A Tarnished Dollar Will Put The Shine On Gold
Introduction: Frank Giustra is not your typical investment banker. As the leader of Yorkton Securities during its rise to market dominance in the 1990s, he and his team helped finance some of the most important and successful mineral discoveries in recent history.
In perhaps the most powerful display of his uncanny sense of timing, Frank left Yorkton and the resource market at the very top in 1996, to head Lions Gate Entertainment, a film production, television, animation and distribution company that has released an impressive string of critical and commercial successes under his guidance.
What interests us most today, however, is that Frank's sense of timing has recently brought him back to the resource market, where he now serves as a director of Endeavour Mining Capital Corp. (EDV.TSXV).
Frank differs from most financiers in another way: He has a deep understanding of what moves markets, and has given great thought to how gold and the dollar have come to an important crossroads, and what the implications are to investors.
It has been my great pleasure to share views with Frank over the past few months, and it is a privilege to share his insights with Gold Newsletter readers in this exclusive article. - BL
Chances are, unless he's in the habit of adding Geritol to his Cheerios, today's investor is perhaps feeling a little clueless in this post-bubble bear market. On the other hand, those who have been through this sort of thing before might have noticed the one bright spot on the investment landscape - gold - which has been in an upward trend since the bubble burst in 2000.
Much as been written about gold's move and the many dynamics driving this trend. In no particular order, that menu includes:
- The widening demand/supply gap, currently at 1,500 tons per annum, is due to an ever-increasing decline in production by the primary producers. At current gold prices and for too many industry reasons to list here, production is expected to decline up to 30% in the next eight years.
- The collapse of interest rates effectively eliminated the once-attractive spread that compelled both producers and institutional speculators to sell forward. They sold forward as much of the stuff as the central banks would lend, and thereby capped the price.
- Ironically, in the face of a reversing tide, these same producers are now scrambling to cover the short positions created by years of indifference to gold as anything but a commodity. Due to lack of disclosure, the magnitude of these short positions is unknown, but could be anywhere from 5,000-10,000 tonnes, or two to four years of production.
- And finally, the last couple of years saw an end to the "peace dividend." Instead, we witnessed an ever-increasing series of geopolitical crises that seem to pop up faster then pimples on a teen's face.
However, the most important dynamic affecting the gold price is, and will be, the fate of the U.S. dollar. The dynamics noted above will, for the most part, play but a supporting role to that of gold's inherent inverse relationship to the dollar.
To understand this relationship, we need only look back 30 years. (Arguably, we could go back several hundred years, as this is not the first time the world has had to cope with the temptations and consequences of paper money.)
In 1971, Nixon unlinked the U.S. dollar and gold, thereby terminating other sovereigns' rights to exchange their U.S. dollars for U.S. gold reserves. Predictably, the dollar took a swan dive, declining up to 70% against some currencies over the next 10 years. Conversely, gold began a decade-long bull market that saw the price top $800 per ounce by 1980.
This "Mutt and Jeff" relationship has played out several times since. One good example is the mid-'80s, when the dollar again declined by 50% over a two-year period, and the gold price moved up to $500. The reverse was seen in the mid-'90s, when the dollar commenced its five-year rise, and gold experienced a five-year bear market. And once again, the relationship reversed itself just last year. You get the picture.
Parenthetically, with the effects of inflation, the dollar has also lost 80% of its purchasing power during this same period. From a long-term perspective, this makes the gold story even more compelling. In the current go-around, with severe post-bubble forces at play, I believe we may be due for a 1970s-style gold market.
The inverse relationship between gold and the dollar began with the dollar's ascent to supreme status as the world's reserve and trading currency, a role once played by gold. It stands to reason that when the dollar's value is challenged, all sorts of people turn to gold.
So why is the dollar's value being challenged today? Well, quite simply, its role has been abused. Since the U.S. closed the "gold window," the only "asset" backing the dollar has been faith in the U.S. system, which was entrusted to it by the global community.
The value of the dollar is impacted by many factors, including a) how much of it is printed, b) the rate of return it generates, c) the fiscal health of the government balance sheet sponsoring it and d) the general state of the economy it represents. As, one by one, the foundations supporting these pillars erode, this faith may, at best, turn agnostic and, at worst, turn outright atheist.
Although history is littered with the destruction of once-supreme paper currencies, the total demise of the dollar may be a long way off, perhaps generations from now. But the statistics show the dollar is heading in that direction. For the purpose of this discussion, the trend alone is sufficient.
