Super-cycle May Be Setting Up For Higher Commodity Demand

May 8, 2018

The Gold Report: Frank, thank you for joining us today. Let's talk about the commodity super-cycle. Would you explain what the super-cycle is?

Frank Holmes: There's lots of research on the super-cycle; new research came out around five years ago that found evidence on commodity super-cycles in particular, and experts believe that we're in the middle of one.

To back up one step, I definitely think government policies are a precursor to change; in fact, that's written in all of our prospectuses, that we really believe in this. Government policy bifurcates to either monetary or fiscal policy. Fiscal policy is tax and spend, along with regulations. Monetary policy is real interest rates and money supply. So, the real significant factors are the fiscal policies of the government and if they're materially strong enough. When you get into the cycle, you need to ask if the government is smart with the money. The first part of the last wave took place in Latin America and Africa when they had the commodity boom, but a lot of those tax dollars that came in were wasted or stolen. So, they never really got the recycling of the money into building an economy.

The exception is China. It did build infrastructure, 20,000 roads and also pushing for 25,000 miles of light rail and super railway trains that go over permafrost at lightning speed. I took my board several years ago from Shanghai to Beijing at 220 miles an hour 30 feet above the ground. They've seen firsthand how the Chinese redeploy that capital. And that's the reason why China has had such a big economy.

The last big cycle was in America. And this big 50- to 60-year cycle is China. The first big wave was building dams. Then we had roads and super train stations. The next big push is the Silk Road, and that's to connect something like 65 countries. And China is going to finance it and then bring in its latest technology because it can build roads faster than any company in America, and it can lay track and railways. This is so important as it can go and touch all these countries along the Silk Road. How those governments deal with the capital flow will create a sustainable super-cycle, or it will end it.

So far, everyone keeps betting negatively on China, and I think that's a mistake. I've heard this since 1994 when I started the China Region Fund (USCOX).

In that 60-year commodity super-cycle, you have 10-year cycles. We've basically come out of a 10-year downdraft. We had this big wave up, then we had the correction, a balance, and then we drifted lower and lower. And we're seeing that there's been a lack of exploration and development for any major discoveries for commodities, but the world continues to print money at a rate that's just incredible. People continue to have babies. Even China's gone to a more than one child policy. I think that bodes well that a lot of the inventories, the excess supply from oil or whatever the product was, was basically used up in the downdraft of this cycle. Now, we're in the next wave, the upcycle.

TGR: What do you think are some of the factors bringing us into this next upwave?

FH: I'm not a Trump fan and I don't really like bullies, but I must admit that he has had the courage to take on the status quo. I was at a hedge fund conference recently where Ben Bernanke spoke and he said that Trump is like Jimmy Carter. The whole room was shocked by him saying that. He said it doesn't matter if it's a Democrat or a Republican. Whenever that president takes on the beltway party, the entrenched regulators and lobbyists, then you start seeing them attack using the media, leaks by our government to go and attack that president. So, a year ago, Bernanke said to expect lots of leaks coming out, and so far he's been correct on that.

But the beneficial part for the commodity cycle is that Obama passed what's called the Obama checklist that basically said if your corporation spent a million dollars going through this checklist, you complied with the law. The Environmental Protection Agency (EPA) had approved you to build that highway, redo the bridges, etc. But the EPA snubbed the president.

When I was in Washington with a group of analysts and met with the EPA and the energy department, etc., what we discovered was that President Trump took the Obama checklist and said that if a company complied with it and the EPA did not approve it, then the EPA would have to report to the Department of Justice to justify why it hasn't done it. And since that date, you won't believe how much infrastructure spending has been approved. You talk to engineering firms, they're on fire. They're just booming with business. So, I think if you had America really focus on redoing all of its bridges, airports—so our airports are cutting edge like when you go to China—and tunnels and subway systems, etc., then we could be in that next important, critical leg for that cycle along with what China's doing on the Silk Road.

TGR: In this next cycle, do you think that all commodities will react equally? Which ones are going to be the winners?

FH: Well, clearly natural gas is going to be a big winner. You can see that in the prices of liquefied natural gas (LNG) which Japan, South Korea, Taiwan and China import, and it's cleaner than some other energy sources.

Solar energy is another area of opportunity; there have been greater advancements in solar cells.

Also, I think the real demand is going to be for copper and aluminum because you have to build this incredible electrical grid around the world. But there's not been a major copper discovery in 30 years. If you have an earthquake in Chile or Peru, it could easily disrupt the copper supply, and copper could be $6 a pound overnight. So I think that the supply side of copper has not kept up with the demand side. And so that's a metal that I really like.

I think that met coal should do okay as well, as it was made for steel. While the coals will stay strong, LNG is going to become much stronger than coal. And we've seen that. The correlation of coal prices has not been as strong. But I think a lot of the rare earths are going to be important as we continue to have this technology boom, from cellphones and smartphones to the advancements of electric cars. Just think, if you have to have your car recharged all across America, how many centers are going provide that capability so you can do that and do it quickly. So I think that there's a real boom in commodities.

