From Don Coxe of BMO, Basic Points - Summer's Storms and Norms
The Oldest-Established Store of Value Moves to Center Stage
Who needs gold?
Over the decade that we have been advocating exposure to gold and gold mining stocks, we have been routinely subjected to basic skepticism: why gold? Isn’t it irrelevant?
If the dollar doesn’t look good, I can buy the yen.
If the yen looks bad, I can buy the euro.
Besides, what good is gold? Other commodities are useful and, in most cases, absolutely necessary.
But gold hasn’t been needed for central banking for nearly a century, and, apart from jewelry or for providing Mafiosi with a convenient vehicle for storing their wealth, it doesn’t fulfill any purpose that sound paper money can’t do better. (This, of course, assumes the availability of sound paper money.)
In answering a question about gold’s rather dramatic return to store of value status with the portfolio managers of one of Canada’s largest public sector pension plans, we took a new tack:
“The longest-established text-based religion in the West is about the God of Jacob—His works and His worship. For roughly five thousand years, a believer summed up his credo by saying, ‘I believe in God.’
“But when this credo arrived, it had to share space with an alternative belief system that was around for thousands of years before the Judaeo-Christian era began. A believer in this system summed it up, ‘I believe in Gold.’”
Two systems—similar professions of faith. Neither could prove to a skeptical rationalist why its tenet was valid.
As we have thought about this space-sharing and competition between spiritual and temporal beliefs, we have mused that large-scale skepticism about both of them occurred only recently. Darwinism, paleontology, and astrophysics combined to drive the Old Testament explanation of history out of the temples of scientific learning. Keynesianism came along to drive gold from the temples of the central bank money-changers in favor of the printed paper promises of politicians.
Why is gold back among serious, respectable investors?
Why is it now available through ATMs in the gold market of Abu Dhabi?
Is it a return of inflation?
How could that be, when, as the wise David Rosenberg routinely scoffs, “What inflation?”
Indeed, Canada reported its first negative CPI in 44 years, the US, its biggest decline in 18 months, and across the OECD there is, (at least for now), more fear of deflation than inflation. Despite astonishingly high housing subsidies that are swelling the already-bloated US national debt, US home prices remain soft, and foreclosure is not only no longer a disgrace—it threatens to become almost chic. (A recent poll of homeowners disclosed that 55% of those with mortgaged homes believed their house was worth less than their mortgage.) Not all the news is bad: The cost of TARP has turned out to be far less than feared: the cost of saving the US from house price collapses on a scale that would unleash a Depression—including the mind-boggling costs for keeping
Fannie, Freddie and the Federal Home Loan Bank alive and lending, and the various cash subsidies to buyers—is many orders of magnitude above the Wall Street bailouts.
If the only thing keeping house prices from collapse is a boost in the national debt bigger than the total cost of all the US’s foreign wars since World War II, then how can inflation be a threat?
Yes, some industrial and food commodity prices have shown some inflationary tendencies, but, with the exception of coffee, cocoa, iron ore and metallurgical coal, prices have been sagging recently—although remaining far above Lehman lows.
Interest rates remain in the zero range, which would be a sure sign of inflation on the horizon if there were projected increases for anything significant other than wages and benefits for government employees.
Although the Fed’s response to the Crash was the greatest goosing of its asset base in history, raising fears among the putatively paranoid that a new Weimar was being born, in recent months the Fed seems dedicated to proving that its previous promises of piety were sincere. Based solely on the numbers, Bernanke almost seems to be willing to risk outright deflation:
So what makes gold so attractive now?
And who is buying it?
According to the World Gold Council, industrial and jewelry demand have come back sharply (after collapsing in 2009), but the big new buying is for bar hoarding. Banks are running out of vault space and are building new above-ground facilities. (At the bottom of Gold’s Triple Waterfall Crash, banks were moaning that their vaults were nearly empty and were costly to maintain.) In last year’s First Quarter, there was net selling of 28.1 tonnes in bars. This year investors bought 89.7 tonnes. Record amounts of coins are being minted.
China and Russia have bought some gold for their foreign exchange reserves, but these purchases have been mostly from their own nations’ mines.
The SPDR Gold ETF’s holdings keep setting records. If it were a central bank, its hoard would put it in the top four.
We think that future historians may well report that the moment when gold once again became a store of value was when the dollar began soaring in response to the stench of seared Greece—and gold climbed right along with it. The asset classes that have been inversely correlated since Keynes’s time suddenly united.
When we first noticed this, we headlined it in a Conference Call, which we titled “The Odd Couple.”
That gold and the dollar are fundamentally inversely correlated to each other is obvious. One bets on gold because one is deeply skeptical that governments will fulfill their promises.
So why are they both in a mini-bull market?
We believe this is driven by the squeeze on the European banking system from the drachmadrama:
This forces the weaker banks to borrow in Eurodollars, thereby driving up the value of the greenback. International corporations also collectively rush to adjust their exposures, switching cash holdings from euros into dollars.
Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon.”
He won the Nobel Prize in Economics in 1976 for his work documenting that dictum. It helped to explain stagflation—rising inflation during recessions.
The Keynesians who dominated global economic thinking after WWII believed inflation was caused when wage increases outstripped productivity gains on a sustained basis. President Kennedy’s famed confrontation with the steel industry came when he convinced the Steelworkers to agree to a modest pay boost at a time of rising inflationary pressures. When Big Steel then boosted its prices above the percentage increase in wages, Kennedy declared war on Steel and the industry capitulated.
In the 1970s, a new collective bargaining pattern emerged, as the big unions successfully negotiated COLA clauses in all their contracts—wage boosts plus cost-of-living increases tied to CPI. As inflation surged, the companies and their unions were widely blamed for causing price increases across the economy even as unemployment was rising and most of the OECD was struggling with recessions.
When Margaret Thatcher became Britain’s Prime Minister in 1979, she dedicated herself to imposing monetarism on Britain as the way to control inflationary wage demands from the big British unions.
As she told me in a private meeting in Toronto in 1978, she had had a meeting with Germany’s Chancellor Helmut Schmidt shortly after becoming Tory leader.
She asked him, “Why don’t your German unions make inflationary wage demands like our British unions?”
He replied, “Each year, we have a meeting with the eight German unions.”
In explaining her surprise at this statement, she pointed out to us that there were 36 unions at the Ford Dagenham plant alone.
“What happens when you meet with the eight unions?”
“They tell us what their wage requests will be and we tell them what the economy can afford.”
“And what if the unions demand more than you believe the economy can afford?”
“Then, madam, I tell them that the Bundesbank will not print the money to ratify those demands.”
As she recounted this event, she said, with rising emotion, “Imagine that! He’s a Socialist and he understands monetarism. I'll bring monetarism to Britain to smash the power of the unions! The coal miners will go out on strike and we’ll just leave them there. Within two or three years, inflation will start to collapse, along with interest rates, and Britain will be on its way back
to being an industrial power.”
She went on, “In 1980, Ronald Reagan will win the Republican nomination and he will defeat President Carter and he will use monetarism to end the inflation era in America.”
What actually happened was that President Carter was forced, because of soaring inflation, to install Paul Volcker as Fed Chairman and he introduced monetarism. He kept raising rates after Reagan was elected, but despite screams from the business community that his tight money was killing the economy, Reagan backed him. The deep recession in 1981-82 with sky-high interest rates arising from strict adherence to monetarism nearly aborted the Reagan recovery.
The most important economic number for portfolio managers in 1980–1984 was the weekly Fed statement showing conditions in the Monetary Base, M-1 and M-2.
We used those numbers to trade bonds, which became our asset class of choice when we dumped commodity stocks once we saw that Reagan would be elected. We moved our portfolio into very long Treasury zero-coupon issues when it looked as if money supply was being brought under control and the Fed could begin to ease.
That was then.
So why didn’t inflation come roaring back when Bernanke doubled the Monetary Base and M-2 was climbing at double-digit rates?
And why didn’t inflation come back when central banks across the OECD were growing their monetary bases and money supplies were climbing? And why did gold take off to record levels when money supply growth began to dwindle and actually turn negative?
We believe that Gold’s recent rise began when investors sought a classic inflation hedge, but its real run came when deflation risks were far more obvious than any evidence of inflation.
As we have written in these pages, gold is the classic store of value. It should retain its value under both inflationary and deflationary conditions.
That means a great time to buy gold to make capital gains is when inflation is rising.
It also means a great time to buy gold to conserve existing wealth is when (1) prospective risk-adjusted returns on bonds and stocks look unattractive because the economic outlook is for slow growth with (2) a risk of a renewed downturn that would hammer the value of stocks—particularly financial stocks—and real estate anew, and (3) bond yields are too low given the endogenous risks in the currencies in which they are issued and (4) the range of future fiscal deficit forecasts is from grim to ghastly.
What we believe is unfolding is a rush into gold by individual investors who look at the astronomic growth in financial derivatives—particularly collateralized debt swaps—and government deficits at a time when the effects of demographic collapse are finally being understood. According to some guesstimates we have heard, the supply of outstanding financial derivatives may be in the $70 trillion range, dwarfing the combined value of money supplies and debts. The total value of gold is so minuscule in comparison to the supply of these software-spawned instruments that it cannot be any real help in stabilizing global finances—but it can be a haven for investors seeking to protect themselves against an implosion of majestic proportions.
That is why gold and the dollar can—if only for a brief time—rise together, as investors see that the only major currency alternatives to the dollar—the yen and the euro—are backed by rising national debts, rising numbers of pensioners, falling working-age populations, falling real estate prices, and a falling OECD share of global GDP.
