21 September 2009

“With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people”.  Friedrich A. Hayek (1899-1992).  Austrian Economist, Author and 1974 Nobel Prize-Winner for Economics.

The Global Financial Crisis is over. Politicians, Central Bankers, Economists and mainstream market commentators have jubilantly declared it so. Everything is ok again; the equity markets are up 50%. Yet these same experts were oblivious to the looming debacle in Financial Markets, notwithstanding the incontrovertible evidence so glaringly obvious to those that cared to delve beyond the superficial. Why now should such unsubstantiated, historically ignorant and fundamentally illogical conclusions be met with anything other than skepticism and guarded optimism? We do not share their opinion. We opine that this is but the early stages of this monetary quandary. This whole crisis is a simple monetary issue not an economic issue, a fact that appears foreign to most.

Indeed, following the two previous periods of wildly excessive monetary growth in the 20^th century, 1920’s and 1960/70’s, one ounce of Gold purchased the Dow Jones Index. Today it takes 10 ounces. Further, each of these periods led to significant distortion in economic activity, dysfunction in banking and currency markets with resultant unprecedented Official/Government intervention. Ultimately, these interventions led to the complete disintegration of the currency system of the day, producing massive increases in the Gold Price.

We contend that one ounce of Gold will again buy the Dow – we don’t know at what level, just that it will. It may be that, due to continued extreme monetary inflation, the Dow hits 30,000. That same monetary inflation will drive gold exponentially higher as investors seek refuge from glaringly obvious currency debasement by the accumulation of Hard Assets rather than paper promises. Similarly, the Dow could be 3000 as the Crisis deepens with spending contraction leading to nasty corporate earnings disappointment, no matter the stimulus. The capacity for Gold and Silver to absorb significant capital flow is small indeed, given the global investment pool and for gold to double or triple from here would not take much of China’s multi-Trillion dollar reserves. Our point being that we expect Precious Metals to outperform all other asset classes on a relative basis.

Given that the typical “Balanced Portfolio” is effectively 70% (or more) equity market exposed, it is not difficult to comprehend why we assert that a quantifiable and transparent precious metals portfolio is a prudent and essential risk diversifier at all times, none more so than today. The Global Macro economic picture is ominously bleak, notwithstanding the best efforts of Officials to circumvent the simple economic law of supply and demand.

The recent 50% rally in equity prices is fundamentally challenging to us, but we understand that markets don’t move in straight lines and as Keynes famously remarked “Markets can stay irrational for longer than you can stay solvent”. Sheer weight of money from Index Hugging Fund Managers moving from just sitting on a pile of cash to a greater weighting for equities, have sent equity markets soaring. The herd mentality has never been more apparent. “The fear of missing out” is a very powerful force. We suspect there are managers heavily exposed to equity markets who would prefer not to be so, given their own analysis and research, but will not move from the herd lest their performance suffer in comparison to their peers. We contend that there is much “reluctant” money in equities and that it will move elsewhere, quickly.

We view this rally with caution and find little evidence to support its sustainability. There has been no real economic improvement apart from that resulting from Government handouts and stimulus, nothing real has been built such as major infrastructure, manufacturing capacity is stagnant following years of contraction due to cheap labour sources offshore, and little job creation (except in the ever expanding Public sector). We do not consider a person working 4 hours a week to be employed. Banking and Finance sector balance sheets have been prettied up, but we are skeptical at best about this sector looking forward. Applying lipstick to a pig changes nothing, it’s still a pig.

Many loudly proclaim that the crisis is behind us. The popular press, the financial television network cheerleaders, taxi drivers, even Ben Bernanke (who should know better). Maybe it is, if that’s all there was to it. We are not convinced. We think there are many more hurdles to overcome. Issues  such as major Credit Card defaults impacting associated securitization instruments not unlike the recent CDO debacle; Adjustable Rate Mortgage refinancing problems (and not exclusively in sub-prime as has been the case thus far) ; Commercial Property refinancing and the resultant negative asset price revaluations for Funds and Banks; Increased unemployment and the flow on effects of falling consumer demand; Mortgagee in Possession sales driving property prices lower again, leading to negative equity for many with Banks becoming huge real estate agencies;  Currency control implementation to stop capital leaving the USA; US Government Debt issuance demanded in Yuan (or Yen or Euro or Gold) not dollars due to investor refusal to be repaid in a currency that is being inflated away; Social unrest arising from whole communities being marginalized due to factory or industry closures – read Detroit and Auto workers; The impact of falling discretionary spending for “tourism economies” like Hawaii or Thailand or Queensland or more obviously Las Vegas partying and gambling. Any of these (and numerous others) are real risks looking forward. Combine a few of these and we wonder where the markets might be.

