Gold: Contagion…Is It Enough?

April 13, 2020

Countries closed borders as the pandemic spread beyond the Chinese, Iranian and South Korean borders.  At risk are lives but the economic impact already is large. The world is in lockdown mode. The economic fallout is only beginning with disrupted travel, tourism, and consumer spending, a critical engine that makes up a whopping 70 percent of the US economy. Global stock markets lost $24 trillion in March, more than US GDP at $22 trillion. Unemployment could soar from 3 percent to 35 percent, surpassing the Great Depression. Oil dropped 67 percent to an 18 year low.   Much is still unknown. It is this unknown that markets fear, and rather than a quick bounce back. We believe a market bottom won’t be reached until the virus numbers peak, or a vaccine is distributed, maybe a year from now.

Fear can be contagious.  In less than a couple months, the markets switched from greed to fear as the scale of Covid-19 (C-19) spread. Ever hopeful after a decade of growth, the bulls counted on central banks to bail them out, trusting the Fed’s interest rate reduction would stem the tide. It hasn’t. Rates were already ultralow and it is the volume of money, not the cost that really matters. For now, lower rates won’t stimulate spending from a populace that is worried about shaking hands or swabbing down everything they touch. The virus is a supply-side shock to the system and a serious recession will cause a chain reaction already weakened from a destructive trade war. Of growing concern is that this bear market will morph into something more persistent, deeper and longer.

Health Crisis Meets Bailouts

Taking a page from its well worn “crisis” playbook, the Federal Reserve quickly sprang into action, slashing rates to zero and introducing backstops to the financial market.  Australia, Canada, and Malaysia soon followed, pumping money into their economies. Governments have embarked on the largest rescue bailouts in history higher than 10 percent of GDP. So far the US is spending $2.3 trillion, Japan $1 trillion, Canada $200 billion and Germany $1.2 trillion, but these are only down payments.  A week later, the Fed is to provide up to $2.3 trillion in loans. More is likely needed. Yet the world’s richest nations have neither enough masks nor ventilators.

In fact, the monetary spigots has limited effectiveness because rates were already low before the virus spread. In the past decade, global monetary policy slashed rates and rounds and rounds of quantitative easing inflated central banks’ balance sheets as they bought their own bonds. Central banks are at the limits of their unconventional policies and instead, fiscal policy has taken over with trillions of government bailouts not dissimilar to Democrat Alexandria Ocasio-Cortez’s Modern Monetary Theory (MMT), so derided only months earlier. MMT is yet another radical economic theory that argues government debt and deficits don’t matter and that these expenditures will only grow the economy. The ensuing deficits are to be financed by the resultant prosperity and the printing of new currency, In other worlds, having your cake and eating it too, not much different than monopoly money or the Zimbabwe dollar.

To be sure, the longest economic expansion in US history has ended. While we learned health is easy to take for granted, markets too were taken for granted. We believe the problem is that the Fed doesn’t have enough tools after the trillions of dollars of quantitative easing left a legacy of near record debt. Today global debt to GDP is at an all time high of 300 percent and will worsen as the virus spreads triggering the “bust” part of “boom and bust”.  We believe that the Fed’s shoveling of money in QE infinity, in the form of unlimited buying of Treasuries and mortgage-backed securities, debases America’s obligations. Money creation is the easy part. Americans believe they can always create more debt and more dollars, since that would be tomorrow’s worry. In kicking the can down the road, they hope to postpone the inevitable deflationary hangover of austerity from cutbacks to discretionary spending and budgets.