There is no constraint on the ability—or, apparently the willingness—of governments and central banks to create new financial liabilities which can only be serviced if GDP growth rises—on a sustained basis—to higher levels than most OECD nations have seen since the Baby and Reagan-era booms.
Given the average fertility rates across the OECD of 1.3 to 1.5 babies per female, return to the economic growth rates of those eras is really out of the question. Each new generation is roughly two-thirds the size of its predecessor, so construction of new homes, schools, and commercial buildings and filling them with workers—an important component of past periods of rapid GDP growth—has to be at lower rates in each cycle. The alternative—to pretend that the number of first-time homebuyers will reach or exceed the numbers in earlier cycles and, with government stimulus, build them on grand scale in the hope that they will come—can lead only to financial disaster.
In the current financial environment in which risk measures such as the TED Spread and VIX are leaping back toward post-Crash peaks, a momentous shift in investor appraisal of endogenous risks within asset classes is unfolding: sovereign credits are no longer being automatically accorded low-risk appraisals, and banks are being downgraded on the basis of their high exposures to sovereign credits—not, as in previous financial downturns, to dodgy corporate debts or putrid mortgage products.
This re-rating of debt instruments is a sign of the fundamental fragility in financial valuations since the end of those halcyon, bygone days when Moody’s was a homely, plain-Jane stock which lived modestly, mostly off municipal bonds. Its puritanically lofty standards for Triple-A ratings could be met by only a handful of corporations and a select few governments and their agencies. Then Moody’s suddenly blossomed into a sexy growth stock fattened in all the right places by fabulous fees for analyzing collateralized mortgage instruments and giving them the Good House-Financing Triple-A Seal of Approval. Too late did we learn that Moody’s “experts” never really understood what the underwriters and math PhDs were confecting. Only the aggregators of the underlying mortgages knew about the deadbeat and dead mortgagors, and the systematic home overvaluations—and the only one of them who has been publicly pilloried is Paulson. (No, not that Paulson.)
The world has gone mad today
And good’s bad today,
And black’s white today
And day’s night today…
This week, Moody’s finally got around to lowering Greece’s bond rating to near-junk. They seem to be cleaning up their act—probably in response to some pressure from Warren Buffett.
So…as a store of value for future generations,
If you can no longer believe in residential real estate,
and you can no longer believe in bank deposits,
and you can no longer believe in the dollar,
and you can no longer believe in the yen,
and you can no longer believe in the euro…
What can you believe in?
How about gold?
It’s so old, it’s new again.
It can’t be synthesized.
It’s been despised by every liberal economist since Keynes.
Among the arguments routinely adduced against it is that it pays no interest—but with interest rates in the zero range, the opportunity cost is minimal.
Treasury bonds? Why bet your future on a ten-year piece of paper that pays 3.2% in a currency that’s been in a bear market for most of the time in recent decades, knowing that the new supplies of bonds will be endlessly growing, in good times and bad, because the issuer’s own forecasts say so (and most independent forecasters say the issuer’s numbers are absurdly optimistic)?
The S&P currently trades at its level of March 1998—when Gold was trading at $302.
Industrial and Agricultural Commodities?
To our sustained disbelief, major pension funds continue to hold more than $150 billion in passive commodity funds like the GSCI. This is the investment equivalent of Einstein’s dictum that one proof of insanity is trying the same experiment over and over, hoping for a different result. Because of the contangos—particularly oil—these vehicles are even worse strategies than putting all the funds into Las Vegas slots—because your odds are better with the one-armed bandits.
Gold is the recently-awakened Sleeping Beauty, who always was beautiful but was overlooked. She is ready to take the throne among stores of value that was long occupied by sovereign credits.
The handsomest courtier in her realm wears the crest of a long-necked water bird.
Until very recently, the case for gold was almost always presented as a hedge against inflation.
That case remains valid, because if the US and European economies revive, then the pressure on the Fed and ECB to raise rates will become intense, even though unemployment will still be at historically high levels and politicians will be screaming that any rate increases will punish the poor to reward the rich.
If the major central banks do not raise rates, investors worldwide will begin to bet heavily on a return of inflation.
However, those monetary Rubicons seem off in the distance, given modest US growth, and barely-perceptible recoveries or renewed downturns within the eurozone.
We believe gold should be a significant component in most high net worth wealth preservation programs, and in most endowment and pension funds.
For the first time since 1980, Germans and other Europeans with long memories are pouring into gold dealerships to exchange euros for coins and small gold bars. Germans have watched as twice in the past century their currency was utterly destroyed. They were strong-armed into believing Ludwig Erhard that their nation could have a currency that was as good as gold, and that revived faith was the underpinning of the German Miracle. That faith is now eroding, and individual savers are protecting themselves. Long-suppressed atavistic attitudes that suddenly coalesce into fear-driven behavior can have momentous consequences.
Browning said it (In Rabbi Ben Ezra), “Leave the fire ashes. What survives is gold.”
Full June report by Don Coxe, a must read for everyone, can be found here.