Consider the USA - a consumer economy, as much as that is an oxymoron. The consumer is drowning in debt and lacking in confidence in the future. He is happy just to have a job and there are no pay increases on the cards anytime soon. He can’t spend like he used to, without the extension of more credit from Banks that won’t lend. His personal ATM of the past 10 years, home equity drawdown, is no longer an option due to falling property prices. He already has the big tv and a new car but see’s all around him people hurting through unemployment, the loss of medical benefits, mortgage stress, rising University and medical fees. His spending has become significantly more prudent. He needs to save in case it happens to him. He needs to pay down his personal debt. Ironically, his Government keeps taking on more debt, “to help him out”. Given that equity prices are a reflection of future revenues built broadly upon consumption, it intrigues us at to where these revenues are to be found.  

The huge leverage and extraordinarily easy monetary conditions which produced this Crisis, were only possible following the 1971 introduction of a global fiat currency system. This could never have occurred under a Gold/Silver standard which imposed strict monetary discipline upon Government, Central Bankers and “normal bankers” alike. It is not hard to understand Central Banker’s dislike of Gold and Silver. Unlike the Gold Standard where money is convertible to metal thereby limiting the expansion of credit, the fiat system allowed governments to create money at will, at no cost. This lack of monetary discipline is further compounded by Fractional Reserve banking. The global fiat currency system established when President Nixon defaulted on US Dollar gold convertibility in 1971, is at the very core of this malaise. Every fiat currency system in history has failed, destroying the currency and economy of the issuing country, without exception.  Albert Einstein maintained that “Insanity is doing the same thing and expecting a different result”.  Precious Metals are the answer, but it is readily apparent that few understand the question.

It appears that some do understand and are taking decisive action. “Hong Kong is pulling all its physical gold holdings from depositories in London ” it was reported on September 3, 2009. China clearly doesn’t want it’s gold stored in a country that is economically crippled and has announced that it has created bullion storage facilities in Hong Kong . The old adage “Safe as the Bank of England” is more amusing than descriptive these days. Similarly, the United Arab Emirates recently announced that it had begun constructing a major gold storage facility that would be marketed to members of the Gulf Cooperation Council. The UAE said it had requested its gold currently stored by the London Bullion Market Association to be sent home. Unconfirmed reports contend that Germany has demanded that its gold held in custody by the Federal Reserve, be physically returned to them.

We ponder what the Central Bankers of Australia, Canada, Netherlands, Great Britain, Spain, Portugal and others are thinking these days when reflecting on the ill-advised sale of their citizens gold reserves, some US$700 an ounce ago. Furthermore, we cannot agree who will be the first Bank to “man up”, admit the error and go buy the gold back. We’d like to think the Reserve Bank of Australia is not so proud, especially with the Australian Dollar where it is. The IMF has just given them a perfect opportunity by announcing that 403 tonnes are for sale “in a responsible and transparent manner that avoids disruption of the gold market”. It is only US$13 Billion, a mere rounding error compared to what has been recently printed up by Governments globally. There is little chance that the market will be disrupted by this sale, China will take it all, smilingly.

Inflation is muted according to government officials and mainstream media. The CPI is not rising. This is misleading to the point of deceit. Inflation has already happened. Prices rise as a result of inflation, the spectacularly flawed CPI is just a measure.  Inflation is the Official policy of the Central Banks of the World. Even the IMF is printing up fresh money with their recent, self-appointed power to issue convertible SDR’s to member nations. An increase in the money supply is the very definition of Inflation. Prices will rise, eventually. The law of Supply and Demand says so.