TGR: How should gold fare in all of this?

FH: Gold is extremely undervalued. Over the last 50 years, the U.S. dollar has replaced gold for what I call the Fear Trade. The U.S. government prints billions of dollars, and 80% of the $100 bills are held outside of America. One of my employees is from Latin America, and he always has three $100 bills in his passport just in case there's a crisis. The U.S. dollar has become the currency of safety and last resort. When the hurricane shut down Puerto Rico, it was dollars, not cryptocurrency, that people used. If you had silver coins and gold coins, you could turn around and get things with them, but more important were U.S. dollars.

And so, I think the government realizes it's like a free source of currency, and it prints billions of dollars. It's estimated that something like $25 billion a year gets lost in overseas currency. And sure, they buy products with it, legal and illegal products, but it's a huge source of funding for the U.S. So, I think it's in conflict with gold.

Now, the U.S. government reports that it has the largest gold holdings in the world; in the free economy, what would be India. Indian housewives have almost five times the amount of gold as Fort Knox does, and it has helped protect them from over 1,000 years of bad government policies.

So, I think there's something happening in the gold market that's going to change things. For instance, a cryptocurrency potentially valued at 1 gram of gold has been discussed. The CME Group can partner with the Royal Mint and come up with 1 gram of gold that trades 24/7 digitally and is securitized by gold. If you just think of that concept, because it's so small and you could pick up the GLD, absorb $50 billion worth of gold, and it became a proxy. So a concept like this might appeal more to a younger group of investors. Millennials might be keener to buying a gram of gold as a crypto than they are buying an ounce of physical gold.

Then there is Goldmoney, which has a subsidiary called Mene, and it sells 24-karat gold investment jewelry. They're just hitting the ball out of the park. It's literally like Amazon. It's 24-karat, beautiful gold. The company will always guarantee a price 10% below the price to buy back your gold. If it moves up 10% then you can sell it and buy new gold jewelry. I think Mene is going to be very disruptive to the gold jewelry industry. Millennials are also more conscientious about their gold purchases. The average purchase for gold even at these price levels is $600. That same amount of gold on Fifth Avenue would be $3,000. I think that we're going to see things like this evolve in the gold space. These will be very important for the yellow metal because 60% of gold demand is for love, or the "Love Trade." And Mene is all about love.

TGR: How about the price of gold itself? Do you have any predictions on it?

FH: I've been saying it could reach around $1,500 this year. I think the only short-term headwind is interest rates. If you look at the inflationary numbers and the consumer price index (CPI) numbers, and you look at the factors that we had in 1980, we have inflation close to 10%. If you look at the factors used in the 1990 gauge, we are at 8%. I believe these CPI numbers are way understated.

The New York Federal Reserve has its own factor analysis for inflation rates too, and it's 20% higher than what the CPI number is. So, I think that even with raising rates, the real inflation numbers are truly understated.

And that would be a game changer if all of a sudden, they say 'well, actually, the factors that we have to live with today to consume, inflation's running at 6%.' That means interest rates are extremely cheap. Gold might then reset itself up to thousands of dollars an ounce.

TGR: For investors, do you want to talk about companies that you think would be good for them to take a look at?

FH: Last year I launched a smart beta gold equity ETF called the U.S. Global GO GOLD and Precious Metal Miners ETF (GOAU:NYSE), and it has shown competitive performance against the GDXJ (VanEck Vectors Junior Gold Miners ETF) since its launch. Why could that be? In my opinion, when you look at the GDXJ constituents, 60 some-odd gold stocks, they have a propensity to issue shares or make acquisitions that are potentially dilutive to the value metrics that people might use to make their stock go up. So it appears there's been a 40% dilution a year. And either gold can go up 40% a year or their production can rise 40% a year or these stocks might just have to lag. With GOAU, we try to focus on smaller stocks that really aim to protect their value metrics per share.

On individual names, I would say to go for a speculative turnaround where something has to happen with it, like Gran Colombia Gold Corp. (GCM:TSX). This company has seen free cash flow. It restructured its balance sheet. And if you look at Gran Colombia's market cap:enterprise value, to companies producing 150,000 ounces of gold, I think this stock has the potential to quadruple. And I think that that's where I would tell investors to look. It has a strong board of directors with lots of mining credentials—Mark Wellings, Mark Ashcroft. These are people whose families have been in the mining business. They're engineers. They've worked in investment banking. So it really helps in the stewardship of that company going through a restructure and turnaround. I think that that's one.

