Quality & Scarcity: Keys for Higher Gold
During the brief, holiday-shortened week on Wall Street, economic data again came in stronger than expected and global interest rates continued to march higher. The reality of a higher-for-longer regime of global interest rates is beginning to sink in for financial markets. Higher global stock markets have created something of their own microclimate. As stock prices rise, financial conditions loosen, financial liquidity increases, and the economy receives a stimulus effect. At the same time, with the highest interest rates in over 15 years being paid out on record government debt, the government is paying roughly a trillion dollars annualized into the financial economy. Much of that interest expense goes back into the financial institutions that hold that government debt. Those financial institutions (hedge funds, sovereign wealth funds, pension funds, insurance companies, family offices, and more) are then further recycling much of that interest payment money back into financial assets. It’s something of a financial market positive liquidity feedback loop that keeps asset prices elevated.
For now, as inflation has cooled from the highs of last summer, financial markets can interpret the current dynamics as a goldilocks environment of still sufficient economic growth, abundant liquidity, and falling inflation. Goldilocks perfection!
The problem, however, is that Goldilocks looks temporary for several significant reasons. First, the trillion dollars of government interest paid on debt is now contributing to a $2.1 trillion total annualized U.S. government deficit. One way or another, that likely means more dollars will need to be created and Treasurys issued in order to finance deficits. In other words, the underlying problem of an unsustainable government fiscal path is only getting worse. Second, while interest payments on so much debt have a stimulative effect on the financial economy and financial asset prices, higher interest rates still crush the real private sector economy on a lag. Recent stronger-than-expected economic data has once again replaced the “pause” narrative about a Fed that is finished hiking rates with a credible and reinvigorated higher-for-longer rates narrative. With that, and with tighter bank lending, a hard-landing outcome continues to be a base-case assumption. Lastly, while down-trending inflation metrics keep the current Goldilocks narrative intact for now, that may soon be set to change.
After July, the base effects for year-over-year inflation metrics become much more challenging. What that means is that real-economy prices will have to cool much more substantially than has been the case so far in order to continue to pull year-over-year inflation readings down towards the Fed’s 2% target. In addition, as HAI has mentioned in the past, energy prices are the great inflation force multiplier. Energy, as a key input cost, gets into everything. Over the last year, energy prices have fallen considerably. This falling trend for energy prices is currently in jeopardy. In draining the U.S. Strategic Petroleum Reserve (SPR) at the fastest pace in forty years to the lowest levels in forty years, the U.S. government went all-out over the last year to lower energy prices and reduce headline inflation. That’s an unsustainable game, however, and that ace is no longer up the government’s sleeve.
At some point, the government will no longer be able to draw down the SPR. In fact, authorities will come under increasing political pressure to refill it. At the same time, something getting precious little attention at present is that U.S. shale production looks like it’s beginning to roll over. Not only is the Baker Hughes rig count now at two-year lows, but legacy decline rates at the big-four U.S. shale basins have now been accelerating for the last 9-months. U.S. shale production has been responsible for 90% of all global oil production growth for the last decade. The average decline rate has accelerated from 5.8% last August to 6.4% as of June. At this point, there are only six counties in West Texas responsible for 100% of all non-OPEC+ global oil production growth, and that growth is waning. With the SPR also largely tapped out, that means OPEC+ is once again emerging as the marginal global price setter for oil. Unlike the U.S. administration, however, OPEC+ wants higher oil prices and is now cutting production to achieve that goal.
If U.S. shale production is rolling over and the SPR is increasingly sidelined, then the U.S. appears set to lose control of energy market pricing. If OPEC+ gets its way, then we are likely going to contend with a global oil supply problem that, by extension, means a reinvigorated global inflation problem just as the base-effects on inflation metrics become much more challenging. In such a scenario, higher inflation for longer means higher global interest rates for longer. That then means, with so much U.S. government debt outstanding, that still higher U.S. debt and deficits are a very likely reality in the foreseeable future. This entire sequence is likely to amount to increasing stress on the bond market, especially the Western Sovereign debt that serves as collateral underpinning most other asset classes. It’s all a complicated set-up with a simple likely outcome – an increasing supply of Western debt, deficits, and Treasury issuance ultimately weighing on the currency.
Recall economist Henry Hazlitt’s observation that “the value of any monetary unit, such as the dollar, depends not merely on the quantity of dollars but on their quality.” Powell’s pickle is that the quantity of dollars and Treasurys appears set to increase substantially as the Fed is forced to finance deficits in the years ahead. That will cause the quality of those dollars and Treasurys to suffer tremendously as the pile of debt reaches increasingly staggering proportions. Meanwhile, gold, with no counterparty risk, offers pristine quality as well as the crucial characteristic of increasing scarcity.
Consider recent findings from S&P Global confirming that there were roughly 180 major gold discoveries of over one million ounces in reserves in the 1990s, 120 in the 2000s, 40 in the 2010s, and none since 2019. With the increasing difficulty of finding new high-quality gold discoveries at scale, we are seeing major gold miners turn to an acquisition strategy in order to replenish, and in only a few instances, increase reserves. The acquisition game, however, can only be played for so long before substantial new discoveries are needed to meet demand. As ever, higher prices will be required to make the increasingly more costly and difficult-to-mine resources economical to unearth. As dollar and Treasury quantity increases and quality decreases, expect demand for gold—already incredibly strong at the global central bank level—to grow even stronger throughout the retail and financial sectors. Growing demand in the face of increasing underlying scarcity equates to expectation for higher future prices. Given the unfolding dynamics on all sides of the fiscal and monetary universe, the relative strength in gold prices during the post-Covid era likely represents a strong floor for price, while the ceiling has yet to be defined.
HAI continues to anticipate upside price discovery in monetary metals over the months and years ahead. In the context of what promises to be a red-hot printing press in perpetuity, monetary metal scarcity never looked so good. While gold promises to deliver wealth preservation in such an environment, gold stocks, with their positive leverage to higher gold prices, will upon a confirmed breakout to new all-time highs be a means to deliver not just wealth preservation, but wealth creation.
Weekly performance: The S&P 500 lost 1.16%. Gold held nearly flat, up 0.16%. Silver gained 1.17%, platinum was up 0.58%, and palladium gained 1.89%. The HUI gold miners index was off 2.39%. The IFRA iShares US Infrastructure ETF lost 1.31%. Energy commodities were volatile and mixed on the week. WTI crude oil was up 4.56%, while natural gas lost 7.72%. The CRB Commodity Index was nearly flat, down 0.03%, while copper gained 0.59%. The Dow Jones US Specialty Real Estate Investment Trust Index was flat on the week, and the Vanguard Utilities ETF was down 0.24%. The dollar was down 0.62% to close at 101.95. The yield on the 10-yr Treasury surged 25 bps, ending the week at 4.06%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager