Saturday, November 28, 2009

Gold: Words Are Not Enough

Gold: Words Are Not Enough

John Ing

"Increasing America's debt weakens us domestically and internationally. Leadership means that the buck stops here" (Senator Barack Obama on March 16, 2006).

On that day, Senator Obama voted against raising the national debt limit. Today the current limit at $12.1 trillion must be increased due to President Obama's spending policies that increased the debt of the United States to the same size of its gross domestic product. The buck stops where?

Inflation Is Back
For some time now, the economic community has declared that inflation is dead and its absence gives the US authorities the leeway to push liquidity into the system. Many believe that the lack of inflation is just the excuse for the Fed and other central banks to keep printing money. With interest rates at rock bottom, no one expects inflation to be a factor, especially when Fed Chairman Ben Bernanke says there's nothing to worry about. Indeed, the markets seem more concerned about deflation than inflation, and point to the fact that over a third of industrial capacity is idled. Also many point to the real estate market which has more unoccupied homes, foreclosures, and diminished demand despite cheap prices. However, economists overlook simple arithmetic in that comparisons are against a period of negative numbers and obviously, future numbers for the balance of the year will finally reflect normalized events such a rising oil price and falling dollar. We believe coming numbers will show noticeable upward pressure.

Overlooked is that the trillions of dollars of liquidity is showing up in asset inflation, though without the leverage that made the bust so bad last time. And, the double digit growth in monetary base is due more to the significant monetization of that debt, rather than the green shots of economic activity. Inflation is a monetary phenomenon. We recall the seventies when Inflation was not simply increases in the consumer price index (CPI), but was preceded by increases in money supply. CPI was actually a lagging indicator. Today, inflation is already here with the so called new money already gone into asset prices.

New bubbles have been created in the stock market and asset bubbles are getting bigger. And yet, President Obama is another round of "quantitative easing", making the same policy mistakes as his predecessors. And despite unprecedented monetary and fiscal easing, like before the Federal Reserve is reluctant to prick the current asset bubble preferring instead to feed it more liquidity.

Liquidity seems to have found a home. Today gold has broken through all-time highs, oil is near $80 a barrel and copper is over $3 a pound. In Asia, the Shanghai market is up 80 percent this year. The real risk is asset inflation will soon show up in price inflation. After all, inflation is a tax on the economy which benefits governments' revenues, allowing governments to devalue debt away. America's economy remains deeply rooted in debt-fuelled consumption like the "cash for clunkers" programs or zero interest rates which has not brought on the much anticipated V-like recovery. To us it looks like another downturn is in the offing that will test the previous lows, cause the dollar to fall even further which will push gold beyond $2,000 an ounce in a made in America hyperinflation.

Debt on Debt is Not Good
Our worry is that the system's balance sheets remains too leveraged, and while down from the peaks, are still too high, particularly since the commercial real estate and residential housing markets have yet to turn the corner. Despite big profits, Wall Street remains over-leveraged and undercapitalized. Needed is more equity capital, but that is lacking in an era of volatility and excessive debt. Debt on debt is not good because the trillions of spending to bailout the financial system has only added to the mountain of public debt. While we avoided the Great Depression, the cost of this tide of red ink may well be higher inflation and more economic problems.

At the heart of the collapse is that the American economy was found to be without clothes. Two decades of economic expansion, was built on a "house of cards". America's prosperity was dependent upon the American consumer who made up over 70 percent of US GDP. That consumer bought homes and financed cars with cheap credit. Housing and financial assets soared. Now one year after the meltdown, this heavily indebted consumer still has $10.9 trillion of mortgage debt outstanding versus $10..43 trillion at the end of 2008. Total gross household debt relative to disposable income remains at 120 percent. Total consumer credit outstanding is at $24.6 trillion. With his healthcare bill still stuck in Congress, health spending alone will consume 16 percent of America's GDP. Americans continues to spend more than they earn. It appears that deleveraging is not so easy.

The rise in house prices and even stock prices gave an illusion of wealth, but this was found to be poorly based since debt for the most part financed this illusion. As long as homeowners and Wall Street could borrow cheap money to buy assets like homes or businesses, the rise in asset prices would continue. Growth was driven by financial leverage. Like a teenager given a credit card with a new limit of $25,000 from $5,000, that teenager might go wild at Abercrombie & Fitch but the illusion of wealth only lasts until Daddy or Mommy cuts up that credit card. Once that credit card was cut, that teenager felt definitely poorer. Of course, Daddy and Mommy would have to pay off the credit card as well as those interest payments. Similarly, faced with rising debts that funded overvalued assets with borrowed money, the US government is like that teenager who had been given an increase in their limit, but the illusion of prosperity ended with the meltdown which was equivalent to snipping of the credit card.

