EPISODES / WEEKLY COMMENTARY

Fireworks Have Yet To Begin With Gold

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Dec 13 2023
Fireworks Have Yet To Begin With Gold
David McAlvany Posted on December 13, 2023
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  • Morgan Lewis Explains What He Looks For In A Gold Stock
  • Fiscal Crises Plus Inflation Would Be Catastrophe
  • Send Questions For Q&A Programs To [email protected]

“The last real cycle in 2008 through 2011, silver was the leader. We had distinct outperformance in physical silver. My bet would be that this time it’ll be in the mining shares, and I think there’s a value trade that has been setting up within the precious metals sector for at least 10 years that I think is absolutely ripe, and I expect to lead with significant outperformance of the upside when gold prices break out and sustainably move higher in all time highs.” –Morgan Lewis

Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. 

Before we get to our guest today, Dave, let’s remind people that as we’ve done for now, what, 15 years, we’re going to be asking our listeners for questions and we’re going to do a couple of Q&As over the next few weeks.

David: Yep. You can send those to [email protected], and a few weeks out we will address those as best we can. Thank you for sending them.

Kevin: That would be [email protected]. David, I’ve been looking forward to this. Often we repeat the things that Morgan said just minutes before we come into the studio, and Morgan has been such a great addition to the team.

David: We have a midweek meeting in the office, and we go around through the various departments and there’s different comments. Sometimes it’s housekeeping, sometimes it’s sort of what’s going on within the markets. And so for those of you who don’t know how Morgan fits into the talent menagerie, some things that are not business related but still fun to comment on. Competitive hockey player up to the collegiate level, and today he’s not playing hockey, but man, is he a lover of baseball, loves to ski.

Kevin: Skier extraordinaire.

David: Moving more towards what we do here. He’s intellectually curious. I think he’s spiritually grounded. He’s culturally astute. For his responsibilities, he’s neck deep in company minutiae critical to our portfolio construction. He’s a co-portfolio for the MAPS strategies. Those are our hard asset strategies. Yeah, so man of many talents. For our listeners, if you haven’t viewed our recent conference call with the hard asset team, you’ll get a more granular view of the precious metals sector from Morgan from that call. I’d encourage you to get that and review it.

Kevin: One of the things I really enjoy is the Hard Asset Insights because he keeps it short. Morgan could go page by page by page because he’s just that deep, but his economic analysis at the end of each week, it’s free. I mean, why in the world wouldn’t a person partake in that?

David: I forgot to mention he’s doing that every week. The Hard Asset Insights. It’s available, complimentary. If you want to know what we’re thinking as a team about what’s going on in hard assets and in broader markets, Morgan leads that up and does the heavy lifting on it. So that’s a weekly routine I would highly encourage. 

So portfolio management engages with the present and the future, and it’s informed by the past. So let’s structure a conversation today with those things in mind around where we’ve been, how we’ve arrived at the present, and then we can explore the significance of where we are. That obviously has significance for where we go next, but you’ve made the case that we are in the late stages of a confidence bubble, late stages of a confidence bubble. I’d like for our listeners to hear from you on that.

The frameworks for understanding data, organizing principles that make sense of human behavior, and those models today include the Keynesian model, the classical model of economics, monetarism, and that’s dominated the classroom for a long time, and those models inform how market practitioners view economic inputs, view behavior in the marketplace. I was a teacher’s assistant for US history, this is almost embarrassingly 30 years ago. Frequently, as sort of the frame-up for our conversation, I’d bring in The Road to Serfdom, and that’s a different model. Austrian school is different than those other two. That is kind of coincidentally where our paths began to cross. Hunter Lewis penned a critique of the dominant theory, Keynesianism, otherwise we might not have met. So maybe we can use that as a starting point, The Road to Serfdom. Have people’s expectations been shaped by the dominant models?

Morgan: Well, first off, thanks for having me. It’s a pleasure to join you on the Commentary. So you mentioned Road to Serfdom, and I’m a sympathetic Austrian in terms of my economic viewpoint, but actually, I think when it comes to Road to Serfdom, what I would point out is not so much the economics of his treatise, but rather I think he made a point in the introduction of Road to Serfdom that is crucial to understanding at least a significant portion of how this policy ball got rolling and where we find ourselves today. So in Road to Serfdom, Hayek observed that classical liberalism, not to be confused with modern liberalism, essentially free market economics, was a profound breakthrough in terms of delivering wealth creation and increased living standards.

But I think his crucial observation was that, maybe perhaps better said a warning, that the free market system could become a victim of its own success. Hayek’s observation was that once people got a taste of better economic prosperity, they would tend to become impatient and increasingly try to find shortcuts to even greater prosperity. And that his observation, I think was quite correct, but that would ultimately undermine the free market system that had already been the original engine of prosperity to begin with. And I think we’re on that road and my impression is that somewhere around the year 2000, the late ’90s things took a decided turn from a policy perspective in the direction of unsustainability.

David: Some people point out that Robert Rubin was instrumental in changing legislation. And all of a sudden Glass-Steagall is put on ice and Wall Street firms can now not only create deals but market them directly. So something changes in the early 2000s which had not been in place since the 1920s, 1930s. I mean the reason why that was put into place in the ’30s is because there was an abuse of public trust. There was an advantage to be gained by structuring products and then moving them out as quickly as possible. That’s the corporate version.