The Virus is Everybody’s Problem

The danger is that the mother of all bailouts and government intentions are not enough and “doing whatever it takes” fails. Unlike the Great Depression, the challenge is not enough money but the need for a collective response to fight a global problem. Covid-19 respects no borders or authority. It is the nearest thing to a world war. Still, the virus and unemployment spreads. History shows that governments must cooperate and work together, putting aside the nationalism, politics and end the petty differences so in vogue today. Instead of rallying allies in a global response to the pandemic, Mr Trump continues to alienate them, like hogging 3M’s N95 masks. The G20 talks were a good starting point to foster a collective response, but there was little substance. And, Germany’s balking at issuing “coronabonds” to help weaker members of the EU, such as Italy and Spain, jeopardises the European Union’s own survival. Organizations like the World Health Organization (WHO) should be properly funded by all.  Rather than the “beggar thy neighbour” protectionism of limiting medical supplies, there is a need to combine forces, to develop a vaccine, manufacture more testing kits and medical equipment to fight the expected second wave, and the next virus. The problem is that the outbreak is everybody’s problem.

As the virus infects their own citizens, only now are governments scrambling after watching China fight the virus early this year. Also with China representing about 18 percent of the world’s GDP and if they are not producing, consuming or travelling, then there has to be an impact. The world should have been ready, we were not. And in the new year with stock markets priced for perfection and recording ever higher highs, the virus hit. Now the unprepared leaders of the G20 hope a whopping $5 trillion of handouts and backstops in fiscal spending will soften the near term blows but neither will solve nor win the war. It is only the beginning. The pandemic’s epicentre has shifted to America, a ticking time bomb due to the fallout to come.

The virus has economic, health and financial impacts. To head off the damage, governments think creating money is the easy part. They are wrong. The problem is not a China problem nor a US problem but a global problem. We believe a serious economic downturn is likely as the virus humbles governments and central banks, exposing the risky and overextended market fundamentals of today. Best estimates call for a depression-like contraction to the US economy of 25 percent, China by 20 percent and the eurozone by 22 percent.  The market pullback then is a rational response given the lack of clarity and how it plays out. Those who believe a “V" shaped recovery or a quick bounce to old highs should heed history.  Like most wars, recoveries could take longer in an “L” shaped recovery with the “buy the dip” crowd, losing to the “sell the rallies” players. No one knows for sure.

It Is Different This Time

While governments are attempting to tackle the underlying cause, looking ahead, governments and central banks will have to deal with the consequences, not of the virus but the bailouts. Today governments are committed to carry businesses and consumers, whatever the cost. Lacking savings, public and corporate debt will soar as the government must carry the economy for months, in a de facto nationalization of our economies. After the 2008 financial meltdown, the US government created the $700 billion TARP which used billions for what was thought to be a one time bailout of Wall Street and the car industry. It worked, but somehow bypassed Main Street. This time on top of the stimulus packages, the Fed is backstopping the once safe money market by buying trillions of debt, financed by an endless stream of printed money.

The financial crisis triggered by the Covid-19 is exceptional on all measures. A chain is only as strong as its weakest link and we believe the world economy is slipping into an economic abyss, weakened by a chain of events. First, investors had to cope with Trump’s two-year trade war, which weakened the global economy, broke supply chains and ruptured relations between China and the US. Ironically, corporate America is asking the White House to lift those very tariffs, citing the tariffs as “taxes that Americans pay” and it is those tariffs that left the Americans short of medical supplies from respirators to masks. Then already weakened, the pandemic descended upon the world coinciding with yet another Black Swan event, the Saudi-Russian oil price war, which halved the price of oil hurting the world’s producers, including America’s shale oil players. And with each calamity, the risk of financial contagion increased.

And while record high debt levels once helped push stock prices to the sky, their debt loads threatens to push prices down to the basement, causing a deleveraging liquidity implosion as everyone rushes for the exits. As the pandemic continues, economic paralysis will continue with both public and private debt set to climb beyond wartime levels. As in 2008, Wall Street’s too big to fail banks must again undergo retrenchment on debt default concerns as the American financial market, the epicentre of the last financial crisis, seizes up, particularly with the repo market on life support. While markets view Covid-19 a short-term issue, history shows that recoveries take time and the mid-term outlook is fueled not only by the economic fallout, but the uncertainty of the American election in November. This pandemic is unparalleled and there is no safe place to hide, except at home.

