Inside Job: Gold
Investment Rationale Revisited
Gold Investment Rationale 3/01/2010
“The US faces rapidly
rising inflation or deflationary recession: credit cycles (and this one is
extreme) always end in a deflationary bust – this is the lesson of
the Kondratieff Cycle. The Fed will most likely try to defy economic
gravity using increasingly inflationary means. Gold is the only asset to
outperform in periods of either uncontrollable inflation or deflation:
the US economy is on a knife-edge between the two.” – Redburn
Partners, November, 2007.i
We think that regardless of the
situation in the future, gold is a better investment vehicle than most
other assets. As an inflationary hedge, it will increase in value as a
proxy for the US Dollar. In a deflationary environment, gold may not
appreciate, but it will outperform relative to financial investment
vehicles and most other currencies.
U.S. Economic Outlook
Where we are
It’s been well documented
where we are and how we got here. Here is our own two cents worth: Easy
money and credit, poor regulatory decisions, irresponsible buyers and
sellers, and other enabling factors have all contributed to the
situation. As a culture, we have been cashing in on the hard work of
generations before us. The American dream has morphed into a feeling of
American entitlement. But we do not pass judgment. This is how the
emotional component of economic cycles works.
It is our analysis however that
the structural issues precipitating the 2008 crisis and its aftermath have
remained unresolved. Simultaneously, the growing cultural austerity of
our populace will be a great impediment to reflating a consumerist
economy in the United States and other western economies.
Why the situation will
Many Cassandra-ish reasons can be
made why we are all doomed. To be clear, we do not feel that way. The
U.S. just has to retool how it generates income to remain competitive.ii
That said, here are three major reasons we feel the U.S. economy will go
nowhere significant in its current state. We are still a credit driven
economy, consumers will not spend like they did in years past even if
they could, and China is not ready to pick up the U.S. spending slack.
Still a Credit Driven Economy
There will be no real recovery
until the economy retools itself from a consumer driven one to a capital
expenditure one. This means an end to credit as a means to buy things,
which won’t happen until the fed stops reanimating the easy-money
David Roche, former Head of
Morgan Stanley Research and Global Strategy, and currently president of
of the core problems that caused the credit crisis have been addressed.
Credit crises end when the economy starts to grow without credit. This
can happen because, in a credit contraction, the price of assets and
goods and services can fall dramatically. Households lose about 20% of
their wealth. But if the price of things (either stuff in the shops or
investments) falls by more than the combined contraction of wealth and
income, they have become cheaper in terms of the ability of most
households to buy them. Those with money do so. They don’t borrow
to buy or invest but they have the cash. Those that don’t are still
busy paying down their debts. But the ‘haves’ can have enough
purchasing power to move the economy off the bottom. This sort of
recovery is self-sustaining.”iii
Governments react to grass roots
changes, they are not proactive. Thus, they are totally behind the curve.
While this administration is busy giving easy credit to banks in the hopes
it will trickle down to the public, the public has put itself on an
easy-money diet. The banks aren’t helping either; they are offering
to lend only to those who do not need it. The fed is just getting gamed,
and monetary policy will not alter the changing habits of Americans. The
credit driven method of growing this economy is dead.
Consumers will resist returning
to looser spending habits and will not be the engine of growth for the
U.S. economy moving forward. High debt, wage pressures from a globalizing
work force, and a moral rethinking of consumerist attitudes all
contribute to this. It is our analysis that those who want credit cannot
get it, while those with ample credit loathe to use it. No one is
deficit countries (the US, the UK) must see a return to thrift (which
will cap consumer spending). One driver of higher household thrift in
deficit-ridden countries is that households and corporations realise that
the wrecked balance sheets and budgets of the government sector can only
be paid for in one way, down the road — with their money.”
If we are wrong and these
changes do not take hold in the consumer psyche we will have a
consumer-lead recovery. This is merely a can kicked down the road to the
next deflationary debacle. It only affects the timing of our investments,
not the choices. Deficit spending cannot be sustainable forever.