And for the real safe players that are wanting a big chip, I personally would rather buy Franco-Nevada Corp. (FNV:TSX; FNV:NYSE), Wheaton Precious Metals Corp. (WPM:TSX; WPM:NYSE) or Royal Gold Inc. (RGLD:NASDAQ; RGL:TSX). They represent 30% of the GOAU ETF. But individually, they're unique animals. The most important part for the readers is that these companies produce revenue. Just think of it this way: Goldman Sachs' revenue per employee is $1 million, and Franco-Nevada's is $21 million. Not only that, Franco-Nevada has royalties on Barrick Gold Corp. (ABX:TSX; ABX:NYSE) and Newmont Mining Corp.'s (NEM:NYSE) gold assets that have a blended average of $600,000 of revenue per employee. So that means the efficiency of owning a company like Franco-Nevada is far, far greater than owning the Barricks, etc. Franco-Nevada has no debt. Historically, it pays more dividends than Barrick or Newmont or any of these other gold mining stocks do. Same with Wheaton Precious. It's correlated. The higher the silver and gold prices go, the bigger the dividend payouts typically are an ounce. So you get that optionality off the group of them. I think unique vehicles like that are more exciting than where you have to go down the food chain and look for a company that's restructured itself and has proven for the past 18 months great performance but the stock is not showing it yet.

TGR: In addition to the GOAU ETF, you have the Global Resources Fund (PSPFX).

FH: I love that fund, too. I have money in it, and we have a great team behind it. It's very much quant driven and basically starts by looking at a universe of 1,600 companies. It's looking for who has the best liquidity of these 1,600 names. After that, we start looking at who has the best metrics on revenue per share growth and cash flow:enterprise value. We look at factors that we back-tested, with detailed quant analysis on what works best in upcycles and down-cycles. The Global Resource Fund is truly diversified.

It will rotate and go overweight to underweight gold as long as the names are showing higher returns on invested capital. It'll go into steel, too. It'll go into oil and gas. The fund will go wherever companies are showing the fastest revenue per share growth and are the least expensive on a cash flow multiple. It does not look at net asset value (NAV). Most mining stocks are compared based on NAVs. I don't buy that because the discount rates make it just a messy, messy spaghetti dinner when you try to detail things. But book value is what the quant funds use. The fund looks for those companies that have more stable book value, less write downs. And so it's done a great job. But it's predominantly mid- and big-cap stocks.

Our World Precious Minerals Fund (UNWPX) will go down the food chain to the micro-explorers, because we know the track record of the geologists, the safety of the jurisdiction, whether the team has done it before, and we'll speculate with them at that level. So that'd be the difference between it and the Global Resources Fund. But if you want a great way to play this Silk Road in China and the demand, we have stocks in Japan, some of them in Russia. We have the cheapest steel stocks and they pay in U.S. dollars. And you can just see that it's done exactly what it's supposed to do.

TGR: Any parting thoughts?

FH: I think that gold trades higher. I think that copper trades higher, aluminum trades higher. And I think that one has to just appreciate the demographics of the world.

TGR: Thanks for your time, Frank.

Frank Holmes is CEO and chief investment officer at U.S. Global Investors, which manages a diversified family of funds specializing in natural resources, emerging markets and gold and precious metals. In 2016, Holmes and portfolio manager Ralph Aldis received the award for Best Americas Based Fund Manager from the Mining Journal. In 2011 Holmes was named a U.S. Metals and Mining "TopGun" by Brendan Wood International, and in 2006, he was selected mining fund manager of the year by the Mining Journal. He is also the co-author of The Goldwatcher: Demystifying Gold Investing. More than 30,000 subscribers follow his weekly commentary in the award-winning Investor Alert newsletter, which is read in over 180 countries. Holmes is a much sought-after keynote speaker at national and international investment conferences. He is also a regular commentator on the financial television networks CNBC, Bloomberg, BNN and Fox Business, and has been profiled by Fortune, Barron's, The Financial Times and other publications.

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Frank Holmes is the CEO and Chief Investment Officer of U.S. Global Investors. Mr. Holmes purchased a controlling interest in U.S. Global Investors in 1989 and became the firm’s chief investment officer in 1999. Under his guidance, the company’s funds have received numerous awards and honors including more than two dozen Lipper Fund Awards and certificates. In 2006, Mr. Holmes was selected mining fund manager of the year by the Mining Journal. He is also the co-author of “The Goldwatcher: Demystifying Gold Investing.” Mr. Holmes is engaged in a number of international philanthropies. He is a member of the President’s Circle and on the investment committee of the International Crisis Group, which works to resolve conflict around the world. He is also an advisor to the William J. Clinton Foundation on sustainable development in countries with resource-based economies. Mr. Holmes is a native of Toronto and is a graduate of the University of Western Ontario with a bachelor’s degree in economics. He is a former president and chairman of the Toronto Society of the Investment Dealers Association. Mr. Holmes is a much-sought-after keynote speaker at national and international investment conferences. He is also a regular commentator on the financial television networks CNBC, Bloomberg and Fox Business, and has been profiled by Fortune, Barron’s, The Financial Times and other publications.  Visit the U.S. Global Investors website at http://www.usfunds.com.  You can contact Frank at: editor@usfunds.com.

One cubic foot of gold weighs more than half a ton (1,306 pounds).