Black Monday

Computerized trading and algo players, which sometimes make up half of the market volume, have also exacerbated the trend, upping volatility and risk as the biggest VaR shock in history wreaked havoc on strategies, across all asset classes. The hedge fund industry was supposed to make money in all conditions but failed to protect clients’ assets, putting in a disastrous performance. In their moment of reckoning, there will be fewer players. There is a new generation of portfolio managers, many of whom have less than 10 years of experience and thus have not experienced a bear market. Many are predictably shell-shocked. Further magnifying volatility is the “herd-like” behavior of the giant exchange traded funds (ETFs), who were trying to exit the same door at the same time. Cash has become king.

But making matters worse, is that real estate had become as big as America’s capital markets as homeowners feasted on 30-year fixed mortgages made possible by near zero interest rates, which created another housing debt bubble. And of course, Wall Street’s derivative products (aka weapons of mass destruction) enabled the real estate bubble to get larger. And back from the dead, Fannie Mae and Freddie Mac, the government-controlled entities that guarantee nearly half of US mortgages, have boosted household debt beyond 2008 crisis levels in a déjà vu moment. Real estate has become the biggest asset class in the world and the value of residential property in America alone is around $34 trillion, rivaling the entire market capitalization of American companies (excluding commercial and retail properties).

Consequently the system today has become riskier and more leveraged than the “subprime” days of 2008. There are still holes. Credit is no longer readily available and there are strains in the markets. Real estate is a shoe ready to drop. Banks still borrow short and lend long. However, negative rates have stretched the balance sheets of institutional savers, like the insurance companies, pension funds and mutual funds. Today banks have problems of their own and real estate will prove to be one of the ugly frogs after the swamp drains.

Repo Market Blow-up

In September the overnight repo market blew up and is now on life support. The repo market is the bedrock of the American financial ecosystem. The virus pandemic is spreading into a credit crisis as companies hurt by the lockdown, must rollover trillions of short-term paper. This crisis has similarities with 2008 and the late Seventies but its depth has parallels with the Thirties. In response, the Fed has again unveiled a bailout of the once super safe $2 trillion commercial paper market, establishing a special purpose vehicle CPFF, to prevent a Lehman-style meltdown. The cost? Billions and billions. Moral hazard has again been dumped.

What is more, the five big Wall Street banks rely on the vast repo market for funding overnight. Earlier, we speculated that the spike in borrowing costs in September reflected foreigners repatriating their funds. Foreign holders of Treasuries dumped $100 billion in three weeks. To date, more than a $1 trillion has been injected by the Fed since September to liquefy an illiquid market, pointing to chronic problems with the nation’s financial plumbing system. In one week alone, the Fed injected a record $150 billion, then $175 billion and $300 billion, and somehow ran out of money. The cost?  Trillions, which must be added to a growing $2 trillion deficit or almost 10 percent of GDP. 

The Great Depression

The last time the stock market recorded a record high and then fell more than 20 percent was just before the Great Depression, when US GNP plunged 30 percent between 1929 and 1933. Such was the severity of the market crash that in the wake of C-19, the spectre of the Great Depression of the 1930s has been raised. The Great Depression wreaked economic havoc, evoking memories of millions of homeless men, soup lines and mass foreclosures. Can it happen again? Let us look back.

America’s national output collapsed for four straight years from 1929 to 1933, a 50 percent drop under the weight of non-performing European debt and a swing to protectionism sparked by the Smoot-Hawley tariffs in 1930. The tariffs were met with instant retaliation from abroad. In late 1930, a rolling series of bank panics began. Unemployment went from 3 percent to 25 percent in 1932.  After a record climb in stocks from 1925 to 1929, sparked by wild speculation (Roaring Twenties), prices fell in half due in part to lower volumes and deflation. By 1931 the depression became the Great Depression.

History showed that one of Herbert Hoover’s big mistakes was an austerity programme at the same time imposing the Smoot-Hawley tariffs, which were meant to protect the American economy. The central bank also tightened monetary policy and reined in spending in an attempt to balance the budget. That ended when Franklin D. Roosevelt, the next president ramped up spending and introduced the New Deal to get the economy going.