You also have sort of from a policy perspective, wanting to get growth at any cost, and let’s create this vision of the world where we never have to have a dip, we never have to have a decline, a recession. In fact, all we have to do is lower rates every time that there’s a hiccup and we’ll just kind of smooth it over. That latitude didn’t exist in the ’60s. It really began to be popularized post ’70s once we disconnected from gold altogether. And we could play with credit dynamics and credit growth in ways that were pretty amazing. Is that what you would say is different in the last 30 years or so? Credit growth is a part of it. Call it regulatory arbitrage. Wall Street’s keeping ahead of the feds to some degree. I mean, is that enough to say that that’s different in the last 30 years than the last 100?

Morgan: Certainly. I totally agree with that. I think also, years ago I spent quite a bit of time looking at some economic series, some data over time, and one of the things that struck me as quite pertinent to the discussion is if you looked at real inflation-adjusted incomes in the post World War II era, we have a long and sort of steady uptrend. It’s not perfect, but it’s two steps up, one step down, two steps up, one step down. When you hit the ’90s and then take it forward from there, a very notable change is the real inflation-adjusted income begin to flat-line.

To me, if I had to guess, I would assume that that was where policymakers, the political pressure to keep the good times rolling, made its way into policy. And shortcuts, I think, were then adopted, probably starting with Greenspan. We’re talking about lowering interest rates, allowing people if they’re not making more money in inflation-adjusted terms through their earned income, then lower interest rates allow them to take on cheaper debt as a means of continuing their lifestyle. Similarly, I think we saw that the policymaker shift was in favor of keeping the stock market elevated, creating a wealth effect through financial prices.

David: At the same time you’ve got that inflation adjusted income beginning to flat-line, very conveniently you’ve got an expansion of globalization. So China enters the WTO early in the 2000s and all of a sudden they essentially have something that is subsidizing a flat income where you feel wealthier when you can buy more stuff. Even if there is an implicit inflationism, there’s a deflationary impact to goods being delivered because of cheap manufacturing overseas. So globalization takes off and offsets what is a significant implicit inflation is coming from policies. We basically got to ignore it for the better part of two decades. Maybe we can come back to that later in terms of the benefits of globalization being undone, but maybe for a little bit later. The economic growth being in lockstep with credit growth, this seems to be the trend. Is that the case that this is just sort of the new unhealthy dependency?

Morgan: Unhealthy is an important word there. I think it is unhealthy, and I think that idea of sort of slowly killing the golden goose is part of what we’re discussing here. Good intentions are not the issue here. I’m not going to suppose that policymakers had anything but good intentions, but unfortunately if you abandon free market principles to conjure a desired state, you’re not letting the free market speak, and ultimately you’re going to create problems that will interfere with the functioning of that system in the long term. So I think that’s what we are running into, and I think that it’s no coincidence that, for example gold, which by my framework, when we abandoned the gold standard, we adopted the Fed standard by my way of thinking about things in that new environment, gold immediately became financial insurance against policy unsustainability and policy malpractice broadly put.

And it’s no coincidence that when Greenspan started to take on more of an activist central banker approach, gold bottomed in 2000, and we’ve seen the price of financial insurance steadily increase in a bull market that hasn’t relented since. So to me, that’s a great confirming indicator that we sort of crossed the Rubicon in early 2000, late ’90s from a policy perspective, and that the market, particularly the gold market, interpreted that as the start of an unsustainable path that ultimately was going to end poorly. And the question is, how long is it going to take and how is this going to play out?

David: It seems like there’s a couple of biases that are in the market today. If you have, from a policy perspective, the desire to keep things in a Goldilocks state, you could argue the biases for lower interest rates. If you’re going to have credit growth as a part of the system growth, economic growth, then interest rates and the accommodation on the interest component side is pretty critical. But it seems to the degree that you’ve had that bias lower in interest rates, that is the pricing bias higher for gold as we’ve begun to experiment with the lower bound.

And of course the last year or two we’ve had this interest rate shock. So I mean create a little carve out as policymakers try to fight inflation. We’re going back here 20, 25 years. If the bias lower over that period of time has been to accommodate an increased quantity of debt, and that debt increases the total economic activity, it’s no surprise, is it, that the bias higher in price for gold is indicative of, yeah, you can take on more debt, you can do this, but you are creating something that is less stable with time.

Morgan: Right. But I think that the fireworks have yet to begin, really, in the gold market. I still think that we’re in the late innings towards a breakout. I think gold has been tracking an unsustainable situation, and when I talk about the lead stages of a confidence bubble, my thinking is that when that confidence bubble breaks, that’s when gold as financial insurance will really get moving. And I think there’s a lot of reasons for that in terms of the amount of money right now that is locked in legacy positions within the bond market, within financial assets that make sense in the confines of a confidence bubble when investors have confidence in continuity of the same assets that have performed well over the last couple decades continuing to perform well because they have unfailing confidence in policymakers’ ability to continue to deliver that Goldilocks environment.

When that confidence breaks down, which I think inherently the unsustainability of current policy ensures will happen at some point, the question being when and how, but when that confidence bubble breaks, I think there’s going to be a great reaction in terms of the current positioning of assets and a reallocation in light of a new environment and a new reality.

