You Can’t Print More Gold

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

What do you get when you mix negative real interest rates with stimulative money supply efforts by global central banks?
An exceptionally potent formula for higher gold prices that could send gold to the unimaginable level of $10,000 an ounce. Negative real interest rates and strong money supply growth are two key factors of what I refer to as the Fear Trade.

Negative real interest rates occur when the inflationary rate, or CPI, is greater than the current interest rate. A quick account of the G-7 and E-7 countries shows that the majority have negative real interest rates.

Across the developed G-7 countries, British citizens are the worst off with real interest rates in the U.K. sitting at negative 4.5 percent. U.S investors aren’t doing much better with rates at negative 3.25 percent and the Fed has all but guaranteed rates will remain there. Only Japan has a positive real interest rate among the G-7 and that rate is barely above zero.

Conversely, the most populous nations making up the E-7 have mostly positive real interest rates. However, the grouping’s grandest economic powerhouses, China and India, have negative real interest rates sitting around negative 2 percent.

Simply put, investors in those countries who have parked their savings in cash and low-yielding investments, such as Treasury bills and money market accounts in the U.S., are actually losing money due to inflation.

That can be tough for any investor, but when you’re the central bank of a country with millions of dollars in reserves, it can be catastrophic. This is why central banks around the globe have sought protection by diversifying their foreign-exchange reserves into gold bullion this year.

VTB Capital’s Andrey Kryuchenkov told The Wall Street Journal this week that, “Central banks are diversifying, and it has intensified to a rate that nobody had expected.” Latest estimates predict global central banks will purchase between 475-500 tons of gold in 2011.

This amount of capital flowing into gold has the potential to push prices up a level in 2012. John Mendelson from ISI Group sees gold prices reaching $2,200 an ounce during the first six months of 2012.

While real interest rates look to remain in the red for the foreseeable future, many of these same countries are printing record amounts of “green” with accommodative monetary policies.

U.S. Global’s director of research John Derrick says central banks around the world have focused their attention on stimulating growth. Beginning with Brazil’s interest rate cut in late August through the European Central Banks (ECB) cut this week, there have been 40 easing moves by global central banks, according to ISI Group.

John says this also means we will likely see more quantitative easing in 2012. The Bank of England has already started its quantitative easing, and many experts believe the ECB and the Federal Reserve will follow in its footsteps.

Bloomberg reports that global money supply (M2) is “set to increase the most on record in 2011.” The chart below shows the year-over-year change of global money supply has been gradually moving higher and higher since mid-2010.

The reason global central banks have shifted the printing presses into overdrive is simple: they need the money. My long-time friend Frank Giustra reminded us of this new reality in an op-ed piece for the Vancouver Sun last week. Frank writes:

“The bottom line is that the money needed to bail out Europe and to fund America’s spiraling debt and future unfunded obligations is in the ten of trillions. IT DOES NOT EXIST. It has to be created by printing money in massive quantities, and despite all the rhetoric you will hear against such policies, in the end it’s the path of least resistance. Printing money is an invisible tax on savings, much easier to initiate, than, say, raising taxes or cutting back on services and entitlements.”

As central banks print money and increase supply, currencies become devalued. Whereas in the recent past, one currency may be reduced in value compared with other currencies, this time there is global competitive devaluation as excess liquidity is put into the system. Historically, this excess liquidity has made its way to riskier assets, i.e. stocks and commodities.

Gold is generally a benefactor of this flight to riskier assets as many investors see it as a store of value. This chart illustrates the interconnectivity of gold and global money supply growth.

However, this image doesn’t tell the whole story. While the price of gold has followed the same upward path as money supply over the past 14 years, it hasn’t been able to keep pace with M2 growth, says the Bloomberg Precious Metal Mining Team.

In fact, if the global money supply were backed by gold, gold prices would be much higher, according to Bloomberg. The yellow line below shows how gold would be greater than $5,000 per troy ounce if just half of global money supply were backed by gold. If all of the money supply in the world were to be backed by gold, the price of one troy ounce would need to rise above $10,000.

It’s unlikely, of course, that this will happen, but it serves as a useful illustration for the disappearing value of the world’s fiat currencies.

Frank reminded readers that we have been down this path before. Frank says, “When great nations mature and over-extend themselves, they revert to the paths of least resistance: borrow and/or print money. They all did it and they all failed; this time will be no different.”

The beneficiary of this type of event has historically been gold.

 

Index Summary

• The major market indices were higher this week. The Dow Jones Industrial Average gained 1.37 percent. The S&P 500 Stock Index increased 0.88 percent, while the Nasdaq Composite was higher by 0.76 percent.
• Barra Growth underperformed Barra Value as Barra Value finished 1.05 percent higher while Barra Growth gained 0.72 percent. The Russell 2000 closed the week with a gain of 1.41 percent.
• The Hang Seng Composite finished lower by 2.68 percent, Taiwan fell 3.46 percent, and the KOSPI lost 2.15 percent.
• The 10-year Treasury bond yield closed 3 basis points higher at 2.06 percent.

 

Domestic Equity Market

 

The domestic stock market as measured by the S&P 500 Index was higher this week by 0.88 percent. Nine sectors of the index advanced and one declined. The best-performing sector for the week was financials which increased 1.68 percent. Other top-three sectors were technology and industrials. Materials was the worst-performer, down 0.11 percent. Other bottom-three performers were energy and telecom services.

Within the financials sector, the best-performing stock was Morgan Stanley, up 5.54 percent. Other top-five performers were Comerica, Genworth Financial, Goldman Sachs and Ventas.

Strengths

• Healthcare facilities was the best-performing group for the week, up 6 percent, led by its single member, Tenet Healthcare Corp. A brokerage firm report stated that all six of the publically-traded hospitals saw a sequential decrease in unemployment in their respective areas from September to October. The report views unemployment trends as a potential precursor to changes in the level of hospital business.
• The specialized consumer services group outperformed, gaining 6 percent on strength in its single member, H&R Block. The tax-preparation company increased its dividend by 33 percent, and it also introduced some new features including tax preparation apps for iPhone and Android phones and tablets.
• The homebuilding group gained 6 percent. A major brokerage house report on the homebuilding industry stated that it has become increasingly apparent that the pieces are beginning to fall in place for a housing rebound in 2012.

Weaknesses

• The real estate services group was the worst performer for the week, losing 6 percent on weakness in the group’s single member CBRE Group. Investor sentiment on the stock of this commercial real estate sales and leasing firm may have been affected negatively by a study of U.K commercial real estate by an English university. The study reported that U.K. commercial real estate investors are unable to refinance about 85 billion pounds to 114 billion pounds of debt because the loans are too high compared with collateral property values.
• The casinos & gaming group underperformed, down 5 percent, led by the group’s largest member, Wynn Resorts. A major brokerage firm lowered its earnings estimates and price target on the stock, saying that Wynn Resorts may not be able to keep up with the overall growth rate in Macau.
• The home entertainment software group declined 4 percent, led by its single member Electronic Arts. Shares of video game publishers declined after one publisher, THQ, lowered its revenue guidance for the holiday quarter.

Opportunities

• There may be an opportunity for gain in merger & acquisition (M&A) transactions in 2011 and 2012. Corporate liquidity is high, thereby providing the means to pursue acquisitions.

Threats

• A mid-cycle slowdown in the domestic economy would be negative for stocks.
• An escalation in concerns over sovereign debt obligations in Europe would be negative for stocks.

 

The Economy and Bond Market

 

Long-term treasury yields ended the week modestly higher as European leaders came together on Friday to form a fiscal pact that placated the market for the time being and led to a sell off in the long end of the Treasury curve.

While there was considerable anticipation and discussion regarding the outcome of the European Central Bank (ECB) meeting on Thursday and Friday’s European Union (EU) summit, the most important piece of data may have come from the other side of the world. The chart below depicts year-over-year inflation in China, which fell to the lowest levels in 14 months. The reason this may be so significant is that this could be a precursor to full-fledged easing in China, which has been the incremental global growth driver in recent years. If China were to cut interest rates, that would be a strong signal that global reflationary policies are back in force and boosts prospects for both global economic growth as well as appreciation in risky assets.

 

Strengths

• The EU leaders came to an agreement, in principle, on a fiscal pact that will hopefully lead to real reform and stabilize markets in the near future.
• China’s November CPI fell to 4.2 percent and opens the door to more aggressive easing policies in China.
• The University of Michigan Confidence Index rose more than expected in the preliminary December release.

Weaknesses

• Weakness is several Chinese indicators also increases the probability of an interest rate cut as China’s export growth and service sector PMI slowed.
• S&P put negative outlooks on 15 of 17 eurozone countries and the EU may lose its AAA rating as well.
• Factory orders in the U.S. fell 0.4 percent in October and September’s data was also revised lower.

Opportunities

• The Federal Open Market Committee meets next Tuesday and, while expectations are low for a significant change in policy, the Fed could surprise the market.

Threats

• The situation in Europe remains extremely fluid and negative news is almost expected at this point; unfortunately, it is politically driven and difficult to predict outcomes and ramifications.

 

Gold Market

 

For the week, spot gold closed at $1,711.60 down $35.15 per ounce, or 2.01 percent. Gold stocks, as measured by the NYSE Arca Golds BUGS Index, fell 1.00 percent. The U.S. Trade-Weighted Dollar Index was essentially unchanged for the week.

 

Strengths

• A study commissioned by the World Gold Council from New Frontier Advisors reconfirmed gold’s role as an excellent portfolio diversifier. The study suggested that the optimal strategic asset allocation for investors with the lowest risk portfolios is to hold 2-3 percent in bullion, for portfolios with a 50/50 split between equities and bonds to hold 4-9 percent, and for equity-focused portfolios to hold as much as 10 percent. The conclusions further support the case for gold as a foundation asset which could provide safety against extreme events.
• Maintaining the rising dividend trend among gold companies, both Goldcorp and IAMGold announced increases in their dividends this week by 32 and 25 percent, respectively. Income streams on gold stocks are becoming increasingly important.
• Randgold climbed 4 percent this week while the Gold Bugs Index fell 1 percent. SmarTrends identified Randgold as having the lowest beta in the gold industry. Lower beta stocks are generally considered to be less risky and offer more stable returns, according to SmarTrends. Randgold is expected to grow its gold production by 60 percent in 2011 and the site of its next development project, the Democratic Republic of Congo, had presidential elections this week which were not disruptive to the future of the country.

Weaknesses

• This week was volatile, playing off investors’ emotional roller coaster in anticipation of news coming out of the eurozone regarding the ever-impending global sovereign debt crisis. In an effort to shore up liquidity, European banks sought new ways to gain access to dollars by lending their gold to the market. This drove lease rates on gold to their lowest level on record this week.
• Kinross Gold reached a nonbinding agreement with the Ecuadorian government over its Fruta del Norte deposit, however, analysis of the terms and conditions shows how strongly resource nationalism has influenced the terms of the agreement. Among the many conditions agreed upon, the government must get a minimum 52 percent of the economic benefits of the project and there is a clause outlining a 70 percent windfall profit tax on the excess of the realized gold price above certain thresholds. In addition, there is mention of advanced royalty payments on the mine before it is even in production.
• David Rosenberg noted that the generation on the brink of retirement has an extremely low percentage of their retirement assets in fixed income investments. For those who were betting on elevated portfolio returns from the equity market to deliver adequate retirements savings, time has run out. He recommends an investment strategy focused on safety and income at a reasonable price and suggests precious metals and energy-based investments that carry a yield.

Opportunities

• Rye Patch Gold seized a “golden” opportunity by taking advantage of Coeur d’Alene Mines’ failure to pay federal claim maintenance fees covering its Rochester silver-gold property in Nevada, by taking control of the land. The land represents 20 percent of Coeur’s Rochester reserves, with total proven and probable reserves around 27.6 million ounces of silver and 247,000 ounces of gold. Rye Patch’s shares price soared 82 percent for the week. The World Precious Minerals Fund is the fourth largest investor in the company holding 3 percent of the company’s shares.
• According to Ernst and Young (E&Y), there is a light at the end of the tunnel for junior miners, who have been underperforming since the beginning of the year and are at similar valuation levels of 2008. E&Y noted senior mining companies are more likely to tap the debt markets for funding as they are sporting underleveraged balance sheet. Lee Downham, of E&Y, commented, “the upside for juniors is that there should be less competition for equity as large producers simply don’t need it in absence of major M&A.”
• Japanese Finance Minister Jun Azumi will be rewarding investors who buy reconstruction bonds with half an ounce of gold, an added incentive that could boost the return by nearly six times. Individual investors who purchase more than $129,000 in the debt with a 0.05 percent yield and keep it for three years will receive a gold commemorative coin weighing 15.6 grams (0.55 ounces), worth about $948 based on current prices for the precious metal. This is interesting development of offering a fixed amount of gold as a sweetener to increase public appetite to buy government debt.

Threats

• This week, the UN Security Council toughened sanctions against Eritrea after it was accused of providing support to Islamist militants to their East African neighbors. The resolution requires foreign companies involved in the country’s mining industry to ensure that funds from the sector are not used inappropriately. So far, early drafts of the resolution included measures such as banning foreign investment in Eritrea’s mining sector and blocking a remittance tax imposed on nationals overseas. This could be a headwind in the future to foreign-owned mining companies with the country.
• TD reported that gold shipments from Japan, the world’s third-largest economy, are at the highest level since at least 1985, as individuals who purchased jewelry more than 20 years ago, are now selling it amid record prices. Japanese gold exports have predominantly been increasing to Southeast Asia and China. Countries with negative real interest rates are becoming significant purchases of gold, such as China, where inflation is eroding the value of bank deposits.

 

 

Energy and Natural Resources Market

 

Strengths

• In another sign of robust emerging market oil demand, China’s refineries boosted daily oil processing to a record last month after state plants maximized production to ease a domestic diesel shortage. Refining rose 5.4 percent to 9.25 million barrels a day in November from October, surpassing a record of 9.22 million barrels a day in February. Refiners are boosting production after plant seasonal maintenance led to a supply shortfall. China Petrochemical Corp., which supplies more than half of the nation’s fuel, will raise its refinery runs to 4.3 million barrels a day in November, the second-highest on record.
• U.S. ethanol production hit an all-time high last week, according to the latest figures from the Energy Information Administration. For the week ending December 2, ethanol production averaged 954,000 barrels per day, which is a new record, 24,000 barrels more than the previous week. Getting close to the end of the year now, the four-week average for ethanol production stood at 929,000 barrels per day, which translates to an annualized rate of 14.25 billion gallons.
• Costs to hire Capesize vessels in the Atlantic Ocean headed for Asia climbed to a 2011 high for a second day this week on stronger demand to transport iron ore and coal. Rates climbed to $55,550 a day, according to the Baltic Exchange, the highest rate since Nov. 10, 2010.
• Palladium prices have rallied 21 percent in the last two weeks on speculation that gains in car sales will boost demand for the metal used in pollution-control devices. Global purchases will rise 6.5 percent to a record 79.5 million cars and light commercial vehicles in 2012, according to LMC Automotive Ltd., a research company in Oxford, England. Also, U.S. sales of light vehicles in November expanded at the fastest pace in more than two years.

Weaknesses

• In a perpetual European headline vortex in anticipation of an outcome from the EU summit, energy stocks, which were up 10 percent last week, decreased 3-5 percent this week. Commodities overall were down for the week, with palladium being an exception, up just over 6 percent.
• Gold has been held hostage by macro developments in Europe this week. Yesterday’s price action was testament to just how focused on Europe market participants currently are: a sharp sweep higher on the ECB policy easing and varied efforts to stabilize the financial system were quickly reversed and the metal gave back all of the week’s gains after ECB President Draghi indicated firmly that the central bank would not act as a lender of last resort in any way, and that the EU treaty does not allow for the ECB to monetize sovereign debt. This came as a blow to hopes for European quantitative easing, which would be a powerful catalyst for higher gold prices if it were to materialize.
• Expectations for a positive outcome of the EU Summit have been running high, suggesting that most participants may already have adjusted positions. The UBS Economics team anticipates an agreement among the eurozone member countries, which would lay out fiscal rules, including sanctions against violators.

Opportunities

• CLSA research highlighted that Wood Mackenzie, mining consultant, unveiled a bullish outlook for the coal market at its global energy forum. Wood Mackenzie sees China’s thermal-coal imports and delivered prices rising to over 400 million tons and $150 per ton, respectively by 2020. Additionally, the firm expects a strong import growth and pricing, and cites that coal equities remain attractive.
• China may see its demand for iron ore reach 1.13 billion metric tons by 2015, said the Ministry of Industry and Information Technology when preparing the newly issued steel industry blueprint for the 12th five-year plan period. Last year, China consumed 920 million metric tons of iron ore. The country imported 618 million metric tons of iron ore from 40 countries last year, which accounted for 67 percent of the total consumption, up from 35 percent ten years ago, due to the rapid development of the high energy-consuming steel industry. In the first ten months, China's iron ore imports grew 10.9 percent year-over-year and its domestic output of the mineral grew at a fast pace of 26.4 percent.
• The rise of the middle class in emerging markets is driving increasing protein consumption. The growth of U.S. beef export volumes and the anticipation of substantial demand growth in coming years with new customers and growing appetites for beef is creating an exciting prospect for the beef industry. In the first three quarters of this year, U.S. beef exports amounted to more than 2.1 billion pounds and were 27 percent larger than export volumes during the same period a year ago. Over 10 percent of the beef produced in the U.S. is now exported and the U.S. is now a net exporter of beef.
• The prospect of oil topping $150 a barrel within a year has become the biggest bet in the options market as the U.S. and Europe work to limit Iran’s crude sales. The number of outstanding calls to buy oil at $150 next December has jumped 29 percent, more than any other option on the New York Mercantile Exchange. The contracts equate to about 38 million barrels of oil, or 43 percent of daily global demand, based on data from the U.S. Energy Department.

Threats

• BBC News reported that China warned of “severe challenges” to exports to the west, attributable to economic difficulties in key Western markets. Sales to Europe and the U.S., which is about 40 percent of total exports, were also not expected to recover next year. Exports to the European Union and the United States fell 9 and 5 percent, respectively, in October versus a year ago.
• The U.S. Environmental Protection Agency (EPA) this week released a draft analysis of results from its Pavillion, WY ground water investigation of suspected drinking water contamination from shale gas fracturing. The EPA says deep monitoring wells in the aquifer contain synthetic chemicals, like glycols and alcohols consistent with gas production and fracking fluids, benzene concentrations well above Safe Drinking Water Act standards, and high methane levels. Detections in drinking water wells, however, are generally below limits established in health and safety standards. The investigation continues, but points toward the need for baseline monitoring.
• Twenty-five out of 77 large- and medium-sized steelmakers incurred total losses of 2.13 billion in Chinese Yuan in October.

 

Emerging Markets

 

Russia Update – United Russia?

 

United Russia (UR), Vladimir Putin’s political party performed poorly in Russia’s parliamentary elections held on December 4. According to official election results released on Friday, UR retained only 238 seats (down from 315 seats) in the 450-member Duma. It could have been worse for Putin’s party. Exit polls predicted an even wider defeat for UR than what was represented in the official results—sparking allegations of fraud and rallies in Moscow. Thousands of people have signed up on social networks and are expected to gather tomorrow in the city center. Their demands include a return to four-year presidential terms, which Duma increased to six years following Putin’s successive terms ending in 2008.

The outcome of the elections places into doubt Putin’s all-but-assured return to presidency. Any resemblance of democracy was trampled when Putin declared that he planned four years ago to swap seats with President Medvedev in 2012. This did not sit well, particularly among young Russians who were raised with the hope of a new, democratic Russia.

Even if demands of the protesters will be met and votes are recounted, progressives are unlikely to gain much ground, as the alleged fraud only limited gains by Just Party, which stands for social justice toward pensioners and communists. Hopes that after the elections the new president and his Cabinet would make a concerted push for reform now give way to a potential shift toward more populist policies.