In May 1931, the financial crisis caused a run on the current world reserve currency of the time, the British Sterling. With an empty treasury, Great Britain was forced to float its currency and suspend gold payments, devaluing the pound sterling. America then was a creditor nation. Franklin Roosevelt confiscated gold in 1934 making it illegal for US citizens to own. He then followed with a 40 percent devaluation of the dollar, which boosted the economy. FDR subsequently printed money and his New Deal introduced major capital spending on infrastructure projects which helped end the Depression. Unemployment fell to 14 percent in 1937. The Dow Jones itself had plunged almost 90 percent from 1929, peaking at 381 in 1928 at a price/earnings rate of 20.5 times but subsequently lost some 20 percent in eight short weeks, before the crash of December 1929  ended in July 1932,  at 41.22. It took 25 years (1954) for the markets to recover to its pre-depression high. 

Also in the Thirties, the forerunners of ETFs were “investment trusts”, created by Wall Street to attract public savings, which failed as did thousands of banks. Investment trusts and interest rate sensitive stocks were punished losing most of their value, such that they were banned for much of this century. Today, European banks have been told to suspend dividends to conserve cash and build-up reserves. Are American banks far behind?

When the Music Stopped

“When men of his temperament get to his age without ever having had real opposition and then meet in its most dramatic form, it’s quite dangerous”

Donald Trump? No, it was written by noted journalist Walter Lippman describing Herbert Hoover, a businessman who served as the 31st president of the United States at the onset of the Great Depression, promising that “prosperity is around the corner”. He was wrong. Almost a century later, the US economy is all but shutdown, unemployment has sky-rocketed and businesses are closing. The lessons then are relevant today. America’s unemployment rate is projected at 32 percent or 46 million people. During the Great Depression unemployment peaked at 25 percent or 15 million people at that time. Noteworthy was that it took 25 years for the economy to recover to the level before the Great Depression started.

Before the Great Depression, France and the US were among the world’s largest creditors but Great Britain, recovering from the huge debts of World War I, lost its superpower mantle when sterling was devalued against gold. The slump in the Thirties followed.  Today, the American dollar is the world’s reserve currency and like Britain then, is awash in debt becoming the world’s largest debtor. This time, China and Japan have become the world’s largest creditors. We believe a shift from the US dollar is in the offing as America has passed the threshold of a runaway trajectory of debt. It is the nation’s fiscal irresponsibility that jeopardized the dollar’s status. The dollar’s reserve status is not forever.

Who Will Pay for The Bailouts?

Nearly a century later, the major indices have lost roughly a third of their value raising then, the spectre of the Great Depression. Almost no economist thinks that we are even close to the Depression, yet there are similarities, such as that ugly blast from the past, Trump’s Tariffs, which boosted protectionism and disrupted global supply chains. The financial history of the Great Depression yielded a lesson that is relevant today. Then, the government was slow to bailout the economy because it tried to keep a balanced budget. Debt to GDP was 50 percent.

Today major economies have embarked on an historic round of money printing with governments literally dropping helicopter money on their citizens (like Les Nessman of WKRP, dropping turkeys from a helicopter, thinking they could fly). The new bailout schemes announced to date are more than 15 percent of GDP according to Fitch, the credit rating agency, which will cushion the economy but the extent that they do will contribute to a deeper fiscal hole. Before the pandemic, the world’s debt tally was at an already sky-high 300 percent of GDP, up a third in a decade.

The good news is that the unprecedented global fiscal response will forestall a collapse like the Great Depression. The bad news is that America then was a creditor nation and possessed the resources to finance FDR’s spending plans. Debt to GDP was less than 50 percent. Today it is at more than 100 percent of GDP, excluding the entitlements and Medicare safety nets which ironically were introduced after the ravages of the Great Depression.