Chinese Spending will
not save us
We believe the view held by some
that the Chinese consumer will be a driver in this recovery is not
happening anytime soon. The reasons are numerous.
stimulus package was intended to gear up for more export growth, not
It is a political issue for
their government to let standards of living grow too much, as it will
invite progressive reforms and social unrest. People will know what
they’ve been missing once they see the potential.
China, like most Asian
economies after their own currency crises, is an inflation hawk. They
will seek to cool down their economy more aggressively than most
Fear of a rollback to a
Maoist regime still weighs on many people. These citizens keep their
wealth portable, and live within their means.
China is deepening
relationships with LATAM countries to export goods, seeding the next big
consumerist economy potentials
Maybe next generation folks. That said, if we are wrong
and China does become a buyer of finished goods and services, U.S.
inflation will explode.
What the Gov’t has
done thus far
Up to now the U.S. government has
embarked on a reflation attempt which will either fail and end in a
deflationary crisis on par with 2008, or it will succeed and slip into an
inflationary environment. The stimulus is a temporary measure at best and
will only serve to delay deflationary pressures without fundamental
changes in our behavior. It’s a circle of hardship. We don’t
judge current actions as right or wrong. We just seek to anticipate what
comes next and hopefully profit from them. And we think the choices
available to the government from here are quite limited.
Government Choices Moving
Not much of a choice
What must be done to combat our
current paralysis and its effect on the U.S. government’s ability to
repay its own debt?
Choices are limited with regards
to the debt: Restructure it or devalue it. Restructuring is essentially
defaulting and letting the deflationary forces run their course, and
devaluing the debt consists of monetization.
U.S. Monetary and fiscal policy
will continue to be geared towards devaluing its debt. Even with these
attempts, more deflationary events are likely. The Greek crisis is an
example. The alternative is a deflationary depression that will wipe out
tax revenues entirely.
The U.S. monetary recipe
In short order we think the
following will be their policies for the next several years.
Monetary policy will remain
much easier than the conventional wisdom due to a backlash against
government stimulus spending. Low rates will be all they have left to
make it work.
Fiscal policy in the form
of another Quantitative Easing (QE2) will be put on the table, but will
have a tough chance of passing due to a trickle up of austerity from the
public to its elected representatives (witness the Mass. election and the
populist rhetoric to cut spending).
Taxes will go up. No
surprise here. It has already started. Wealthy families will be taxed
directly, and the rest of the country will be via the companies in their
portfolios getting taxed at higher rates.
The global situation does not help matters, and will only
force the U.S. hand.
As a consequence of
globalization, our economies are more tied together than ever. One of the
factors that brought about the great depression was a nationalistic
backlash against trade. The result of which was countries pulling in the
reigns, drying up liquidity, and consequently deflating asset prices even
more. Governments are resisting this urge today, and have learned the
lessons of the past. But, banks may not care so much.
As global credit risk causes
lending institutions to decrease international loan exposure, banks begin
to repatriate their money and lend more locally. This is an economic
nationalism, and can have the same effect as the political ones did in
the 1930’s. Governments have little choice but to engage in
competitive devaluations in an attempt to stave off the effects of these
(localized) lending practices.
Race to the bottom
In order to attract trade away
from competing countries, it behooves most governments to opt for a weaker
currency. If every country knows this, then we have a prisoner’s
dilemma situation. We believe there may be less honor among governments
than among thieves, and a race to the bottom will be the result. Such a
situation may be good for the winning individual country, but it is bad
for the group and citizens everywhere. In this case, global inflation is
the outcome. The countries with the most to lose are those with the most
debt, and the least flexibility to deleverage. They must devalue fastest.
- Governments almost always
choose devaluation- it is better politically, and is consistent with the
kick-the-can down the road mentality of short term outlooks, limited to
reelection time horizons. Some end up defaulting regardless.
