Is Gold a Crowded Trade?

Paul Brodsky & Lee Quaintance run QB Partners, a private macro-oriented investment fund based in New York.

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Investing in gold is tough because it challenges the investor to come to terms with the faults of his or her government, and then to act upon them. It requires the admission that there is risk in holding cash. This is counter-intuitive to this generation’s vintage of financial asset investor accustomed to thirty years of a credit build-up alongside declining interest rates.

There is certainly much more chatter in the press than in years past surrounding gold, and there certainly is more US retail investment (through ETFs) than there has been. That has been reflected to some degree in its rising price, no doubt. An ounce of gold has risen from about $250 in 1999 to current levels, having moved higher in each year and making it one of the best performing assets over the last ten years. So then, is a person that pays $1,100 an ounce today top-ticking the market by entering a crowded trade that has little upside and great downside?

We don’t think so.

Do your own research. Call your investment advisers and ask them what percentage, if any, they recommend investors allocate towards precious metals. Ring up prominent friends with substantial portfolios and ask them how much gold they have as a percentage of their portfolios. What about your fund managers overseeing, say $50 billion? Are they actually long $2.5 billion to $5 billion in precious metal plays? Our guess is that the figures in both cases will be very small, say 5% to 10% (if any at all).

Let’s extend this thinking. If people you know have only dipped their toes in the water and are doing more watching than investing in gold, then the past ten years of price appreciation must have come from elsewhere. Did it come from institutional investors? No, not in any great way. Most mutual and pension funds that report their holdings don’t own any gold – zip – other than very minor positions in precious metal mining stocks (and these stocks usually comprise less than 1% of their holdings). Hedge funds? Yes, it seems hedge funds have been buying gold but of those that have, most have less than 10% of their holdings in precious metals.

What about foreign central banks, Middle-East sheiks, Russians, ultra-wealthy families around the world? Yes, we would argue they “get the joke” and have been diversifying their wealth out of their home currencies and fiat currency-denominated assets into this scarcer currency.

Currently there is about $55 billion in global gold and silver ETFs – that’s it. (Does that qualify to be in the top ten of the any single issue in the DJIA?) It is estimated that all the gold mined in the last 5000 years is about 130,000 metric tons (each tonne converts into about 35,274 ounces). It’s a cube that would be roughly the size of a tennis court.

So let’s say there are 4.6 billion ounces of gold above ground, which means that at about $1,100/oz, the total global market value of all mined gold is currently worth a little over $2 trillion. By comparison, US Treasury debt was approaching $13 trillion, last we looked and we believe total US equity market capitalization is about $11 trillion. And then there are other bond markets (at least $8 trillion) money market funds, etc. There is also real estate.

In the US alone there is estimated to be about $65 trillion in present value private sector credit outstanding and trillions more in unfunded government obligations. And then there are the financial assets (stocks and bonds), real estate and public sector obligations for the rest of the world.

Global central banks are trying to keep it all afloat by printing even more money (by making more debt). The response by central banks to declining velocity has been and will continue to be the same as their responses to credit deflation – they will continue to print money. They may give it to their fractionally reserved banks that may then use the money multiplier to distribute more credit and in turn raise systemic velocity, or they may give it directly to debtors in the hope they will spend like drunken sailors again.

There is enormous embedded inflation already and more to come. The high-powered money has already been created; it is leveragable and it is there to increase velocity. Higher prices must follow.

Will the Fed and other central banks withdraw liquidity? No, never. They never have and they never will regardless of how many tools they proclaim are in their toolbox to do so. If money velocity picks up leading to rising consumer prices, it will also lead to rising market-priced interest rates. They may decide to cut back their monetization, but they will not drain money.

We can look at price inflation contemporaneously or we can throw the ball ahead of the receiver. The result will be the same. The defense is blitzing; Jerry Rice is standing all alone in the end zone; Joe Montana is going to get sacked….but the ball is already in the air.