Perhaps even more telling is the fact that budget subsidies compared to population failed to produce votes this time around compared to the 2007 election. However, it’s not that money no longer has the power to drive an outcome of the election in Russia since the chart below only captures budget subsidies but not the private capital that is funding the campaigns.

In July 1996, Boris Yeltsin gained only 35% of the first round vote but was re-elected as president with financial support from influential business oligarchs who owed their wealth to their connections with Yeltsin's administration. This time around some oligarchs have chosen to funnel money overseas rather than sponsor Putin’s UR party, judging by capital outflow from Russia this year.

 

Strengths

• China’s CPI in November was 4.2 percent year-over-year, lower than the 4.5 percent market consensus. November CPI was 0.2 percent lower than October’s reading, meaning that consumer prices were actually down month-over-month. November’s PPI was also down to 2.7 percent year-over-year compared to a market estimate of 3.4 percent.
• China’s retail sales increased 17.3 percent in November on a year-over-year basis, higher than the estimate of 16.8 percent, showing consumption in China is still growing.
• Malaysia’s exports climbed 15.8 percent year-over-year in October, more than twice the 7.3 percent gain estimated in a Bloomberg survey. Imports rose 4.6 percent.
• Philippines’ inflation slowed in November as the CPI increased 4.8 percent, down from 5.2 percent in October.
• Both Korea and Indonesia kept their benchmark interest rates unchanged at 3.25 percent and 6 percent, respectively.

Weaknesses

• China’s industrial production in November rose 12.4 percent; lower than market expectation of 12.6 percent. China’s November fixed asset investments (FAI) was up 24.5 percent year-over-year, lower than market estimate of 24.8 percent.
• China HSBC Service PMI fell to 52.5 in November from 54.1 in October. PMI above 50 indicates the sector is in expansion mode.
• Malaysia’s industrial production grew 2.8 percent year-over-year in October, beating expectations but down from a gain of 3 percent in September.
• Official figures show that economic growth stalled in the third quarter for Brazil, with growth now expected to be 3.5 percent, compared to 7.5 percent of last year, due to the worsening situation in Europe.
• The Czech Republic’s flash third quarter GDP was revised lower from 1.4 percent to 1.2 percent. In quarter-on-quarter terms, the data showed that the Czech economy has shrunk by 0.1 percent, comparing poorly to 0.5 percent growth in Germany.

Opportunities

• The International Monetary Fund (IMF) has approved a two-year, $30 billion credit facility with Poland, replacing a one-year arrangement agreed in July. The extended credit facility would help to insure Poland against external risks.
• The chart shows how stocks in the MSCI China Financial Index inversely followed China’s sovereign debt swap rate trend. Currently, the swap rate is trending down, which might point to a price up-trend for financial stocks. This might be possible due to depressed valuations for financial stocks and the possibility of an easing monetary policy by the Chinese policy makers. China announced today that it will maintain its prudent monetary policy and proactive fiscal policy next year, but fine-tune policies as conditions change.

Threats

• At the Political Bureau’s annual economic work conference, the committee said it would maintain its regulation of the property market in 2012 to allow housing prices to return to a reasonable level. Notwithstanding its good intention, the government’s harsh housing policy may potentially depress housing sales. The situation could get worse if there is a tightening monetary policy and slowing economic growth.
• The Roubini Global Economics team is expecting Argentina’s peso to depreciate by the end of 2012, due to the recent capital controls. The incentives for Argentina to devalue its currency outweigh the incentives to protect its currency. Since President Cristina Fernandez was re-elected late October, the Argentinean government introduced a number of measures aimed at reducing capital flight and increasing the number of U.S. dollars in the country: an oil, gas and mining law repatriating all export revenues, increased detailed reporting of foreign held investments, and increased regulations regarding currency transactions have been instituted. Roubini believes these measures have already shown their weakness, as depositors withdrew $645 million from private sector banks, prompting the central bank to reduce the reserve requirement on dollar deposits to 20 percent.

 

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