How Much Longer Can America Spend Money That Isn't Really Theirs?
Investors once sought the relative safety of the American currency now realize that the policy prescription of printing dollars only devalues existing dollars. Underlying the dollar's weakness is a growing perception that America has not solved its debt problem but only postponed it. Exacerbating the trend is the so-called carry trade where investors borrow in cheap dollars to invest in higher yielding assets. As Iceland and Japan found, as soon as interest rates rise or the currency shifts, there is a rush for the exits causing a collapse in the price of assets and currency. Once again the Americans are pumping an ultra-loose policy to inflate their economy and once again, they appear to have no understanding of the potential ill consequences of their actions.

After all, spending is the real burden on taxpayers. Either way, where is the money to come from? Take a guess. It must be either borrowed or taxed. Given the magnitude of the spending spree, swelling deficits and the replacement of private debt with government debt on an unprecedented scale, there is good reason to expect more borrowings and higher interest rates since no amount of tax increases can realistically begin to finance all of this. Borrowing is Geithner's first option but for how long?

Shadow Banking System Is Frozen
The central issue is that the shadow banking system created by Wall Street is still paralyzed. Deficits were once financed by Wall Street and today derivatives and debt securitization still provides almost sixty percent of all credit in the US. The alchemy of securitisation allowed Wall Street to create value and even money out of thin air replacing the traditional banking system that at one time provided three of every four dollars in the credit markets. Credit Default Swaps (CDS) for example were designed as insurance contracts that allowed investors to hedge or insure their investments from losses or defaults but were instead bought by speculators who discovered swaps were an easy way to bet on the demise of companies or countries with so little capital. Wall Street, giddy with the heights of the Dow, never imagined a default would happen, and happily collected fees. Those swaps soared to over $90 trillion and even today stands at a formidable $42 trillion. Credit default swaps were also highly concentrated among the big banks accounting for half of the CDS market. In the latest crisis, this concentration exposed a vulnerability of the system and the need for another government rescue.

Taxpayers continue to bear the costs of the global meltdown as central banks print money to prevent further losses. Already the United States underwrites eight of every nine mortgages and effectively owns Fannie Mae and Freddie Mac as well as controlling a good part of Wall Street. That price tag will go up since one in four mortgage holders are either behind in mortgage payments or in foreclosure. In 1990, the ten largest financial institutions had ten percent of financial assets in the United States. Today, Henry Kaufman points out that the ten largest institutions now hold over 60 percent of US financial assets.

And with that, systemic risk has increased with the Fed becoming an effective clearing house as it takes on the liabilities of Wall Street. And worse, with a frozen banking system, the Federal Reserve has replaced the shadow banking system by becoming buyers of the very structured products and complex instruments that triggered the crisis last year. Little is said of the government crowding out the private debt market, particularly at a time when some $4.2 trillion of that comes due over the next few years. Re-financing this wall of debt is not a sure thing. AIG is a ward of the state and now GMAC has been nationalized. As such, the banks still too chastened by the meltdown, are reluctant to use their remaining capital. Instead the Fed's surrogates, the large banks have become big buyers of Treasury debt. In September, commercial banks bought $25 billion of Treasuries and $125 billion of Fannie Mae and Freddie Mac paper.

Stuck with their toxic securities, the banking system is left to lick its wounds and hope the Fed will take on even more paper. However even the Federal Reserve having spent trillions to buy back some of this paper must still purchase mortgage debt until the end of March next year. Of more importance, this "too big to fail" market has become bigger than the Fed's balance sheet.. For example the commercial estate market has over $50 billion of securitized commercial property loans due to be reset next year. Again, taxpayers will have footed this bill in essence, taking on the liabilities - debt has been transferred from the private sector to the public sector. The national debt consequences are troubling.

Yet Another Bubble
With the national debt rising according to the International Monetary Fund (IMF), the US deficit will hit 13 percent, while the UK deficit is close to a staggering 14 percent of GDP. Governments have borrowed so much that lenders are questioning whether this is sustainable. It is not. As a percentage of GDP, net public debt will increase in the United States from 42 percent in 2007 to over 85 percent. The inclusion however of public debt easily takes that debt ratio over 100 percent which has sparked many hyperinflations in the past. Debt is ballooning from already high levels. We have been here before, when repeated devaluations in the late 1970's, tight energy supplies and easy monetary was followed by hyperinflation ended by a vigilant central banker, Paul Volcker who sent interest rates to double digit levels. Gold went from $35 an ounce to $850 an ounce.. This time Paul Volcker is older but Tim Geithner appears to be no Volcker pursuing a policy of ease that devalues away America's rising debt burden.

The value of any currency is determined by the supply and demand of that currency. Simplistically, if the Americans supply dollars to bail out Wall Street or tax cuts or fight wars, the amount of dollars obviously increases. Today, there is a much larger supply of dollars than there is demand resulting in the continuing fall of the greenback. Of course, central banks can always intervene in the markets and sterilize those dollars which results in purchasing dollars. However, the world's holders, particularly Asia, now find that holding dollars has become a risky proposition because they are being depreciated every day. And the credibility of central banks have been further strained by their collective acquiescence to print fiat money instead of acting as stewards of money.

Hyperinflation: The Consequence of Obamanomics
There are striking similarities between the events of today and yesteryear. As we wrote in our September report "Hyperinflation: Millions, Billions, Trillions", which examined five hyperinflation periods in the last century, there are too many similarities with the hyperinflations of the past from America's unprecedented printing spree in order to avoid a serious recession, to the nationalisation of America's banking system like the Chinese hyperinflation, to the seizure of private property like the French hyperinflation in the 1700's, to the rampant speculation a la Madoff similar to the Weimar Republic's speculative frenzy, to the politicization of the Federal Reserve as in Argentina's hyperinflation. The recent increase in monetary base also parallels other hyperinflations as all governments gave lip service that the printing presses would be reined in, but each time the printing presses ran overtime. Also in each period, government spending increased significantly.

America's deficit is due to Obama's spending which is set to grow to an all-time record at almost 30.2 percent of GDP, double the federal spending after the Great Depression.. Equally disturbing is that Mr. Obama's sinking poll numbers as well as the continuing deterioration in the economy is causing his policymakers to consider extending the ill-fated TARP program involving even more debt. The mounting level of debt has caused the US dollar to slide to another fifteen month low as investors migrate to hard assets propelling gold, commodities and Asian stock markets to new highs. History does not repeat itself exactly but today there are too many parallels to ignore.

A China-centric World is Good For Gold
For the first time in two decades the world's central banks actually bought more gold than they sold. Central banks are accumulating gold, after running down their holdings. Gold's role as a risk diverser is just beginning. While the Americans are pushing China to float the yuan against the dollar, momentum is building for the replacement of the dollar as the currency benchmark. China may be the first. Facing deficits as high as the eye can see, Americans should be careful what they wish for.

China celebrated its 60th anniversary of Communism. China was once the world's most powerful nation in 1862 but wars, inflation and ironically Communism caused it to retreat into a century of isolation. Ironically the renaissance of the Chinese nation is due more to a decade of loosened restrictions and a liberal dose of capitalism has returned China to great nation status. Part of this growth is due to a "going out" policy, which is a form of globalization as China secures not only strategic supplies but acquires what they do not have today. China is believed to account for about 40 percent of demand in almost every commodity. And geo-politically speaking, China's influence in the financial markets is only now being felt. China is the largest investor to a heavily indebted US government. However, China rightly worries about the preservation about the value of its holdings so they have diversified by purchasing key strategic supplies, commodities, companies and gold, all denominated in dollars.

Since the Chinese cannot dump their dollar assets without hurting themselves, the "going out" strategy has lessened but not eliminated their exposure. China has also become a critic of US monetary and fiscal policies, issuing repeated warnings that the US should not inflate away its mounting debt burden. Yet America does not listen. China has signalled that it will allow the yuan to rise against the greenback, putting further pressure on the already battered dollar but allow for a freer flow of the yuan. In another sign of the "going out strategy", the Chinese government issued its first yuan bond sale in Hong Kong that was three times oversubscribed. The sovereign offering is part of the move to internationalize the yuan. Also, by loosening its ties to the dollar, China also paves the way for an alternative to the dollar such as gold or a basket of other currencies.

Meanwhile the Chinese are spreading their wealth by sending money to Africa and Latin America that not only secures strategic supplies but also creates demand for Chinese products. There is no need to occupy a country anymore, one only has to finance these countries' treasuries. Today, South Africa and Brazil have become China's biggest trading partners.. China's exports to the US in the first nine months of this year was worth some $185 billion, making up 18 percent of all US imports. China's exports to Japan totalled $87 billion which represented about 22 percent of Japanese imports and exports to the European community totalled $61 billion, accounting 17 percent of the EU's total imports. The new political reality in Asia is that China is increasingly on an equal footing with the United States in a relationship defined by economic interdependence. China lends, America borrows, China exports, American imports. China saves, America spends.