The first pillar is that of supply. Like any commodity, it stands to reason that the more dollars created, the less valuable they become. Therefore - in overly simplistic terms - when money grows more rapidly than the economy backing it for a prolonged period, it is logical that the value of the currency will be worth less.
In the past 10 years, U.S. money supply (M3) doubled from $4 trillion to $8 trillion, with 25% of that increase occurring in the past 18 months (an obvious attempt by the Fed to prevent a market crash). So far, this monetary expansion, coupled with an even more dangerous artificially-cheap money policy, has not produced the traditional inflation of goods. Instead, it has fueled an asset bubble. This trend will continue as long as the CPI remains stable.
Additionally, actual currency in circulation, most of which is held by foreigners, has more than doubled, from $260 billion to $600 billion, in the same period. Yet, in the same time span, the GDP grew at half the rate of money growth. What is truly alarming is that the recent surge of money growth is not consistently producing the desired economic and stock market results.
To appreciate the relevance of the second pillar, the rate of return the dollar generates, we need to look at what drove it to its recent highs in the first place.
During the '90s boom, with imaginations running wild, the U.S. capital markets became Nirvana for many investors, not just for the locals, but for foreign investors as well. From the time the boom really took hold in 1995 to present, foreign ownership in U.S. capital markets more than doubled, with equity ownership going from 6% to 13% and U.S. treasuries ownership from 19% to 42%. While approximately $7 trillion has been wiped out from U.S. equities values, the existing market valuations, when compared to historical averages (never mind bear market lows), are still a long way off the bottom.
Promoting a market with P/E multiples of 25-times-plus and dividend yields of 1.7% may scream value for the CNBC cult and its largely domestic audience, but may soon wear thin with many foreign investors. Moreover, these multiples are based on "projected earnings," which are being increasingly threatened by a sluggish economy, widening credit spreads, record low post-WWII capacity/utilization levels, threats of war and terrorism and the fairytale treatment of pension fund earnings inclusions.
So why, in the face of daily barrages of worsening earning forecasts and economic news, has this market not crashed, like say, 1929?
I believe the reason is largely due to the fact that the preceding bubble period was over twice as long, and much greater by magnitude, as the bubble period preceding the 1929 crash. Investors have therefore had all those additional years of conditioning and many still believe in mantras such as "buy for the long run" (words they will chant all the way to the poor house, since post-bubble bear markets traditionally last 15-20 years).
Add the pervasive reach of the mainstream media, acting for the most part as a conduit for the merchants of Wall Street, to the mix and it's no wonder the average investor is, at best, paralyzed into in-action and, at worst, hyped into investing additional money. One can daily witness the unabashed manner by which the likes of CNBC trumpet the most trivial information, providing a rallying call to all the lemmings to mount yet one more heroic charge at the cliff.
Look at the silly charades in which, quarter after quarter, companies' earnings beat the "Street" by 1 cent per share. Of course, these are the same earnings which were only recently downgraded by the same "Street" in its forecasts. Finally, I must mention the musings of the most overrated citizens of the Wall Street community - the market strategists. For three years running, these highly paid folk have continuously forecast market indices to end the year at levels which were on average 30% higher than at the time of their predictions. In reality, they ultimately saw those indices shrink even lower than the levels were at the time of their forecasts.
It's only as this bear market wears on that those still holding jobs are lowering their targets from the laughable to the merely improbable. One has to wonder, since presumably these people are not total idiots, what motivates them. Who knows? Perhaps one day Elliot Spitzer's office will intercept an e-mail from one of these guys, calling the entire market "crap." Given this setting, I see a prolonged slow-motion crash, interladen with spectacular rallies.
The other market favorite is the U.S. Treasury market, a $6 trillion market that, as previously mentioned, is 42%-owned by foreigners ($1 trillion in various foreign central banks). With yields bouncing around 40 year lows, and the Fed racing to catch up with Japan, one must ponder how long it will be until these holders start unloading and heading for greener pastures.
U.S. short-term notes are already as much as 200 basis points lower then their U.K. and euro-zone counterparts, making "hot" money flows a lot less attractive. With the dollar weakening and the shine coming off both equities and Treasuries, exasperated foreign investors will soon exit these markets, putting even more pressure on the dollar.
Even if the U.S. equity markets defy all historical precedents and continue to trade at near-nose bleed valuations, there are plenty of other forces that will work against the U.S. dollar.
