The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: As promised, David, you have returned from Shanghai with some information about the gold market. For the listener who is just now tuning in who maybe owns gold and is asking, “What are we looking at China for?” I think the main reason we are looking at China is that U.S. demand for gold is about 5% of the market. In China, what is the demand relative to the United States, for gold in China?
David: Right. When looking at the physical gold market, the U.S. accounts for 6% of total global demand, and China and India combined are over 50%. What we are witnessing is a rapid revolution, or even evolution, of the controlling interests of the metals market, and it is very evident that the hand-off from the U.K. markets to the U.S. markets is being repeated again here in history with the baton being passed to China as we witness it now.
Kevin: So what you are saying is, England used to be the place, London was the place that controlled the gold price, and the demand, and then it was handed off to the United States for 60 years, maybe?
David: Yes, and volumes in London are still the highest in the world, but you could say, between London and New York, they are the controlling interests. I think, when I look at the role that gold has played in our economy, I’m thinking, also, not just of the quantities and volumes, but the implication of the gold holdings and what that enabled the underlying economy to become and develop into. So you had the greatest economy in the world, the British economy; that baton was passed, along with the gold standard from the pound sterling to the U.S. dollar.
As our currency gained legitimacy and credibility, so did our economy grow and expand in terms of its international reach and importance, and I think we are seeing that, too, in China. We have had investor demand here in the West, which has been very fickle, particularly this year starting in April, and the East will end up dominating the gold market within 36-48 months and they will become, not just the price-takers that they are today, buying on cheaper prices, but the price-makers of the gold market on that kind of a time frame.
Kevin: We talked a few weeks ago about how you and your dad were there in China, very similar to why your dad was in South Africa years ago, when South Africa was the dominant player as far as production of gold. Meeting with the World Gold Council’s Albert Chang, that was an important meeting for you because he is the representative for the World Gold Council in China, and that really is where the action is in gold right now.
David: And he covers all of Asia. He will be our guest on the Commentary in a few weeks, and you will want to make sure to listen in for that. But some of the things that we’ve reflected on are above-ground stocks. This is the total gold which has ever been mined, pulled out of the earth, of about 174,000 tons. That is, in dollar terms today, the equivalent of about 7.4 trillion dollars. Half of that, 50%, is in jewelry, 17% is in the official sector, or what they would call central bank holdings, and 20% is private investment, and there is another 13% which is sort of a random mix-match of things. But that 20% of private holdings, private investment, exceeding the official sector, that displacement took place just a few years ago, with individuals now controlling the market far more than central banks.
Kevin: Just to put in perspective, Dave, you said all the gold that has ever been mined, that we know of, is 7.4 trillion dollars’ worth. That’s an amazing figure when you figure that our deficit is over 17 trillion dollars. So we couldn’t pay the American debt off even if we had all the gold in the world, and we don’t.
David: And to be fair, that’s not all of the gold that is available for purchase at any price. You have to realize that much of the gold which has been purchased will never come back to the market at any price, and that’s particularly in that 50% category. A lot of that is wealth that is worn, so whether it is India or China or frankly, jewelry that I have bought my wife, not that it’s on any kind of a comparable scale, but I think you do see sort of a permanent holding.
And that’s something that goes from one generation to the next. When a granddaughter inherits a gold ring from her grandmother, this is the kind of thing where it’s an honor to own it, and it would be almost sacrilegious to go ahead and melt it down. Somehow you would be offending the grandparent that had gifted you so generously. That’s the notion of, again, half of the gold stock is not even available except and unless you are the divorcee who wants to get rid of the wedding ring. (laughter) Obviously, there are instances in which the jewelry becomes expendable.
Kevin: Maybe we can discuss scrap gold, which is what you are talking about in that situation, a little while later. But given this year, Dave, we have watched the United States move back into the stock market, we have watched people have unusual faith in a dollar that even the guy who was head of quantitative easing has come out and said you had better not put too much credence in. But the Chinese support for the market, the Chinese have just been buying more, and more, and more, as the United States has waned.
David: It has been absolutely critical, and prices would have been far worse this year had it not been for Chinese demand. We saw this primarily in the second quarter of this year. If you are looking at year-to-date numbers, we have seen a decline in demand, in total, of about 12%. That is in aggregate, it includes a rip-roaring increase of jewelry demand by 20% and investment demand, which has fallen in half. It was, primarily, again, in the second quarter, because third quarter declines have only been about 4%. Central banks are still buying several hundred tons this year, with Turkey and Russia being at the top of the list, and it is not as aggressive as 2012, the official sector or central bank purchases, but still fairly impressive, and well above the liquidations. Because remember, on a net basis, we were seeing liquidations as recently as 2009, and now we still have several hundred tons in net purchases.