Before the pandemic, the world’s dominant nation was budgeted to spend $4.7 trillion but the never ending bailouts could cause the deficit to be as high as 25 percent of GDP. This must be financed either by foreigners or internally.  America’s fiscal hegemony and profligacy is its blind spot. Foreigners have financed about a third of America’s money supply, own a third of America’s assets and a third of the $1.3 trillion of debt issued last year. Today, unlike the Thirties when America was a creditor nation, America is a debtor nation, in fact the world’s largest debtor. As a result, there is an oversupply of dollars outside the US. America will learn dollar supremacy is not forever and in this crisis, money does not grow on trees. It is different this time.

Problematic is that the world’s largest creditor in the world, China is reluctant to increase their dollar exposure, because the United States and China have become Cold War rivals. China lately has been reducing their dollar obligations. Others are concerned that America’s growing obligations are being debased by a Fed printing dollars to infinity in an effort to plug their financing gap. Lessons should be learned that while stimulus did turn the economy around in 2009, the misallocation of resources and mispricing of credit resulted in lost productivity and investment, creating asset bubbles that gave an illusion of prosperity and came at the expense of a record pile of debt. We believe that it is this debt that will exacerbate the downturn from a recession to a depression.

False Remedies

Can anything be done to contain the spread? Not of the coronavirus, but the misinformation? Without sports, theater and going out, much of what we watch today is through the lens of the media, social or otherwise, which is swarming with political and partisan messages, particularly in the United States.  Mr. Trump himself has staked his credibility on the economy measured by the stock market performance and in King Canute fashion, initially declared that he had a “hunch” that the virus  would soon be over. However, since the market collapse erased the gains achieved since he took office, the president has sent out mixed messages, declaring himself the “wartime president” and, even raised hopes that Easter would be a time of resurrection for the US economy. He was wrong.

The growing fallout from the coronavirus outbreak is being matched by the spread of fake news, such as the post for an inaccurate “simple self-check” for the coronavirus of holding your breath for 10 seconds, which claimed falsely to be from Stanford University. In a world of fake news, misinformation has undermined trust in governments including the very institutions that are responsible for stopping the pandemic. Governments, like the response to the C-19 epidemic, have again failed in their collective response.

Is Gold The Ultimate Hedge in the Apocalypse?

The Four Horsemen of the Apocalypse are allegorical figures in the New Testament of the Bible and each riding on white, red, black and purple horses, respectively representing pestilence, war, famine and death, thought to usher in the world-ending apocalypse.  At a time when the Covid-19 pandemic has swept across the globe (pestilence), the onset of wars (trade), famine (Africa) and death (Covid - 19), there are some who believe the apocalypse is just around the corner. Or, others worry that the actions taken to defeat the virus might kill the patient, particularly when it appears that America is on the brink of catastrophe. It is neither.

The spread of the virus has damaged trust in most governments’ leadership and institutions. No longer is this about a fake disease. The rise of gold is not a surprise. Markets are hopeful that the Fed’s use of the old 2008 playbook to quell the illness’ impact, will work. However, for years the US has operated a wholly reckless financial system whose main characteristics were a rising US stock market and rising deficits. Ironically, while Beijing is to be given high marks for its quick response to the spread of disease, Western dithering, posturing and complacency seems to be the norm and will not solve the liquidity panic nor stop the spread of the virus. The problem is that the virus is a temporary phenomenon. Bailouts are forever.

What If The Lockdowns Are Only The Beginning?

Today, governments are relying on massive and maybe permanent bailouts to stop a repeat of the Great Depression. Again, we are in unchartered waters. Bailouts and safety nets, like unemployment insurance can help but they won’t help demand until the pandemic is stopped. Gold was an effective hedge in the Thirties, maintaining its value, something that Apple, Tesla and Facebook have not done today. Buddy, can you spare an ounce of gold?

Noteworthy was that gold did very well in these deflationary times, even though the price of gold was fixed. Homestake Mining, as a proxy for gold, went from $80 in October 1929 to $495 in December 1935, or a 500 percent move during the horrible collapse.