Debasement of the US$ through inflation is the only way to deal with the insurmountable debts that have been accrued. Some have put the total US Stimulus/Bailout package at US$20 Trillion dollars, so far. The US National Debt stands at about US$12 Trillion. Add on US$55 Trillion in unfunded domestic liabilities of the US Government due pre 2025. Unfunded corporate pension plans total in the Trillions as well. The US annual deficit now stands at close toUS$1.5 Trillion per annum and still the spending and borrowing doesn’t slow. We concur with Einstein’s observation that "We can't solve problems by using the same kind of thinking we used when we created them.”

To beg for creditor benevolence or be forced to raise interest rates to attract funding no longer restrains increasing indebtedness. The U.S. Government wants the public to believe that China , Japan and Europe are still happily buying U.S. debt to fund the American economic turnaround. The only problem is - they're not. The reality is that the US Treasury has changed the way U.S. Govt debt is accounted for when purchased on the open market. U.S. Govt debt selling on the open market can be considered as having been sold to "foreigners" even if the purchaser was the Federal Reserve! Voila! A sleight of hand by the U.S. Government whereby China and Japan can appear to be buying debt while at the same time selling debt. We find a number of “acceptable” market practices unacceptable, this is but one.

Another practice, unacceptable to us, allows Governments to buy their own debt through the quaintly named phenomena of Quantitative Easing. More remarkable is the lack of scrutiny and informed criticism of such a practice. In earlier times this was simply known as Printing Money. Inevitably, the currency of the country ignorant enough to pursue such an avenue of monetary policy became worthless. Zimbabwe and Argentina come to mind as recent examples, with the most famous being Weimar Germany back in 1922. The US and UK governments (among others) are behaving no differently to Mugabe’s Zimbabwe ; it’s just not as obvious in their “mature economy” and they can “spin it” better. To invest in or save in currencies whose creators’ official policy is inflation and debasement, is irrational to the point of negligence. Inflation is great for the indebted, but truly destructive to investors.

How can all this debt ever be repaid? The US Government must increase taxes, reduce spending, rely on the benevolence of its creditors, default or continue printing more money. Surely, the USA does not intend to default on its debt twice in 40 years. The silence is deafening.

There is some talk of deflation. We believe they mean lower prices, because deflation is the decrease in Money supply and Bernanke has stated that just won’t happen. Prices will eventually rise, but not for all things. Our original analysis concluding that there will be higher prices of what we need and lower prices for what we want, remains unaltered. The latter price falls will be due to decline in demand (discretionary spending constraints) combined with deleveraging of overextended investors.

China has had enough. They are openly questioning the safety of their Two Trillion Dollar holdings of US Assets (read Debt!). University students openly laughed at Treasury Secretary Geithner’s attempt to placate these concerns while visiting Beijing recently. Chinese Officials openly talk of dollar diversification, including buying gold. They encourage their citizens to save in gold, which was declared illegal for the Chinese public until 2002. Recently, silver has been banned from being exported from China . They know the old adage “He who has the gold makes the rules”. Chinese State owned investment vehicles like Chinalco are roaming the globe buying hard assets, effectively turning their pile of hard earned US Dollars into Goldmines, base metal mines, agriculture and energy producers. Building strategic international alliances with commodity economies such as Brazil guarantee the long term supply of the raw materials required to accommodate China ’s internal economic expansion.  Such logic and action we cannot fault. We’d do the same in their position. Protectionist policies and Foreign Investment barriers are being erected by some countries, but China ’s motives are clear. The IMF’s imminent gold sale must look like a gift horse to the Chinese – for someone wanting out of US Dollars it cant get much better than this, except of course if the IMF put more than just 15% of its gold holding up for sale!  The US Dollars inexorable march to oblivion is gaining momentum. The British Pound appears further along the same path in fact only last week, the World Economic Forum listed the British economy as less stable than Peru . The glory days of The Empire are but a chapter in the history books.