Kevin: I think it is interesting to note, Dave, we may be decreasing our buying here in the America because we have more confidence in making money in the stock market, as a country, but the Chinese buy gold for a different reason. We have had the reserve currency now for half of a century, and they are looking at America and they are buying gold for a completely different reason. They are looking at our labor market. They look at how we adjust for unemployment. They look at how the Federal Reserve is trying to print money to increase the employment rate. So what were the observations from the Chinese side?
David: I think the simplest observation came on the plane ride over, sitting next to two folks who were just returning from the Los Angeles area, they had been on vacation there. The man works at power plant just out of Shanghai, has been there all his life. I told him that I was going to meet with a number of people in the gold industry, from around the world, and he said, “Oh, gold, we love gold.” And I said, “What do you mean we? We, as in you and your wife, or we, the Chinese people?” He said, “We, the Chinese people.” I said, “Tell me the primary reason why.”
And without skipping a beat he said, “Ten years from now my savings will not buy what they should if I just put my money in the bank. That’s why Chinese people like gold.” And I thought, in a nutshell, he has understood the nature of inflation better than I think any American I have ever met, because 1% per year, while it’s a nuisance, it is not a dangerous thing to encounter 1% inflation, 2% inflation, 3%, which is the current inflation rate in China right now, 3%, with a 3.5% target. But he is basically saying, you take that 3% to 3.5% target over a ten-year period, and you have just devastated, compounded negatively, your savings by 3.5% per year, and that’s the PBOC’s target? You have devastated your savings. He understands that one year does not a tragedy make, but ten years, and you are so far behind the curve as a saver, you can never meet your financial objectives or goals in life.
Kevin: I think of Americans thinking that they have free press and that we have much freer minds than they do in Communist countries, but I hate to say it, Dave, the people that I have learned more about America from are the people who have been through the propagandized media for so many years, the Russians, the Chinese, and these guys are looking back and they are saying, “Can’t you even see that they’re misreporting the CPI?”
David: There was a massive contrast between the folks that I met with, a number of precious metals analysts who work for major Wall Street banks, that’s both European and U.S. banks, and their assumptions all tied to official U.S. government statistics. It was interesting because one of the first Chinese economists to share his ideas started by saying, “Listen, if the labor market improves substantially, you will see the U.S. unemployment rate increase.”
Kevin: That sounds counterintuitive. He said if the labor market substantially improves, the unemployment rate would increase.
David: And that is because you look at the labor participation rate and it has been in decline. We now have the labor participation rate at levels we haven’t seen since the 1970s, and if anyone is paying attention, not just to the 7, 7.2, 7.3 number, if they are paying attention to how we compute that number, what you find is that we have seen shrinkage in the people who are in the labor force.
Kevin: Sure, they fall off after a year anyway.
David: And that has improved the number significantly, far more than the addition of new jobs. They are keenly aware of this, keenly aware of this, and again, we are recalling that if you held the labor participation rate constant over the last five years, the unemployment number, today, would still be north of 10%. So what are we looking at, an improvement in the economy? Because, I tell you what, the analysts who were negative on gold were so on the basis of a recovery in employment, and yet it was the Chinese who were saying, “But we look at that employment number with a somewhat suspicious eye.” Another Chinese metals analyst from a very large Chinese bank who started by discussing U.S. inflation, and how frankly inadequate the CPI was as a measure of real inflation.
Kevin: Let me just insert here, we just talked about employment, and now we’re talking about inflation, which is monetary stability. The two mandates of the Fed that we talked about with Andrew Huszar were employment being misrepresented and CPI being misrepresented. What did have to say?
David: It was interesting, because again, you look at the U.S. and European precious metals analysts and their core assumptions were low inflationary environment, economic recovery in the United States, improving labor market. All of these spell lower, significantly lower, gold prices.
Kevin: They were drinking the Western Kool-Aid.
David: And I think the Chinese are just happy to hear us spout that stuff because it provides an opportunity for them, and that’s an opportunity they have been taking advantage of, and you can see it in the tonnage imports through Hong Kong.