David: Central banks seem to have been leading in that regard with Western investors being sort of the laggards in that respect. You mentioned innings and being in the later innings, I can’t help but think of a cultural reference for where we’re at. Could you have, 20 years ago, conceived of a baseball player being paid $700 million for his talent? I mean, it’s remarkable. The fact that it’s a Japanese player and he’s willing to receive the lion’s share of that compensation 20 or 30 years out on a delayed basis, which is just fascinating to me because implicit to the Japanese model of economics is, “we’re not going to worry about inflation. We’re not going to worry about purchasing power. I’m happy to take the money tomorrow instead of today.” Kind of the opposite of Warren Buffett running Geico. “I’ll take the money today, invest it today, and we’ll pay off our obligations, our debt, and liabilities in cheaper and cheaper currency.” I thought it was fascinating. Speaking of innings, 700 million.

Morgan: Yeah, it’s a lot of money. I’m saddened that the Yankees didn’t get Ohtani, but hey, what are we going to do?

David: Pay up. Pay up.

Morgan: That’s right.

David: Make it a cool billion.

Morgan: No, no, I can’t complain. I’m happy we got [unclear].

David: Okay. If—

Morgan: They had a fair chunk of change, or at least in prospects and players and their trades, so—

David: If the shift in monetary policy specifically is ultimately unstable, it sounds like Minsky’s views tie into your thinking quite well, the notion of an instability thesis. Yeah, your thoughts on Minsky.

Morgan: So first, let me back up. When we’re talking about unsustainability, when we first sort of define what I’m talking about, when I speak about Goldilocks, to me that’s an environment which can be thought of as some form of policy equilibrium that results in maintaining a simultaneous combination of economic growth, low interest rates, low government interest expense, stable bond and currency markets, and low inflation. So that’s your cocktail right there for the current financial market bubble to continue to expand over time. 

But, unfortunately, the unsustainable means we have used in order to create those Goldilocks conditions over time are ultimately unsustainable. They cannot be taken to their extreme in perpetuity. For example, interest rates, we can bring them down to zero. We can talk about negative interest rates, but in any kind of real sense, negative interest rates is kind of a joke. What we need right now, the current policy prescription to continue business as usual requires not just easy monetary policy and easy fiscal policy, but ever-easier monetary and fiscal policy. And that’s the problem.

David: I mean, but that doesn’t even make sense today where debt and deficits are these huge factors. If what we need is a multiplier effect on what we already have— I mean, you begin to see how absurd that notion would be to maintain Goldilocks with those variables you just listed as the key variables when we’re already at 34 trillion in debt and we already have an interest component on that debt of over a trillion dollars a year. I mean, not chump change anymore.

Morgan: No, not at all. Exactly. And I think this is a crucial point. When I look at the market, this is exactly what I’m trying to assess. I’m trying to see where, on the margin, things are shifting in the direction of markets responding towards a deepened state of instability, a deepened state of unsustainability, and the changing character in various markets. So I’ll point to a couple of signposts, let’s call it. One would be back in, I think it was 2013, when Draghi did his “We’ll do whatever it takes” moment. To me, that was a period of time where, essentially, we were early enough in this game where central bankers could— They had the rope, they had the ammunition essentially to deliver Goldilocks through whatever it takes. And what you saw was you saw financial assets respond, moving higher, initiated a multi-year bull market that’ll go down in the history books.

David: Markets were flooded with liquidity, and that helped.

Morgan: But we also had generally a low interest rate environment, low inflation. There are always going to be issues along the way, but more or less we had an environment of majority Goldilocks for the stretch, and that was necessary to propel and maintain the financial asset bubble that we had.

More recently, however, when we’ve had the post COVID environment, we obviously saw debt and deficit spike, we saw inflation surge. Those were big hits to the Goldilocks thesis. And I think that Powell was charged with convincing the world that he had his own, “We’ll do whatever it takes” moment. And I think he was charged with convincing the world that he could and we could pull it off and essentially return to a Goldilocks environment.

What we’re seeing, if we look closely and sort of look at the margin, I think we’re seeing some key markets respond very differently today than they did back then, which I think is a good indication that we are, and I don’t know what inning we’re in, but if we were in the 5th or the 6th inning before, I think maybe it’s becoming clear we’re in the 8th or the 9th now, and one of those would be gold as financial insurance. When Draghi had his we’ll do whatever it takes moment, we saw gold drop in half and essentially descend into a cyclical bear market for multiple years. The market interpretation was probably not that we were on a sustainable path, but I think that the market understood that central bankers were going to take it as far as they needed to create Goldilocks for an additional period of time.

David: Yeah, I mean if you come back across the pond to the US in that timeframe, we were in the 6 to $8 trillion in debt range. It’s been a quick increase in pace from 6 to 8 trillion to 12 to 18 to 20 to 34. So we’re farther down the road. If you’re saying what worked then worked, but you were early enough along in the journey to be able to do that. There was latitude. Was it healthy? No. Was it ultimately sustainable? No. But you are talking about different variables today given the scale and scope of debt. So when you’re suggesting that we’re sort of playing with fate here with the confidence bubble, it’s because you really are dealing with the credibility of the financial markets, central bank credibility. And as you said, we went to the PhD standard at some point. And it’s to the PhDs that we bow. It is to them that we genuflect and respect and rely on. So if they fail us, we don’t have anywhere to go. I mean, it’s a breaking of the financial system because we’re talking about the heart of money and credit.

Morgan: Right. It’s a catastrophe for the financial system as we know it now. That doesn’t necessarily mean it’s a catastrophe for the financial system or the economy, it just means that business as usual is over.

So again, to sort of contrast the Draghi moment and the Powell moment, and I’ll get into some of the things that were different, but when Powell tried to convince the world that his bugaboo was inflation, but nevertheless, if you broaden out your perspective on what he was really trying to do, he was trying to convince the world that he can get us back to Goldilocks. And when he began to increase interest rates, when he looked to be quite serious about tightening financial conditions and doing some of the things that are traditionally necessary to get inflation under control, what we saw was gold did sell off. We saw the dollar move higher. We saw interest rates move higher. And again, we saw gold drop. Financial assets also dropped.

But pretty quickly what we started to see was that the strong dollar and higher yields were causing a lot of instability in the bond market. And it wasn’t very long after that that the talk of the end of the rate hike cycle started to materialize. The dollar, there was a lot of liquidity that the Treasury general fund was injecting into the market, so it was taking the edge off dollar strength. And sure enough, gold bottomed quickly in the fall of 2022 and subsequently went to new highs. Now if you interpret that as a statement from an asset that I consider to be speaking of financial insurance, really what we’re saying is that the initial move on Powell’s declaration of, “Trust me, I’ll get you back to Goldilocks,” was to give him the benefit of the doubt.

And then as some of the complicating factors started to materialize and as the bond market started to buckle under the weight of the debt and deficit issue that we now face, and still elevated inflation. It became increasingly apparent to the market that Powell was not going to be able to finish the job. And so gold subsequently goes up and actually makes new highs. Very different character to how gold reacted to the Powell moment than the Draghi moment. I think again, that’s indicative of where we are in the 8th or the 9th inning as opposed to the 6th inning in this game.

The way I think about it is that we’ve transitioned from the period of time where Goldilocks was tenable. We’ve now shifted to a period of time where it appears the best we can do is play Whac-a-Mole. Policymakers can try to address one issue, but in doing that, the tendency is that they’re going to inflame and exacerbate other problems that we are now facing. So right now, the government is spending a ton of deficit spending on GDP growth essentially. So government spending is 25% of GDP. It’s growing at one of the fastest paces we’ve seen in history, and it’s keeping GDP growth fairly strong. Again, this is unsustainability in action. If we continue to deficit spend at the rate we’re spending, then we’re going to fast track debt and deficit crisis.

David: So why haven’t markets taken into account being on an unsustainable path? I guess to be fair, if gold is indicating that there are a subset of investors who’d see the unsustainability and prefer insuring financial insurance through ounces—somebody sees it, but certainly not here in the United States. I mean we’ve had net liquidations, seven billion in liquidations from ETFs this year. An outflow, a move away from gold, a huge confidence in the investor space. The AAII measure of investor enthusiasm, 19.6% bears, one of the lowest marks in six years. Enthusiasm for equities is there. How do you square that with being on an unsustainable path? Is it just, “Well, we’ll just take care of it when we get there. We’re not going to worry about it today. That’s a tomorrow problem”?

Morgan: Well, I think it’s a tomorrow problem until the timeline shortens enough and the issue becomes acute enough. And again, my whole point is that I think that we are watching. And what I try to do is I try to watch the market reaction and gauge whether or not we’re progressing towards a point where something has to give in terms of financial assets, recognizing the unsustainability of policy, recognizing that the era of Goldilocks is either over or very, very soon to be over, and we’re nearing the point where markets have to react to that new reality. It’s not just the deficit issue. The two biggies are obviously inflation and debt and deficits.

David: Yeah, it goes beyond debt and deficits, but still, you referenced in Hard Asset Insights recently the Bank of International Settlements and the key question that they were asking: when does debt go from good to bad? And I think of this notion of deficit spending, the fact that we can gin up GDP growth through deficit spending. But it used to be that you spent a dollar and you got more than a dollar of GDP growth. And then it went to less than a dollar. And now you’re getting less than a dime of GDP growth for every dollar that is represented by deficit spending. There’s a diminishing return here, and has been for some time. Again, we’re just back to this issue of sustainability. When does someone say, “It’s not working”? Even the Bank of International settlements is saying, “Doesn’t look great.”

Morgan: Right. This issue of sustainability or unsustainability is multi-pronged, crossing the line where debt turns bad is quite right. BIS, Bank of International Settlements, they had the level at 85% debt-to-GDP. Beyond that, they see debt as growth negative. We’re at 120 plus, so we’re way over the line there. If you look at other research done by Lacy Hunt, one of our favorite economists, he makes it even more clear and even more ominous. For him, the positive impact to growth from government spending is at best several quarters. And by the time you get three years beyond the government expenditure, it turns into a growth suppressant. That should put everybody on alert because we are now three years after the biggest government spending binge ever post-COVID.

There is certainly that issue of unsustainability, but that’s not the only one. Certainly we’ve already seen the debt and deficit issue bleed into other important policy tools. In my opinion, interest rates as a means of fighting inflation has become materially compromised. It’s one of the reasons that gold has turned around from its original decline and started to poke its head above all time highs again. Because with 34 trillion in debt, when you raise interest rates, the interest component goes crazy. And as a result of Powell raising interest rates on 34 trillion of debt now, all of a sudden we have interest expense that is surpassing defense spending and is also our fastest growing program.

If we extrapolate the lesson from that and we look downfield, what we can certainly assume is that if 5% plus interest rates on 34 trillion of debt to fight inflation is causing a debt and deficit doom loop, where the amount of interest just keeps piling up and piling up in total debt, then any further we travel in time, the problem is only worse. If we try to raise interest rates to 5% to fight inflation on 40 trillion of debt, it’s going to be worse. 50 trillion of debt, much worse. If we have to raise interest rates above 5% on 50 trillion of debt, much worse.

David: Yeah.

Morgan: Right.

David: So ultimately where that shoves us is a place where we’ve basically broken the monetary policy brake that interest rates have traditionally been. Again, this is just a symptom of unsustainability in practice. As we continue to pursue the policies that we have had in place for the last 20 years, their inherent unsustainability causes their own demise.

David: So let’s just do some if-then scenario analysis, because if that’s not going to work, what are the choices? Lower rates are what the market would like. It certainly relieves tensions for corporations needing to roll over debt. If you’re a leveraged speculator, paying less is always nice, you get margin loans at a smaller number, or what have you. But what are the consequences? Lower rates? Okay. Be careful what you wish for.

Morgan: Yeah, lower rates, great. It’s great, except that it’s going to reacquaint us with inflation, so we can do that, again, this is Whac-a-Mole, we can address one problem at the expense of exacerbating other problems. So yeah, if we lower interest rates right now, we take the edge off of economic growth slowdown that we’re facing. We take the edge off the debt and deficit doom loop, but we do it at the cost of very likely re-accelerating the inflation problem. And again, the inflation reaching 9% is what started this whole thing.

David: And raising rates or leaving them elevated, more elevated than they have been in recent years, seems to exaggerate the fiscal crisis.

Morgan: Absolutely. Also, it’s a big drag on the economy.

David: What about the potential scenario of fiscal crisis and inflation simultaneously?

Morgan: I suppose that is—

David: Heartwarming?

Morgan: No, if one had to look at the situation right now, you’d say that’s probably the path that we appear to be on. It’s a very frightening future to spend your way into an inflationary crack-up boom. It’s not a world anybody wants to live in, so I hope policymakers would not travel too far down that plank, but anything’s possible.   

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Kevin: As Dave continues to talk to Morgan Lewis about the economic picture, we want to remind our listeners to send questions for our questions and answer program to [email protected]. 

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David: Just a few months ago, we were getting ready to do our quarterly review for clients, portfolio review, and we do this every quarter. Four weeks out, three weeks out, two weeks out, one week out, we’re looking at our notes and updating things. And even on that kind of a timeframe, we were having to update our slides, because the debt numbers were growing by a hundred billion, another a hundred billion. It was funny, but not funny how quickly we were out of date.

Morgan: Yeah, absolutely. I remember just having to constantly refresh the deck.

David: So let’s go back to BRICS. I mentioned earlier, the benefit that we had from globalization was a diminishment in the price consequences of inflationism. We were importing deflation through lower pricing of finished goods, and that helped for a long time. Now we’ve got something that’s interesting; post-COVID, deglobalization is more of a trend, and that underscores or buttresses this inflationary problem, whether you’re looking at inflation as a purely monetary phenomenon, relating to monetary policy. Here we’ve got input costs which are going to be a factor, and fabricating costs which are going to be a factor. What do you think about the input costs? What do you think about the BRICS and the fact that they control 75% of the world’s hard assets, the global natural resources? How do you square these global transitions away from a cohesive; let’s just grow the pie and we’ll all be better off, to now more of an isolationist, we got to take care of our own mentality, with the BRICS controlling 75% of the world’s natural resources and us having to figure out how to navigate a lower inflation world. We’re not in control of the inputs, labor or resources. So, it makes me think, “Goldilocks, really?” You can hope for it, but is that even tenable?

Morgan: There’s a lot there. As far as inflation goes, there’s no doubt in my mind that we have entered a new era of secularly higher inflation than what we were dealing with over the last 20 years. The question would be, how much more inflationary? Where do we settle as far as a new baseline on inflation? But all of the things you mentioned are factors. Some of them are speculative and some of them are less speculative. And I would just start with pointing out that, for one thing, the monetary policy that we have had for the last 20 years where central banks have essentially tried to backstop financial assets in the pursuit of creating a positive feedback loop between Goldilocks conditions and the positive wealth effect in markets, one of the side effects of that, again, back to unsustainability, one of the unwanted side effects of that is that money has been incentivized to invest in financial assets. It has a central bank backing essentially.

So, what happens in that environment, well, natural resources, real assets tend to be neglected, there’s not so much of a central bank backing for an oil project or a copper mine. So there’s less capex put into the real world and into the real economy, and that over time has a very negative impact in terms of the supply side of global commodities. So, in the West we have underinvested chronically in hard assets. So we have a supply problem, and to your point, 75% of global natural resources being under the BRICS umbrella means that if they wish to, they can weaponize their holding of commodities, they can charge higher prices, they can create inflation if they wish to. So, I would call that more speculative. We don’t know that they will do that, but we do know that our own policy is creating a vulnerability on our end, on the inflation front.