Former Federal Reserve Chairman Alan Greenspan wrote in 1966 in his essential essay "Gold and Economic Freedom". "The abandonment of the gold standard made it possible… to use the banking system as a means to an unlimited expansion of credit... In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value... Deficit spending is simply a scheme for the 'hidden' confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.” This essay should be compulsory reading for all in high school. Greenspan’s actions as Federal Reserve Chairman are completely opposite to his monetary thesis as described in this essay. Cynics might suggest that his actions will soon prove this monetary thesis to be true.

Precious Metals are the natural hedge to inflation and currency debasement. The low to negative correlation to other asset classes provide an avenue for risk diversification that has been ignored in conventional investment portfolio risk management. Clearly, asset consultants and fund managers have forgotten many of history’s lessons. We contend that Precious Metals always have a place in any investment portfolio; the weighting of the allocation is the only variable, dependent on the stage of the economic cycle.

The vast majority of Fund Managers globally have no quantifiable, transparent allocation to Precious Metals. Asset Consultants neglect Precious Metals as an asset class altogether, dismissing the fact that it has been the best performed financial asset of all for at least 5 years. Routinely Precious Metals are categorized as an “alternative asset” and given scant regard. We contend that they are the pre-eminent asset, the only financial asset that cannot default. Physical Gold has no counterparty risk unlike all other financial assets – Paper gold is another animal altogether. A claim on gold is not the same as owning gold. We submit that for each ounce of physical gold, there could be as many as 10 paper claims over that same ounce.

Indeed, a common argument is that gold can’t be “valued”. There is no PE and you can’t apply a Discounted Cashflow Model. True. It is what it is…Pure Money..and always will be. Forever. Greenspan succinctly describes “Why Gold” in his 1966 essay much better than we could here. Readers would do well to get acquainted with this essential work. Some say gold and silver are just commodity metals. Greenspan commented before a May 1999 Senate Banking Committee hearing “Gold still represents the ultimate form of payment in the world. In extremis, fiat money is accepted by nobody. Gold is always accepted.” When we all can buy gold fry-pans at David Jones, we may then agree that it’s just a commodity. Until then, we’ll agree with all of mankind’s history, notwithstanding the last 40 years, that Precious Metals are the purest form of money.

Furthermore, we contend that an Equity portfolio of Gold/Silver Producers with Proven and Probable Reserves in the ground provides investors with a naturally leveraged exposure to the underlying metals price. Unlike a bank/finance/insurance sector stock where paper asset prices may be unquantifiable and values rather “elastic”, the assets of a producer portfolio don’t change, even when the stock price gets irrationally hammered 50%, like in October 2008. Our portfolio, on a weighted average basis, has 21 million ounces of gold in the ground. Whether the shares are $5 or $50, the gold in-situ remains unchanged. Last October provided some almost “free gold” to those who understand. It should be noted that Silver has a pre-eminent position in our positioning and strategy.

As with the current equity market increases whereby increased equity allocation by Fund Managers from cash have driven the market violently higher, the same phenomena is certain to evolve in the Precious Metals sector. With zero capital specifically allocated to this asset class, a simple allocation of 1% to precious metals will drive precious metals and their producers significantly higher. Capacity in this area is very limited. Every gold and silver mining company in the world, combining reserves of over 750 million ounces of Gold and 3 billion ounces of Silver can be purchased for less than the market capitalization of Microsoft.  Consider Australia’s Trillion dollar Superannuation Pool. A simple little 1% allocation to Precious Metals would immediately dwarf the largest specialist gold funds in the world. Expertise in the sector is difficult to access and the first to allocate will be richly rewarded, especially once “the herd” catches on.

The old “fire in the cinema” analogy could not be more appropriate. Some suggest that the Precious Metals bull market is done and dusted. We declare that it hasn’t really begun.

The recently announced hedge book close-out by the world’s largest gold producer, Barrick Gold Corporation, has led to much speculation, spin and conjecture. We see it for what it is – the crystallization of a close to $6 billion dollar trading loss and a 12% dilution of current shareholders. Closing out the hedges at US$1000 per ounce, having watched gold quadruple in 7 years, taking into account the global-macro environment, is hardly first rate management. It’s pathetic procrastination and hope. We’re sure Barricks hedge counterparty Bank’s are very pleased to free up over $5 billion capital, given the parlous nature of their own balance sheets and we wonder whether this decision was Barricks alone. Interestingly, despite the hedges and transparent mis-management, almost every gold fund we checked has a significant (top 10) exposure to this company. We fail to comprehend why, given other alternatives. 