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At current valuations the gold market is a tiny speck in relation to where perceived global wealth is being housed. The fundamental issue is one of ratios and relative future value. Our bet is that the gold-to-everything-else spread will narrow substantially. We are indifferent to whether gold rises to $10,000/oz. while the DJIA stays at 10,000 or gold stays at $1,100 while stocks and bonds crater. (In fact, we would love it if gold stayed at current levels while financial assets fell because then we would greatly increase our purchasing power vis-à-vis the rest of humanity and wouldn’t owe any capital gains tax!)

Further, we think that fundamentally gold is worth many multiples of its current price. Remember, it rose from $35/oz to $880/oz in a matter of nine years from 1971 to 1980, and the piece de resistance came in the last few months when everyone had to own it and its price went parabolic (it became a bubble).

There is chatter and there are fundamentals. (Consider that 250,000 people watch CNBC on a good day and 10 million people regularly watch Good Morning America. And remember CNBC and most business media focus on financial assets, not commercial business.) We think the gold chatter is a bunch of financial asset predators talking up their businesses. Needless to say, we don’t think gold is a crowded trade.

Chinese Strategy

It seems the Chinese are the marginal price setters on the global market for consumable commodities. Recognizing they are sitting on a boatload of dollars and knowing, as they surely do, that their dollars are burning matches (or soon to be expiring coupons), it makes perfect sense that the Chinese have been loading up on commodities.

If we were running their economy, we would buy consumable commodities forward, so as not to create obvious panic-generated demand that would undermine their purposes. (Maybe they learned this in 2008 with crude?) We postulate this may be the reason for the seemingly steep contangos in so many consumable commodity markets recently.

With regard to gold, it doesn’t behoove the Chinese to reach for gold until they’ve sated their appetites in consumable commodities. To drive up gold first would simply make the USD prices of oil, copper, zinc, wheat, etc. jump as well.

It is possible that the last leg of their US dollar purge will be to reach for precious metals, which would drive up the nominal value of their huge commodity hoard. In this sequence, they would dump the maximum number of USDs forward with the least amount of pain. If they jumped into gold first, a relatively small amount of their reserves, say $100billion, would drive the price of gold to the moon. They would be left with too many dollars and nothing but higher nominal prices for consumables.

The consumable commodity markets are much deeper than gold and silver. We think rising precious metals prices will be the last leg of the Chinese grab. It would validate their strategy politically as well. (This is not to imply we think the prices of consumable commodities will rise first – just the opposite. Precious metals should rise on steadily in anticipation of the end game and consumable commodities should rise from money printing and output growth.)

Whether it knows it or not, the US CFTC is an ally of the Chinese by clamping down on western “speculators” in the consumable commodity markets. Are the Chinese effectively stealing from American investors (because Americans’ long exposure to consumables is effectively restricted)? It seems so. Like the Afghanistan copper mine bought on the cheap by the Chinese, could such machinations be a quid pro quo for China not disrupting the US Treasury market? That would make sense.

Outline

1. Cause of current economic problems: shifting macroeconomics over the last forty years are now converging:
– Abandonment of fixed currency values in 1971
– Currencies no longer a definable store of value
– Technology allowed shadow banking system to securitize and distribute credit
– Opening and new competitiveness of emerging economies altered global supply/demand equilibria for goods, services and wages
– Political dimension in developed economies stepped into the competitive breach to sustain nominal growth and employment
– Fed, BOJ, ECB, BOE extended increasing credit to banking intermediaries (credit = claims on future currency yet to be manufactured), which distorted pricing functions
– US manufacturers and distributes the world’s reserve currency, which also acts as a benchmark for floating global monetary regime (USDs = “gold”)
– Triffin’s Dilemma came to pass: Nominal global growth pressured US policy makers to continually manufacture more dollar-denominated credit to satisfy global claims
– US trade and budget deficits grew as US economy had to spend forward

Conclusion: Future global US dollar-based claims are now estimated to be above $100 trillion versus a current US dollar monetary base of about $2 trillion. Global markets, policy makers and politicians are beginning to recognize that existing US dollar-denominated public and private credit (claims) cannot be settled with current USDs outstanding. Either far more USDs must be manufactured or credit must deflate far more.