Furthermore, back to the point we were making before about the intent for the Fed to raise interest rates to slow down inflation on 34 trillion of total debt, the interest rate break is essentially compromised. So we’re entering in a secular era of what looks very likely to be higher levels of inflation—

David: Without a break.

Morgan: —without a break. These are exactly the things that a market like gold will look at and say, “We have a problem.”

David: Yeah, it’s going into a crisis without a general, going into the ’70s without a Volcker. You have to have a will, you have to have the tool set available and the willingness to use that tool set, compromised on both fronts.

Morgan: And inflation is just one of the issues. The debt and deficit thing, I can’t emphasize this enough that what we’re dealing with in the debt and deficit thing is another problem, that it doesn’t just hurt us on the interest rate front, it also is starting to affect Treasury issuance. We’ve seen Janet Yellen start to issue a disproportionate amount of debt onto the short-term end of the Treasury curve and avoid issuing long-term debt, presumably because there’s an illiquidity problem on that side of the Treasury curve.

David: And by the way, this week is a case in point; you’ve got issuance of 3s and 10s and the market hasn’t really liked what they were given; a couple hundred billion in IOUs and expected to pay X and have to pay up for that. The market is saying, “No, we have to be compensated more,” which was a disappointment for the Treasury Department.

Morgan: Right. And then we also have a slowing growth environment. It amused me a little bit in a sad kind of a way, but just a couple days ago, Biden was out saying that—and again, I’m not trying to cause a political issue. I tend to think that both parties are equally to blame. But Biden was out a few days ago trying to encourage the Fed to stop raising interest rates, and I believe he described our current economic environment as “an economic sweet spot.” I think that’s rather comical. If one takes a look at where we are economically, look at the leading indicators in the economy, and we’ve had the Conference Board’s LEI, the Leading Economic Index, in decline for 19 straight months. That’s the third-longest decline we’ve ever seen in the history of the leading indicator.

David: And to this point—it may change of course—but to this point it’s axiomatic; that kind of a decline in the LEI leads towards recession.

Morgan: Absolutely. Unless this time it’s completely different. Again, this is the third-longest streak of a decline. It gets even worse, though. We’ve had 13 straight months where the decline has been to the point of actually reaching the threshold that the Conference Board calls the recession threshold.

David: So you’d basically argue that the growth we saw in GDP, even though it was a super strong number, over 5%, you want to put an asterisk by that and say, “Yes, but look at the amount of government deficit spending that ginned that up.” So, certainly as a headline, it’s impressive, but the reality is, and as you mentioned, going back to the BIS’s numbers, 85% debt-to-GDP, and any growth that you think you’re generating from the increase in debt is actually negative, going forward, not positive. So, you can feel good today, but that’s almost like shot of whiskey feel good. Yeah, wait for the hangover, because that is now a part of the math equation.

Morgan: Right, that is the equation. If you look at the breakdown of the economy, 25%, maybe pushing towards 30%, is government spending. That’s booming. You look at the rest of the economy, the private sector, that’s interest rates, that’s struggling, that’s struggling under higher rates. The leading indicators are telling us that the private economy, the private sector is headed towards recession. And again, if you want to listen to the BIS and what they have to say about spending at this level of debt-to-GDP, if you want to look at Lacey Hunt’s comment about the negative money multiplier of government spending after three years, what we have here is a private sector that we’re going to need to fall back on that is headed very distinctly towards recession based on the leading indicators of the economy. The leading indicators have not been advertising recession for one or two months, but 13 straight months where the leading indicators have been below the historical recession threshold set by the Conference Board. And again, that’s the third worst in history as far as the performance of the leading economy, and it’s still deteriorating. By the time this whole thing is over, maybe it’ll be the worst performance of the leading economy. We don’t know yet.

David: Okay, so to brass tacks, because we don’t get paid for speculating around ideas, we do get paid for placing bets and having them on the right side of a trend, the market is positioned for a Goldilocks scenario, if you’re looking at the equity market today. Let’s talk about asset allocation. And this is obviously a complex environment, but let’s look at a long-term view and a short-term view, where the long-term, you could say that our approach has been to focus on hard asset exposures, where there’s still very good value to be found. Makes sense, long-term. Could be tricky short-term. Just talk a little bit about asset allocation, in the event that the Goldilocks scenario doesn’t come to fruition.

Morgan: Financial assets appear to be priced very sympathetically with a future of perpetual Goldilocks, does not seem at all likely to ultimately materialize. So, you have to anticipate some serious vulnerability to the pricing structure within financial assets at the moment. Commodities are hard assets, can be broken down into several categories, but essentially the economically sensitive commodities, they have vulnerability. We don’t exactly know how this cycle is going to play out. Like we were trying to cover earlier, the number of avenues of unsustainability are numerous, and which one manifests first and how it manifests will ultimately matter in terms of price performance in various assets. So, if government spending cannot continue to prop up the economy and we slide into a recession, economic demand’s going to take a hit, and economically sensitive commodities are likely to have a rough patch before, ultimately, I think a very positive trajectory going forward in the longer term.

But given all of the uncertainty, I think you can settle on gold at the moment as a economically insensitive form of financial insurance, which I think plays perfectly with a moment where financial assets are still clinging to the notion that policymakers will manifest this bright and glorious future of Goldilocks. When that becomes increasingly obviously a figment of the market’s imagination, I think you’re going to see a scramble for financial insurance. And interestingly enough, I think we’ve seen a bit of a microcosm of that dynamic already play out, something we’ve talked about and we’ve seen in the futures market for gold, we’ve seen that the character of gold holders in the futures market has shifted over time.