We believe the consequences and the eventual cost of the string of those bailouts and the market impact has yet to be discounted, let alone measured. Conditions of falling asset prices and tighter credit are similar to the global financial crisis of 2008-09, but we believe it is different this time. The US has a serious problem with its deficits and overvalued dollar. This time the pandemic has hit every sector of the economy. Businesses large and small need help as does the far reaches of the economy. The cost will be painful. A perilous adjustment lies ahead. Likely is the need for more powerful stimulus packages from governments and even more intervention as they bailout everything and everybody. Investors will need clarity to make decisions. Until then, gold will be a good thing to have – it is the ultimate hedge. 

Gold is at an eight year high as the deepening economic impact of C-19 sends investors scurrying for the metal, which is in short supply because of declining mine production and closures of refineries in Switzerland and South Africa.

The time bomb of bailout packages lies ahead in higher inflation. We should not worry about the Great Depression, but instead learn from Weimer Germany in the Twenties, when the value of savings was destroyed from the endless printing of money that led to financial and social disaster. Each big inflation period, whether during the 20s in Germany or the Vietnam War in the US, started with a massive expansion of the money supply.

Last year central banks purchased 658 tonnes of gold, according to the World Gold Council, their highest levels since 1971. Turkey bought 41 tons of gold in January and February, following Russia which purchased 19 tons, selling US debt to boost its reserves to about 20 percent of gold. We believe that investors are already choking on too much US dollar debt.  Investment demand for gold remains strong with inflows into the gold exchange traded funds at near record highs. A bright spot is gold has increased 5 percent this year versus a 20 percent collapse in S&P 500. Gold futures were also caught in a squeeze, forcing up physical demand, rivaled only by the scramble for toilet paper. Yet, gold has outperformed every asset class and in euros and yen, have already posted record highs.

We continue to target $2,200 before yearend, a target that has been much maligned and a target that few expect. A century ago money was a claim on gold. Today money is a claim on nothing, but the full faith and credit of the United States. Debt on debt is not good. We believe that the debasement of the dollar to rescue the US economy will result in rising inflation possibly hyperinflation, which will be good for gold, but bad for the dollar.

Recommendations

The mining industry is in lockdown mode as companies put mines on care and maintenance due to concerns of health and safety. Fewer supplies will hit the market at a time when the industry’s refiners are also shutdown because of the virus. As a result the producers have suspended their guidance.

A bigger concern is reserve replacement. Of the 14 gold producers, less than half replaced reserves and three only replaced reserves through acquisitions. As such, we expect further industry consolidation through M&A activity because it is cheaper to buy ounces on Bay Street than to explore and develop those ounces. Kirkland Lake Gold’s acquisition of Detour was an opportunity to solve a short reserve life problem with richly valued paper.

Gold producers remain cautious on costs and are sustaining capital expenditures to improve balance sheets and reduce debt. Most are throwing off substantial free cash flow at today’s prices. This building cash hoard could see a ramp-up of dividends, enhancing shareholder value and even allow increases in dividends.

Needed also is an increase in exploration, the life blood of the industry. However to date exploration has largely been confined to brownfield projects around miners’ mines. We expect a rotation from the seniors to the mid-caps with growth prospects. Exploration will have to wait for the “trickling down” effect.  Still, the industry has become too concentrated. Needed is a discovery or even higher gold prices to spark activity. Gold shares are under-owned and unloved – the perfect ingredients for the next “10 baggers”.

As such, we continue to like Barrick and Agnico Eagle among the majors possessing above average mineable reserve per 1000 shares (see chart). Not all reserves are alike, so we emphasize mineable reserves. We also like B2 Gold and Lundin Gold among the mid-cap players for their growth potential.

We wish all happy holidays. Stay safe and healthy in these uncertain times.

John R. Ing

jing@maisonplacements.com

Please refer to the Legal Section of our website (maisonplacements.com) for our Research Disclosures for an explanation of our rating structure at  https://maisonplacements.com/research-reports

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Throughout history the ruling class has always sought to own gold and silver because they represent purity and longevity.

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