2. Expectations: Three “Flations”

– Price Inflation/Deflation: Price deflation is a natural economic function (through competition, economies of scale and innovation); price inflation (though monetary/credit inflation) is a political construct meant to offset the natural tendency of prices to decline

– Credit Inflation/Deflation: Credit inflation temporarily warps pricing structure of goods, services and wages, which leads to broad economic and asset mal-investment

– Monetary Inflation/Deflation: The only true inflation/deflation metric (“inflation is always and everywhere a monetary phenomenon…”), the growth or decline in a currency’s monetary base best defines the increase or decrease in that currency’s purchasing power over time.

Conclusion: In the current lexicon, “deflation” is commonly and mistakenly confused with economic contraction. They are very different dynamics that may not correlate. Monetary growth/contraction may cause rising/falling nominal prices over time independent of changes in supply/demand fundamentals (see Zimbabwe). Thus, money and credit growth from an economy’s political dimension could synthesize nominal output growth while real (inflation-adjusted) output and real asset values may contract. Real output and assets are produce sustainable economic capital and employment over time.

3. US Monetary Base

– M0 = Money in circulation plus bank reserves held at the Fed
– High-powered money => May be leveraged further through fractionally-reserved banking system
– M0 just increased 135% in last 18 months

4. Reflexive Cause & Effect
– Output contraction => central bank generated monetary inflation
– Monetary Inflation in the form of M0 (new money given to the banking system) unaccompanied by a further bank system multiplier effect and/or by an increase in monetary velocity (thereby increasing M1, M2, M3) will effectuate a different form of monetary inflation
– Will checks be sent to homeowners (debtors, not creditor banks) made out to their servicers?

In a global paper currency monetary regime, where banking systems do not multiply their new high-powered money and where velocity does not rise (i.e. today’s environment), price inflation is a lagging consequence of monetary inflation. Demand-led output growth does not matter; indeed contracting demand is likely to push prices higher because it engenders more aggressive policy intervention.

Q: So what has been the true rate of inflation already experienced?

A: Something closer to 135% than popular price baskets. Of course, this may not be manifest through price inflation in any discrete year and it is likely the goal of policy makers to drag it out.

Q: Will policy makers withdraw the inflation they have already created?

A: Yes, if they don’t mind economic contraction. No, if they do not want to witness substantial credit deflation leading to output contraction and rising unemployment.

Q: What will be the ultimate outcome of global central bank monetary inflation?

A: It seems inevitable that there will be a new global monetary regime. That is not as radical as it sounds, given the current one is only 39 years old and no paper money system has ever lasted throughout millennia.

Q: Would Americans suffer from a new global regime?

A: American debtors would benefit from inflation because the burden of their debts would be inflated away vis-à-vis their higher nominal wages and asset prices. American dollar holders would suffer because they would lose future purchasing power, as would dollar-denominated bondholders because the purchasing power from their coupon interest and principal repayment would be inflated away.

There are more American net-debtors than net-savers and US federal and state governments are deeply indebted. Thus, it is politically expedient for policy makers to inflate away the burden of existing and future US debt repayment (which will grow as the burden shifts from private and state debtors to the government).

Conclusion: Investor analysis should shift from defining nominal relative valuations to defining real relative valuations and investor objectives should shift from seeking nominal returns-on-assets to real ROAs.

Paul Brodsky
QB Asset Management Co.
pbrodsky@qbamco.com

This material is not an offer to sell or a solicitation of an offer to purchase securities of any kind. This report may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties, and we might not be able to achieve the predictions, forecasts, projections and other outcomes we may describe or imply. A number of important factors could cause results to differ materially from the plans, objectives, expectations, estimates and intentions we express in these forward-looking statements. We do not intend to update these forward-looking statements except as may be required by applicable laws. Return figures herein are estimated net of all fees and charges. Any comparisons have been obtained from recognized services or other sources believed to be reliable. No part of this document may be reproduced in any way without the prior written consent of QB Partners. Past performance may not be indicative of future results.