There’s an analyst Chris Rutherglen that made me aware of this point back in 2020 or 2021, but looking at the futures market, it had always been the case for at least 10 years prior to COVID where the hot money, hedge fund, momentum trend-following crowd would buy into gold or sell gold just based on price performance. They would buy strength, they would sell weakness, and it was a little more than a momentum trade. What has happened since COVID is increasingly obvious unsustainability of government policy was increasingly on display with the response to COVID. And I think, as a reaction, what you started to see was much more of the investor community step into the gold futures market. Now, I still think this is a small group of people, but I think we’re talking about the first movers who started to make the connection between unsustainable policy, the reaction to COVID, the problems that would come from that, the problems of either stopping what we got started with COVID or doubling down on the same unsustainability going forward. I think what you saw was that in the futures market, the tendency for the hot money traders to hold the majority of long futures contracts shifted towards stronger hands, shifted towards an actual investment cohort. We’re talking about insurance companies, pension funds, family offices that started to step in and, rather than trade gold just as a financial instrument that was either falling or rising and needed to be traded, these were actually investors that were buying on the thesis of, I think, policy unsustainability. It’s been interesting. So that we’ve seen that shift happen in the gold futures market just this week to manage money. The sort of—

David: Hedge fund guys.

Morgan: Hedge fund, hot money crowd, they jumped out.

David: Cranked up last week and then popped out this week.

Morgan: Right. And yet on the decline this week, we saw big buying from the pension funds, the insurance companies, and the family offices. So, again, what we’re seeing is the floor in gold price get established at higher levels because we have real investors that are stepping in and buying weakness. So this is a new phenomenon, and again, I think this is just so far the tip of the iceberg. I think it’s a small cohort within the investment community that’s participating as investors in gold. But I think that as the confidence bubble breaks, we’re going to see this phenomenon that is currently something of a microcosm. I think it’s going to become a much more obvious phenomenon where trillions of dollars may be moving in the direction of financial insurance as uncertainty grows and people who have been able to take for granted a continuity of business as usual have to rethink their positioning.

David: So just to summarize, you like all hard assets with a strong demand component, but recognize that you could have drawdowns either on a liquidity event or a recession. And so you have to operate with some caution as we get through the disappointment of the Goldilocks hoped-for scenario. So then the highest conviction allocation, if you’re talking about a hard asset portfolio, is with the less economically sensitive metals, gold in particular.

Morgan: Right. I think so because if we have a liquidity event, if we have a deep recession or anything like that, I think gold will suffer to some extent, but it’ll be shorter and more mild. The economically sensitive commodities will be damaged for longer and deeper. And then I also think that the safe haven properties of gold in that environmen and gold in light of what would likely be a government response to a recession, an inflationary response, I think gold would in short order move appreciably higher in that environment. So there’s some downside risk to it, but I think it’s the most immunized. And then, if we don’t have a recession, I still think that probably means that we’re looking at government spending and inflationary environment in which I think gold will do very well in that environment as well.

David: Okay. So if gold’s a highly relevant allocation, then the case for mining stocks as a trade may improve. Maybe that needs a few qualifications, but when it’s game on for the physical metals, mining stocks can be interesting. Talk to us about relative outperformance, again assuming that we’ve got some legs in the physical metal market.

Morgan: Yeah. My experience is that in various cycles within the precious metal market, we always have bear cycles, we have bull cycles, and in each bull cycle there tends to be a different leader. The last real cycle in 2008 through 2011, silver was the leader. We had distinct outperformance in physical silver. My bet would be that this time it’ll be in the mining shares. And I think there’s a value trade that has been setting up within the precious metal sector for at least 10 years that I think is absolutely ripe, and I expect to lead with significant outperformance of the upside when gold prices break out and sustainably move higher in all-time highs. We already have a situation where the companies are as financially healthy as they’ve ever been, they are as well run as they have ever been, and yet their relative value to physical gold’s about as low as it’s ever been.

So I like that dynamic quite a bit. I think they’re still being punished for sins that were committed during the last cycle. They were bad, they were egregious. They took on way too much debt. They assumed that the price of gold would go higher infinitely and made some poor decisions along with that train of thought. When gold suffered a bear market, the mining stocks were completely out of tune and vulnerable. So I think that the hangover from those mistakes and from that disastrous period in the mining shares is still priced into the mining stocks. But at the same time, I think management strategically has learned a very dear lesson. And I think that they’re actually performing now very well and managing with a great deal of discipline.

And so we’ve never seen a situation here where the mining stocks, from a balance sheet perspective and a management perspective, are looking about as attractive as they’ve ever been and are as healthy as they’ve ever been, where one can look at the physical market and say, “We should get a further breakout in physical gold from here.” And that just translates directly to margin expansion for the miners on what is already a very healthy bottom line. And that’s something we’ve never seen before, but I think that will charge a relative value play where mining shares claw back an enormous amount of value that they’ve lost relative to physical over the last 10 years.

