold as the ultimate “risk on” trade.
At Sprott, our investment thesis for gold has never been limited to popular relationships, such as CPI-type inflation, financial meltdown or political instability. We prefer to focus on the irretrievable gap between financial assets (claims on future output) and productive output (GDP). In essence, the most compelling reason to own gold is that financial assets have lost their underpinnings to sustainable productive output. We train our analysis on the United States because we believe the “dollar-standard” system is at the heart of mounting global monetary stress. To us, the ultimate litmus test for gold’s ongoing relevance as a productive portfolio asset will always be the relationship between claims on future output and the productive output itself. We believe U.S. paper claims (aggregate valuations of stocks and bonds) have become completely untethered from underlying productive output.
The outlook for gold rests squarely on the mathematics that U.S. GDP can no longer service U.S credit-market debt without fresh credit creation on the order of nearly $2.0 trillion on an annual basis. In essence, new debt claims on this order of magnitude are now necessary to support the burden of outstanding debts. During the past 15 years, this mandatory debasement of existing claims has been at the nexus of gold’s ongoing bull market. It is a common misconception that gold’s strength since the turn of the millennium has been closely linked to central bank programs. However, gold posted nine straight years of advances before the Fed’s first asset purchases in 2009.
We believe quantitative easing programs reflect the Fed’s tacit and comparatively recent admission that a credit-creation backstop must be provided to forestall U.S. debt defaults whenever the U.S. economy’s capacity for fresh credit creation stands at low ebb. Gold’s wealth-protection relevance will not diminish until the ratio of debt-to-GDP reverts to a sustainable, functioning level, which history suggests will certainly be no greater than 200%. We believe current GDP levels suggest debt-defaults of at least $20 trillion will ultimately be required to rebalance the U.S. financial system. In an environment of likely, large-scale debt-default, gold remains a mandatory portfolio asset.
We have developed three litmus tests for gold’s portfolio-diversifying relevance which we believe every global investor should currently be mulling.
First, could the U.S. financial system endure even moderate normalization of interest rate structures?
Second, has the process of debt rationalization been allowed to proceed in U.S. financial markets?
Third, is the U.S. economy capable of achieving 3%-to-4% GDP growth with a healthy net national savings rate of say 8%-to-10%, alleviating the need for copious amounts of U.S. nonfinancial credit growth.
If the answer to all three of these questions is not, “yes,” gold remains a mandatory portfolio-diversifying asset.