Precious Metals have been the purest form of money, the ultimate store of wealth, the asset of last resort for thousands of years. The fiat US Dollar has been in existence for 38 years and has lost 95% of its value against gold in that period. We advocate trusting 4500 years of monetary history versus saving in paper issued against the US Government’s ability to tax its own citizens and an unsubstantiated belief that it will not fail.

As in all cases in history where such outrageous and profligate monetary mismanagement and disregard for the law of supply and demand has occurred, the consequences will be severe and far reaching. The 30 year orgy of deficit spending, excessive growth in monetary supply and the corresponding compounding mountain of debt cannot be sterilized in 18 months with little or no pain.

Bernanke said “the recession/crisis is probably over’ on the 16^th September 2009. We have dire reservations that this is anywhere near over.

Confidence in the US/UK/Euro Banking sector has only been restored via unparalleled assistance from Government funds. The “bad assets” have just disappeared, purchased by freshly created money (theoretically to be repaid by future taxation revenues) and parked in new toxic asset portfolios of Government entities. We are of the opinion that there will be further rounds of significant upheaval in the banking/insurance sector corresponding with further deterioration in property prices and further credit market dysfunction.

We are unconvinced by the renewed strength in global equity markets and confidence walks a fine line. Many commentators and analysts have pontificated that the lows of last October will not be revisited. Maybe, but we ask what differentiates this rally from Japan ’s asset price inflation experience? Consider that in the past two decades there have been 3 rallies of 50% or more on the Nikkei Index, yet today it still trades at only 25% of its high. We also note that this market cannot sustain any real growth, even with “free money” available to it for nearly15 years! We ask why the Dow would behave any differently given the conditions in 2009.

Investment Returns from debt instruments such as Government Bonds do not reflect fair pricing of risk due to the Invisible Hand of Quantitative Easing. Investors in many Government Bonds around the globe choose to earn a negative real interest rate. Why, is beyond our comprehension.

We are not doom and gloomers, just realists. We have tried to find more palatable conclusions that are factually and logically robust, but there are none that we have found or heard of, anywhere. We have young kids that we hope don’t have to grow up in the economic climate that our analysis suggests, but it is what it is.

We believe that a prudent, diversified investment portfolio should have at least 10% exposed to Precious Metals including a core of physical metal. Then hope we are wrong!!! Our analysis suggests that the 10% allocated to precious metals will be more valuable than the rest of today’s portfolio, sometime in the not too distant future.

We leave you to reflect on a short extract from John Birmingham’s remarkable historic work Leviathan; The unauthorized biography of Sydney . He describes economic conditions in Sydney circa 1840. “These gross tidal flows of capital…excited fantastic growth…with enormous fortunes made by auctioneers and banks and the soft-handed professional classes who serviced them. They in turn poured their wealth into luxurious new townhouses and estates, while the men they employed –hundreds of carpenters, stonemasons, blacksmiths and coopers, painters, bricklayers and engineers-all spent their generous wages in new shops and taverns, filling the pockets of publicans and waiters, cooks and coach drivers, tailors, barbers, shoemakers and brewers. These men and their families also needed houses….The streets roared with life and madness and greed… speculators gambled their newly found fortunes buying land and cargo which they simply sold on to the next greedy fool… fuelled by credit advanced by banks …a giddy round of commercial poker where the stakes kept soaring long after everyone had run out of chips…. And the giant, confused, untenable, creaking mountain of debt upon which everything rested suddenly slipped and crashed”.  Is Sydney 2009 really all that much different?

Good luck and remember - “The opinions of ten thousand men are of no value, if none of them know anything about the subject.”  Marcus Aurelius, Roman Emperor from 161 – 180 AD.

Laurie McGUIRK

AgAu Capital Pty Ltd

21 September 2009                            

To see the previous article 'Why Precious Metals', click here