David: It seems to me the asset class is fairly differentiated, but not obviously so. You’ve got notorious promoters in the space which know how to tell a great story, but know nothing about running a mine from an operations standpoint. It’s a joke, and you kind of have to have all the stars in alignment between great assets, great operators, great balance sheets, great geography, great cost structure. That, as you begin to dig into the details, that differentiation— Again, not all mining companies are created equally. Some are just storytellers and snake oil salesmen, and then there’s really quality operators. What are you looking for in producing companies? What are you looking for in prospective companies? Sometimes we talk about generational assets and things like that, but as we construct our portfolio, how do you separate the wheat from the chaff?

Morgan: Primarily starting with two points. One is absolutely to your point there, you want to find the best in breed from a management perspective. You want to always be associated with the teams that you believe in and that are certainly not selling snake oil. You’re looking for those kinds of companies. And then, on a separate note, you’re looking for those companies married to assets that you think are the best in the world. And when you can put the two together, when you can put the right people with the right asset, that’s when things get exciting. So at that point, it just becomes a game of price, paying the right price. So to your point, you mentioned generational assets. What we’re focused on right now is, I think I’ve already shown my bias as far as what I think the future holds in store for the price of gold, but I think there’s also a asset scarcity issue that we haven’t talked about.

And back in the ’90s, for example, when you’re looking at major gold discoveries during the decade of the ’90s, we had 180. If you fast-forward to the 2010s, that number of major discoveries over the decade drops to 40. And we’ve had none since 2019. So it’s getting a lot harder to find good assets. It’s getting a lot harder to find big assets. And again, that points towards a scarcity issue in the future. So I think in light of that, our main focus has been twofold. Assuming that we’re always looking for the right operators and the right management teams, then when we turn our focus to the right assets, I think we’re looking primarily at generational assets, which can be defined as assets that are in production for two decades or more and where their production rates will be steady, if not even increase in time.

That stands in comparison to your average precious metal asset that may have a six to nine year mine life on decreasing rates of production. So we think that the best generational assets in the world offer a great anchor for a precious metal mining portfolio, particularly in the hands of great operators. So we are very much on the lookout for those assets, and have patiently waited for prices to enter attractive levels in terms of waiting for a sufficient discount to net asset value on those companies that we like the most, that have those best generational assets. And so far, we’ve been able to gain exposure to 13 of what we think are the 15 best generational assets in the world. And on the other hand, we’re also obviously looking for the gold of tomorrow, and then that means the new discoveries out there.

David: So 13 of 15 of the best world-class assets.

Morgan: Right, exactly. Waiting for the last two laggards to get crushed in price so we can buy them on the cheap.

David: I like it.

Morgan: But also we keep our eye out on the best new discoveries out there. And the best way to do that is to take into account several factors. One would be below initial capital expenditure necessary to get the operation running, and then looking at that in conjunction with high production rates and a low all-in-sustaining cost profile. And the new discovery assets that are out there in the world that rank best on those criteria are very interesting in a world of increased resource scarcity going forward. So we’ve identified what we think are 22 of the best, and to date managed to get exposure either through royalty, agreements, or outright ownership of the controlling company of 17 of those 22.

David: So 17 of the 22 best prospective mines in the world. And you’re taking into account geography and likelihood of coming to market with those ounces, not just stuff that is really intriguing, but inaccessible, I mean, comes to mind, the Pebble project, unbelievable copper and gold discovery not coming to market. Why? The environmental lobby has said no. Not only no, but hell no. So it doesn’t matter that there’s millions of ounces and potentially billions of tons, good luck. So you’re talking about 17 of the 22 which are feasible, which are in motion coming towards production.

Morgan: Yeah, always. There are instances where an asset will be perhaps priced for not getting approval, where the market is skeptical that environmental problems will arise or something like that. I mean, if we disagree with that, that would be one thing, but generally speaking we’re talking purely about assets that we think have a pretty straightforward path to production.

David: It comes to mind, there was a time in life where you spent a lot of time on the ice, and I did too, just an earlier period of life. I played for the Mini Mites, practiced at the DU Ice Arena. We were the halftime entertainment, little grommets tripping over each other. I decided since I couldn’t skate, I’d play goalie. You’re used to skating to the puck. In essence, that’s what you’re describing, not only with the gold market today as we come to terms with the inability to deliver on the Goldilocks scenario, but then the ramifications of that into the financial markets and specifically financial assets and how that passes through or how the dominoes line up and fall, impacting hard assets, gold, the miners, and things like that. It sounds like this is just practice coming together and now game time is in. The game has commenced.

Morgan: Always. Yeah, I think that’s a hundred percent right. As you mentioned that, it makes me think of Bob Farrell, the Merrill Lynch legend, and his quote, “In a shift of secular or long-term significance, the markets will be adapting to a new set of rules while most market participants will still be playing by the old rules.” And I think, when it comes to markets, it’s always where to have your head is to be looking for mispricing in the form of markets playing by rules that are no longer applicable. And I think that’s exactly what we’re watching with financial assets right now. I think that’s what we’re watching with the progression of unsustainable policy. I think gold is ready to be repriced in light of a new reality. And I think the only reason we’re able to get some of these great prices in some of these mining shares, for example, is because the majority of market participants are still playing by the old rules.

*     *     *

You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany and our guest today, Morgan Lewis. Just a reminder, please send your questions, if you’d like David to answer them, to [email protected]. That’s [email protected].

This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.

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