Back to the inflation issue, the discussion centered on how higher the rates of inflation are in developing countries. And one of the points suggested was that you are not really looking at an apples-to-apples comparison, because the U.S. uses one methodology for calculating inflation, but every country uses its own unique methodology for counting inflation. It’s not the same equation. And lo and behold, when you look at the BRIC countries, whether it’s Brazil, Russia, India, China, or your other developing countries, less developed, even, than those four big ones, you see higher rates of inflation, but that is, in part, because they are not as practiced in the art of obfuscation, in the art of hiding real inflation rates.
Kevin: And we can hide real inflation to a degree, just like we can keep interest rates unusually low, because we are the reserve currency of the world, but David, isn’t the renminbi turning into an international currency, far more than what it had been, say, five years ago?
David: An incredible improvement in cross-border use of the RMB, and this is where their currency is becoming much more important with their primary trade partners on a global basis, and even more powerfully right now on a regional basis, and for them to really step into their own, and have the RMB become a significant force in the world monetary structure, you are looking at this subtle accumulation of gold ounces by the PBOC. We’ll talk about that in a few minutes. But really, the things that are helping the Chinese gold market mature, target-setting, and reaching their objectives, and an improvement in technology and trading, which they have moved leaps and bounds in a very short period of time, two places come to mind, both the Shanghai Gold Exchange, as well as the Shanghai Futures Exchange, a different exchange.
Kevin: And it is important to point out, gold is exchanged physically, and it is valued physically, in China, but we set the prices, even though we have 5%, 6% of the demand, we set the pricing of gold, basically, with our futures market here.
David: Because the volumes traded in futures contracts ultimately dwarf anything in the physical market today, 30 times, at least, and in high-trading volume days you can have it dwarfed by 100 times. The Shanghai Gold Exchange is the physical market hub in China and they currently work with four million individual investors, 7,000 institutions, and they continue to tailor products for further segmentation of the market. Again, physical market hub, in contrast with the futures exchange, also there in Shanghai. This is your primary distribution to jewelers, and this is what is really intriguing to me. Fourteen different banks, obviously primarily state-owned banks, with now over 100,000 branches distributing gold, both in physical formats and via gold-backed savings and deposit accounts.
Kevin: So don’t tell me the Chinese don’t love gold, I mean, 100,000 branches. Obviously people are buying and selling gold.
David: When I go to a local bank here in Durango, Colorado, I see posters which advertise the insultingly low interest rates offered on 1, 5 and 10-year bank CDs, certificates of confiscation, I mean, deposit. We walked into a number of branch banks, both for the Agricultural Bank of China and the Industrial Commercial Bank of China, two of the largest banks in China. In terms of rankings for international, looking at the market caps of large banks in the world, they rank up in the top ten. Their branch banks have posters with gold bars stacked on each other, and this is what you are putting your investments into. This is what you are putting your savings into.
Kevin: They’re not trying to earn interest right now, they are trying to accumulate preservation.
David: Right. Now, they can take delivery of their savings or deposit accounts denominated in gold, from a paycheck or what-not, adding to those deposits they can do it in as small a fraction as one gram of gold. Or they can actually just buy and take physical delivery of gold, and we’ll talk about bar demand for gold in just a minute, but the futures exchange is very different.
Kevin: This is the paper side of the market.
David: The futures exchange in Shanghai ranks #3 globally, with every expectation in the future to exceed NYMEX volumes and take out the #2 position that is NYMEX COMEX, and be that #2 right behind London. This is what is intriguing. The U.S. and London are still determining the price, but will not do so forever, and it was very clear from the Chinese, in translation, of course, that the goals and objectives there in China were to develop the infrastructure, the technology, and the trading capability to not just be price-takers, but be the price-makers in the gold market.
Kevin: Let’s put it in perspective, then. What percentage do they do now, of what would be traded normally on our commodities exchanges here?
David: They are currently about a quarter of what COMEX trades in terms of gold, and in terms of silver trading, they actually exceed COMEX trading in silver. That’s astounding, for an exchange that didn’t exist ten years ago. By year-end 2014, they will have 24-hour trading, and they are now in the process of developing an options market, as well. They are very close to having 24-hour trading now because this year they opened up another window from 9:00 p.m. until 2:30 a.m., and that now accounts for close to 50% of their volume. So they are seeing very active trading, even through the evening session, and they are very close to having 24-hour trading capacity.