- Fiscally taxes will go up,
there may be a QE 2 but most of the work will remain monetary policy.
- We will either get deflation
resulting in inflation or inflation resulting in deflation, but we will
- 1970 Chevy Malibu carburetor
analogy- the U.S. economy is an old car with a sticky carburetor. The
fed’s foot has been on the gas and will continue to be until the
spring loosens and the intake opens (inflation) or the spring breaks
(deflation) and the intake snaps shut. Either way, the fuel system has to
be fixed, because that spring is going to break soon regardless.
The only thing that remains is what to invest in, and to
either time the market or just diversify risk.
Moving forward we think inflation and
deflation are both a risk to the markets and that the golden age of
capitalistic monetary management is over. We like real estate in countries
with little or no leverage on their balance sheets (personal or
government), especially LATAM and Caribbean countries that may benefit
not just from growing credit cycles but from an influx of wealthy U.S.
and European retirees. We like seats on agricultural commodity exchanges,
and we are buyers of gold in spread, physical and option form.
Before we go further, we’d like
to lay out our definitions of inflation and deflation.
Inflation is a function of monetary
policy. All monetary systems can experience inflation, but paper money is
most inherently prone to it. The two most popular and conflicting
definitions of inflation are Keynesian and Austrian.
To oversimplify it: Keynesians believe
inflation is largely demand-based and occurs when prices increase.
Austrians see inflation as strictly a function of money supply, and
increasing prices are merely a symptom of the problem. Either school of
thought works here.
Deflation is closely tied to fractional
reserve banking. At its worst, it ends with runs on banks. People and
institutions would rather have currency jingling in their pockets due to
its scarcity than a debt from someone to give us money at a later date.
During a panic, that is exactly what happens. Depositors see their money
as a loan to their respective bank and call in the loan.
Both of these have horrendous
implications for citizens. In a deflationary situation; cash is king, and
everything else deflates as the word says. In an inflationary devaluation;
cash is trash because purchasing power is destroyed and assets must keep
pace with inflation just to justify ownership.
We like gold in a domestic inflationary
environment for obvious reasons. But we also feel it will hold its own
against other currencies. Gold is money, that is all. And as a store of
value, it will compete with paper currencies more and more. We also
believe as do others, it will increase in an almost Giffen Good manner
Gold is also subject to
fractional reserve banking. We have seen firsthand what happened in 1997
when Warren Buffet decided to take delivery of silver. The result was a
backwardated spread market equal to a $40% yield annually. Unallocated
gold accounts where investors have claim to a pool of vaulted gold can be
subject to the same risk.
We like gold in a deflationary
environment as well. Everything drops in a deleveraging, deflationary
period to be sure, except currency. Gold will also most likely drop. But
it will suffer the least of other assets for a couple reasons. It is
money and can be easily quantified as such. It’s portable. Finally,
gold is internationally recognized and understood.
We believe this all ends in a
deflationary collapse and healthy economic retooling. Gold may end up
being the tallest pygmy in a deflationary environment. To date we have
implemented our spread strategy. We expect to accumulate a physical
position over the next 60 days.
The information, opinions, scientific data,
quantitative and qualitative statements contained in these reviews have
been obtained from research, trade and statistical services as well as
other sources believed to be reliable. The information, opinions,
rankings or recommendations contained in these reviews are submitted
solely for advisory and informational purposes. Echobay Partners Ltd.
opinions and estimates reflect current judgment; they are neither
all-inclusive nor can they be guaranteed to be complete or accurate. The
opinions expressed are our current opinions as of the date appearing on
the review only. Our analysis is subject to possible change without
i Mylchreest, Paul. “Gold War.” Nov. 2007.
ii Easier said than done.
iii Roche, David. “De-lipsticking the pig.”
Aug 2009. Global Markets.
iv Gross, Bill. “The Ring of Fire.” Feb 2010.