Gold's lustre is also attracting Chinese retail consumption. Not only are there many ads on CCTV but Chinese banks are providing financing for bullion purchases. During the first six months a mid-size bank traded some $3 billion worth of gold for its clients on the Shanghai gold exchange or almost three times of an earlier period. While leverage is not allowed in China's stock markets, banks are permitted to provide gold customers with financing as much as ninety percent of the value against the gold contracts.

Today, China has become the world's biggest gold producer and jewellery consumption alone is spurring China to overtake India in consumption. Moreover, bullion purchases by its consumers will likely see China among the world's largest gold consumers. Today, the average per capita consumption globally is 1.2 gram. India's per capita consumption is .6 gram and China today is at .2 grams. We expect China's consumption to increase to as much as 1 gram per person, which would take up half of the world's gold production.

Gold: The New Currency
Gold bullion acts as a canary in the dark recesses of the market. Gold is portable and for thousands of years has been used as money as a median of exchange. Money is based on trust, more than anything else. Without that trust other forms of money that retains value will surface. It has happened before. Gold anyone? Gold has outlived governments, hyperinflation and during times of monetary upheaval is a store of value. Gold has surged through $1,100 posting new highs amid worries about inflation and the stability of the US dollar. To us, we are not surprised and remain bullish on gold, expecting $1300 an ounce near term and then $2,000 an ounce.

This Bull Market Is Only Just Beginning
Our enthusiasm for gold is not because of its shininess, but because of its role as a protector of wealth. Investors no longer believe that the stewards of the dollar can protect the integrity of the currency and doubt whether they can. Central banks too, worry over the growing indebtedness of western governments and some are seeking alternatives by converting dollars into gold. State Street's gold ETF or the people's central bank are among the biggest holders of gold in the world today. And to meet demand, the American Mint has resumed coin sales while Britain's Royal Mint is quadrupling the production of gold coins.

Gold is also a good index of currency fears. Central banks around the world now view gold as a hedge against a devaluing dollar so by default gold has become a defacto reserve currency. When the US was on the gold standard, the Fed was disciplined by the reserves of gold. If they printed too much money, they had to buy more gold or risk a run on the dollar. That happened in the seventies, and when the US abandoned the peg, gold went from $35 an ounce to $850 an ounce. Gold prices today are soaring. As mentioned central banks have joined the gold rush, led by India that purchased 200 tonnes from the International Monetary Fund (IMF) last month. China too has increased its holdings by 75 percent but still holds less than 2 percent of its reserves in gold, far below the world average of 10.3 percent and European country average of 15 percent.. And tiny Mauritius has purchased two tonnes of gold from the International Monetary Fund raising its gold holdings to 5.69 percent from 2.34 percent.. If China wanted to increase its holdings of gold to just 5 percent equivalent to half of the average major economies, it would need to purchase all the world's mine supply for the next two years.

So what to do? There is an inconvenient truth. America holds 80 percent of its foreign currency in gold, the largest in the world. A tenfold rise in the gold price would be enough to pay for America's $2.5 trillion foreign net debt. Plausible but unlikely.


Gold shares continue to be laggards relative to bullion. Part of the reason is that:

* The industry has Issued too much paper eg: Barrick's issuance of almost $5 billion of paper to pay for hedge losses or Goldcorp's serial funding of acquisitions with stock.
* Until this year, most gold companies were actually losing money, so many issued more paper to repair balance sheets. However gold miners today are profitable and cash costs are down due to lower oil, steel and chemical prices. Gold mining is now a growth business. Earlier, there was little growth except though dilutive acquisition.
* With gold now above $1,100, companies at yearend will revalue resources upward, particularly open pit players like Eldorado who recently revised Kisladag reserves in Turkey upward.
* Project risk is a real concern and miners face difficult operation issues because of the lack of good people. Premiums will rise for good managers like Barrick.
* Finally the industry faced "peak gold" issues.

John R. Ing
Maison Placements Canada
130 Adelaide St. West - Suite 906
Toronto, Ont. M5H 3P5
(416) 947-6040

27 November 2009

The information contained herein has been obtained from sources which we believe reliable but we cannot guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell for the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that Maison Placements Canada Inc. is to be under no responsibility whatsoever in respect thereof. Directors, shareholders or employees of this company may be beneficial owners of the securities referred to herein.

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