Math, The Monetary System’s Buzz Kill…Gold Miners Weekly

December 13, 2013

“If You Believe in Math, Buy Gold” -- This quote, taken from a CNBC interview with Brent Johnson, CEO of Santiago Capital, made its way into several commentaries this week. Most notably, it was the title of a follow-up interview published in Sprott’s Thoughts, which we featured in our News Corner.

In the interview, Mr. Johnson explains that the current monetary system “has a [fatal] design flaw” that makes it unsustainable. [Emphasis ours]

He is referring to the fact that the Federal Reserve is creating money out of thin air to the tune of US$85 billion per month under its QE3 program in order to buy U.S. Treasuries and Mortgage Backed Securities.

The wisdom, or lack thereof, behind the program is that the commercial banks will lend money to businesses and consumers who will then spend it in various ways and thereby stimulate the economy.

However, in practice, instead of lending the money into the economy, the injected liquidity has simply ended up creating asset bubbles in the stock, bond, real estate, and farmland markets.

The problem of course is the Fed has gotten caught in a trap of its own making.  Unless they want to see these asset bubbles deflated, they have to keep the QE spigot wide open.

To provide some perspective on the scale of this money pumping operation, the Fed’s balance sheet has mushroomed from just under $1 trillion before the Global Financial Crisis (GFC) to a fast approaching $4 trillion.

In the meantime, commercial banks are engorged with a significant chunk of these QE funds.  But, instead of lending the money out, they are accumulating it in their excess reserves.  Considering this, one could think that they do not presently see U.S. businesses and consumers as a good credit risk.

As a result, banks are awash in QE funds and since there is no un-creating of these funds, one day they will find their way into the economy and when that happens it will be highly inflationary. Especially given the fact that the growth rate of these funds far exceeds the growth rate of goods and services being produced in the U.S. economy.

Equally, if and when the Fed does taper, the asset bubbles it created in stocks, bonds, and real estate will come crashing down.

In Mr. Johnson’s interview he suggests that this crash is baked into the cake because it will require ever increasing amounts of money at ever increasing flow rates to achieve the same results.  Ultimately the rates of growth required will go exponential and become unsustainable and highly unstable, with a crash not far behind.

Thus, in his view, the numbers don’t lie and therefore you might want to own gold in preparation for these eventualities.  We humbly agree.

Addition and Subtraction

Another straightforward reason to own gold is because of its favorable supply and demand fundamentals.

According to the World Gold Council (WGC), the mined gold supply for the last 12 months through September was 2,862.5 tonnes. It might surprise some to know that during the same period, worldwide demand was 4,476.9 tonnes. The difference between the two registers a significant supply gap of 1,614.4 tonnes.

This supply and demand imbalance is glaring and definitely bullish for gold. It will be impossible for ETF sales and central bank leasing operations in the West to continue to indefinitely bridge this gap.  Their supplies of gold are finite and dwindling rapidly, while organic worldwide demand remains large and constant.

An annual supply deficit of 1,600 tonnes could drain all ETF and central bank holdings in a matter of a few years. But, it is very doubtful that these gold owners would be willing to let their holdings go to zero.  Therefore, at some point, the massive dishoarding will cease or slow dramatically and that will be a very bullish moment for gold.

As a subplot to this story, we think the supply and demand shift from West to East is also quite noteworthy.

In an article “Gold Production Wars: The East Slays The West,” Steve St. Angelo of the SRSrocco Report highlights the structural shift that has occurred in world gold production.

In 1997, cumulative gold production of the top three Western producers; Australia, the U.S., and Canada peaked at an aggregate 845 tonnes.  In stark contrast, the East, represented by China and Russia, only produced 290 tonnes.

Fast forward to 2013 and the gold production dynamic has changed dramatically.

Production from these same top three Western producers is estimated to be just 624 tonnes, representing a decline of 26% from 16 years ago. Meanwhile Eastern gold production increased considerably to approximately 664 tonnes this year, representing a 129% increase over the same time period.

This is an intriguing development with regard to supply and demand fundamentals because both countries have proven to be fairly stingy with their gold, exporting very little onto the international market.

As far as we can tell, China does not export an ounce of its production, while Russia exports just a small percentage.  And, as they are two of the largest producers in the world, they are holding back a tremendous amount of gold from international markets. This greatly diminishes the amount of annual production available to supply global demand, which is a very bullish portent for gold.

So What Gives?

The trend of increasing gold production by the East is by design.

In “China to Rebuild Great Wall with Gold” we outlined how China’s mining sector awakened in the modern era and its posture towards gold changed. Starting in 1975, China mined only 13 tonnes of gold.

Today they lead the world in gold production by a large margin and are expected to produce 430 tonnes or 15% of world annual mine supply.

Although a little later to the game, Russia has also made a strategic effort to increase their gold production.  In “From Russia with Gold,” we detailed Russia’s recent gold production expansion.

“Since 2008, Russian gold production has risen dramatically. In 2009, 2010, 2011 production figures were 185, 202, and 211 tonnes. In 2012, gold production jumped to 226 tonnes and is estimated to reach 237 tonnes in 2013.”

Increased gold production is not the only thing China and Russia have in common. They also share a negative opinion of the U.S. dollar’s current role as the world’s dominant reserve currency.

We have provided an abundance of commentary over the last several months regarding China’s feelings on this matter and their strategic moves designed to change the balance of monetary power.

On the Russian front, Vladimir Putin, the President of Russia, is on record saying at the 2009 World Economic Forum, “The one reserve currency [i.e. the U.S. dollar] has become a danger to the world economy; that is now obvious to everybody.” [Clarification ours]

He has stated that the world should have multiple dominant currencies. As an interesting side-note, the Russian’s have just released a new symbol for their currency.  Perhaps this is a branding exercise to market the ruble as one of these multiple dominant currencies?

As we’ve reported before, in 2011, the Chinese news agency Xinhua, published this statement with respect to the U.S. dollar,

“International supervision over the issue [printing] of U.S. dollars should be introduced and a new, stable, and secured global reserve currency may also be an option to avert a catastrophe cause by any single currency.”

These statements are indicative of increasingly aggressive words and actions by China and Russia in a committed effort to reduce monetary risk by diversifying global trade away from the dollar.

An important part of this diversification effort has been to accumulate official gold reserves to give themselves and their trading partners an attractive and sustainable alternative to the dollar and the U.S.’s underlying monetary policy of endless QE.

In last week’s Weekly “China finds Secret Door Leading out of Dollar Trap”, we highlighted how the U.S.’s commitment to devaluing the dollar via QE puts global commodity markets at great risk due to the fact that the most important commodities are priced and traded in U.S. dollars.

China and Russia’s focus on gold production and accumulating gold reserves as part of a common strategy is by itself another bullish portent for gold.  However, the idea of displacing large amounts of U.S. dollars from international markets also adds to our earlier discussion of inflation.

If the world begins to diversify trade away from the U.S. dollar, there will not be a need to hold as high a level of dollar reserves.  These dollars will be displaced by other reserves (i.e. other currencies like the Chinese yuan and gold).

As a result, these dollars will have no place to go but back to the U.S. from whence they came.  And once there, these dollars will join the ocean of QE dollars and will ultimately be unleashed on the U.S. economy.  It really is an inflationary perfect storm waiting to happen!

All this adds a double whammy to our bullish gold prognosis.

Putting it all Together

As the above discussion suggests, there are many factors percolating around the globe that are bullish for gold.  And they all have one thing in common and that’s an unsustainable and unstable monetary regime with the U.S. dollar at its center.

In our view this may be one of the most unique moments in gold market history.  The gold price is weak and the gold miners that produce the yellow metal are as undervalued as they have ever been.

At the same time, there are a swarm of historic bullish factors converging from several directions.  Thus for discerning investors there is an historic window to accumulate the shares of those gold miners that are poised to leverage a rising gold price. We specialize in identifying these companies for our discerning subscribers.


Carlos Andres

Managing Editor & Chief Analyst

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Carlos Andres is the managing editor and chief analyst of both the Gold Miners and the Frontier Research Report investment newsletters. Both are natural resource and mining oriented publications focused on publicly-traded investment opportunities. Gold Miners covers large to mid-cap gold producers whereas the Frontier Research Report covers junior explorers operating in emerging and frontier markets. Carlos has been a natural resource analyst and investor for over 15 years.

Gold is found in nature in quartz veins

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