Once a pillar of strength, the U.S. government balance sheet is abysmal. Coinciding with the unlinking of the dollar and gold, the U.S. borrowed and spent its way into black hole status. Public sector debt has increased 12-fold to a record $6.2 trillion since 1972. It now represents 60% of the GDP, which is an ominous ratio shared by Japan a decade ago. (After a 10-year funk, Japan's debt/GDP now stands at 140%, and its credit rating is dropping to dangerous levels.)
Meanwhile, fiscal budget surpluses are a distant memory, with this year's deficit expected at more than $150 billion. With the prospect of "war on terror" costs, war with Iraq expenses, talk of permanent tax cuts and a slowing economy (read: lower tax revenues), the U.S. government will have no choice but to continue to issue debt at a dizzying pace for years to come.
Eventually, foreign lenders will build in a higher risk premium to compensate for America's deteriorating credit quality. This will prove problematic for the U.S., given that its weak economic environment calls for low interest rates, even though its deteriorating credit rating will eventually dictate higher rates.
Without being cynical, it seems fortuitous that the U.S. can finance its "guns and SUVs for all" vice by issuing debt denominated in an overvalued currency, while yields are at all-time lows. With such low yields and little current income, it's puzzling that foreign buyers are eating this stuff up when the end result is so predictable. By the time the debt is repaid, it will most likely be in devalued dollars that will require much higher yields to allow the U.S. to issue additional debt. Why not wait it out instead? Were it not for the dollar's "safe haven" status, I don't think the appetites would be nearly as strong.
The final and most important pillar is that of the general state of the U.S. economy. One could write volumes on this topic alone. Much of what is wrong with the current health of the U.S. is structural, and has been worsening for a long time. The U.S. has evolved from a nation of producers to a nation of consumers. This has led to several major problems that will impact the future of the dollar.
With consumption voraciously outpacing production, consumer debt has grown to approximately $20 trillion (total private sector debt is $30 trillion, or 300% of the GDP). Not only is this a global historical first, but it is currently growing at a rate of six times the GDP growth. Both corporate and consumer debt have doubled in the last 10 years, and this debt must now be paid off or written off.
The service costs alone on the consumer debt are equal to over 10% of the GDP. In a stable economic environment, this burden steals capital that is otherwise needed to maintain a growing and productive economy. In a slowing economy, this is the sort of thing that may lead the way to deflation. Personal bankruptcies and loan delinquencies are already at all-time highs.
Eventually, something has to give. The consumer, who has been supporting the economy single-handedly of late, will stop spending and begin saving. The art of saving being a discipline that was lost in the go-go '90s, when savings plummeted from 10% of the GDP to zero, before rebounding to a recent 2%. Corporate America has already stopped spending or hiring, and its profit outlook is far from rosy.
The inevitable adjustment to eliminate debt and reduce over-capacity will take many painful years to work out. Unfortunately, the Fed and all types of commercial lenders fail to see, or are ignoring, this trend. They continue to squeeze a little more life out of the sickly consumer by continuing to provide access to easy money.
For his part, in a desperate attempt to maintain the illusion of wealth and with the equity markets in such disarray, the consumer's attention has now turned to the housing market as a source of spending money. With the increase in home values overshooting any kind of business or income growth, the writing is already on the wall. What will the consumer junkie hock next when this game ends?
Yet another by-product of this consumption economy is a growing current account deficit, which at approximately $500 billion or more this year, accounts for 5% of the GDP and requires 75% of all the global trade surplus capital to maintain. As a nation, the U.S. buys $1.2 billion more a day from foreigners than it sells to them. This imbalance is unsustainable, and has held up only as a result of the blind appetite for U.S. investments by foreigners, clearly a remnant of the '90s bubble period.
Without that $1.2 billion a day, this imbalance will only be corrected with a cheaper U.S. dollar, which will make imports more expensive and U.S. exports more competitive. With both the economy and the markets heading south, these inflows are bound to slow down dramatically, if not reverse completely. At that point, the dollar heads south, too.
A recent Goldman Sacks report stated that a further 15%-20% devaluation is probably a good thing for the U.S. economy. Morgan Stanley's Stephen Roach has argued for an end to the U.S. "strong dollar" rhetoric as a means to help the dollar down. Historically, countries that run current account deficits approaching 5% of the GDP and concurrent large budget deficits, as the U.S. is running today, have their currencies devalued. Both the U.S. and the UK experienced 40-50% devaluations during the '80s for these same reasons. As the U.S. dollar has thus far declined a mere 15% of its recent peak, we are only in the first couple innings of this game.
Normally these type of currency adjustments are not cause for alarm. But what concerns policy makers today, given the world is awash with dollars, is any dramatic downward move by the U.S. dollar which may cause panic and put the financial system into a crisis mode.
For this very reason, I believe that gold, which has always been a precursor for financial distress ("the canary in a coal mine"), is most likely being "managed," and prevented from spiking up too quickly at times when the dollar is falling.
That said, it may seem surprising with all these negative forces stacking up against the dollar, that it hasn't fallen more quickly. That is partially because currency values are relative, and the alternative currencies against which the dollar is measured are not that attractive either.
The yen can hardly be considered safe, given that Japan's economy, stock market, bank system and credit rating have been in a decade-long meltdown. As for the "Rodney Dangerfield of currencies," the euro, it represents a number of economies plagued not only by sluggish growth but also by rigid regulatory structures and monetary/fiscal control mechanisms that will do more to impede growth than encourage it. In addition, if you think the U.S. equity markets have been a disaster, consider the dismal performance of their European counterparts. The U.S. dollar is most likely getting some of the benefit, as both U.S. and foreign shareholders bail out of European stocks and invest in the U.S..
The dollar's reserve status is clearly the most important reason for its continued strength. At last count, the dollar represented a whopping 76% of global central bank reserves, while gold reserves are at levels not seen for 50 years. Although the tide has turned on the dollar, the fact that these holdings are so pervasive means this devaluation process may play out over a long period of time. Since the dollar's dominance was achieved largely at the expense of gold's status, it will be gold that eventually benefits from the dollar's fall.
Imagine yourself as a foreign central banker today. You may have looked intelligent during the past decade, selling or otherwise pledging your non-yielding gold reserves and using the sale proceeds to invest in high-yielding U.S. Treasuries. How smart might you look now in the face of a rising gold price, a declining dollar and yields plunging to negative real rates of return?
Consider, also, the increasing rhetoric by a number of Asian central bankers and politicians, promoting a view of less reliance on the dollar and more on euros and gold as either reserves or transaction currencies. Even a small diversification away from the dollar as the settlement currency in Asian-block intra-trading would remove several hundred billion in dollar-demand.
Therefore, I believe central bankers will increasingly favor gold as the currency of last resort and although they may not be buyers of gold (certain Asian central banks aside), they will certainly reduce or completely stop their selling. (How they get back all the bullion they have loaned out, now that gold is rising, is another question.)
Therefore, I believe central bankers will increasingly favour gold as the currency of last resort and although (certain Asian central banks aside) they may not be buyers of gold they will certainly reduce or completely stop their selling.
Finally, one of the most confusing debates taking place today is that of a possible deflation or inflation scenario. There exist intelligent arguments on both sides. In making a case for gold, I don't think it matters which scenario plays out.
Although most people believe gold performs only in an inflationary environment, they might be surprised to learn that 200 years of U.S. history has shown hoarding of gold occurs during deflationary periods when confidence in the credit quality of issuers of currency (whether sovereign or banks) is shaken. Given the current high level of foreign ownership of U.S. assets, if credit quality is called into question there will be immense downward pressure on the dollar as these holders rush for the exits. In this scenario, gold would rise in U.S. dollar terms. In a global deflation environment, which is very possible today, there would be an exodus of all major currencies, with gold being the only beneficiary.
The most likely outcome would be a preemptory Fed move, if, once rates catch up to Japan, deflation is still looming. The Fed's final bullet, and something that Greenspan and his cohorts have recently hinted in a not-so-subtle fashion, is to print more money. Although this move may prevent deflation, it would certainly destroy the value of the dollar and likely cause all kinds of nasty side effects. (Think Argentina - when a central bank creates way too much money, foreigners panic, causing the currency to collapse.)
This would create both a credit crunch (deflationary) and massive inflation, since imports would become extraordinarily expensive. In any event, a worthless dollar would drive gold through the roof. At the end of the day, it matters little on which side of the debate you are - if you own gold. You could lose the argument and still get the prize.
Will America's imperial economic status prevent the dollar's fall, even in the face of the overwhelming odds stacked up against it? Who knows for sure? I wouldn't bet my entire portfolio on it. The tide turned last year, and it may be only a question of time.
Remember, as with all bubbles (and we are witness to history's all-time champion as measured by current account deficit, debt and equity market) - whether they are stock market, real estate, tulips or dollars - people will believe until they stop believing.
Just make sure you own some gold when they stop.
December 19, 2002