Kevin: In a way, they have to take the horse by the reins because they are the primary market. Haven’t they even exceeded India’s demand at this point?
David: They have. China exceeded India in demand this year and that’s another category of displacement by the Chinese. The Chinese displaced Japan as the #2 economy in the world here recently. Yes, they displaced India as the #1 consumer of gold. Just one word on India, because there was some comment given in our conversations and discussions there. The rupee has been incredibly weak, and it is important to remember that when you price an asset in a weak currency its price will be higher. So the Chinese market and the Indian market are both price-sensitive consumers. They are buying gold, and if it’s on sale, they buy more.
Kevin: The lower it goes, the more they buy. That’s opposite the West.
David: It very much is the opposite, and we didn’t see as much Indian demand this year, but it was still close to 1,000 tons. I think 832 was about the tonnage imported, and of course, that’s with import restrictions, as well as a very high import tax, with a combined duty and premium putting the price of gold, in some instances, as much as $200 above the spot price. So Indian demand, even with, at times, that $200 premium, was fairly robust, although you could say it suffered as a consequence of gold, in rupee terms, being incredibly high. You see what I’m saying?
Kevin: And the other thing we have to take into account, we watched Pakistan’s gold demand go up 830% over the last quarter, so some of this gold coming into India is not necessarily being measured. What we are talking about are official gold demand numbers.
David: That’s right, because when you raise taxes to the extent that they have, and you begin to see physical premiums, with that kind of a stretch, $100 to $200 an ounce, you have just written a business plan for black market imports into India.
Kevin: Coming in from Pakistan. (laughter) At least.
David: (laughter) Or anywhere else. Dubai, Pakistan, you name it. Demand has traditionally been in the form of jewelry. Now, as we mentioned, the savings programs and bar purchases are on the increase. In 2012 we saw a demand for bars around 240 tons. That’s pretty significant. This year’s bar demand will exceed that, coming in closer to 350 tons. That’s according to the Vice Chairman at the China Gold Association.
Kevin: And that gives us a picture of the type of buyer that is buying gold. A jewelry buyer is not buying bars.
David: Right. So investment demand is a new and growing segment in Asia, and in China, specifically.
Kevin: That brings up a point. Talking about the West versus the East, the ETF, the Exchange Traded Funds, really represent a Western way of thinking. “We’re going to jump into something because it’s going up and we’re going to jump right back out because it’s going down.” But demand changed with the Western world institutional investors selling, not only gold, but actually, a lot more ETF gold.
David: And it’s very critical to see that there was a trigger in the marketplace which was in the futures market. These were naked contracts, in other words, no gold actually backing the transactions. Large volume, naked contract, liquidations which were the triggers which then set off an avalanche of selling amongst institutional investors. These are your Western world institutional investors, Wall Street types, jumping out of investments in gold.
Kevin: Right, which is to make money, not to preserve, or do what the Chinese are trying to do.
David: Yes, very much in contrast with the physical consumer demand, which in the Eastern markets this year was 2,167 tons. Compare that with Western market consumer demand in contrast with investor demand. Consumer demand in all of the Western markets, that includes Europe and the United States 402 tons, in contrast to Eastern of 2167 tons.
Kevin: So, about one-fifth.
David: It’s pretty astounding. But again, there was a trigger in the futures market, followed through with the ETFs. On the physical side, that’s where there has been a tremendous amount of strength. Average monthly imports into Hong Kong have exceeded 100 tons.
Kevin: That’s per month? 100 tons a month?
David: Yes, and the big change in 2013 was Western investors seeing no need to hedge against sovereign default, because apparently there are no problems in Europe, and the U.S. has already solved its problems, in terms of long-term debt and structural issues.
Kevin: Or even a hedge against inflation. They’re just talking like inflation doesn’t exist.
David: Yes, or other various risks. Well, there is confidence in U.S. statistics. So we’ve had improved GDP numbers, we’ve had zero inflation, we’ve had improved housing numbers, we’ve had better labor statistics. All, of course, which are dependent on official information gathered by the Bureau of Labor Statistics, and groups like that here in the U.S.
Kevin: In other words, so say the people who benefit by you believing them. (laughter)
David: (laughter) Well, there are many here, and in China, who consider those numbers to be dubious. That’s just to contrast the Wall Street party line. Very interesting. Every one of the precious metals analysts for the major Wall Street banks deferred 100% to the house economist. They wouldn’t say, “My opinion on growth in the global economy…. My opinion on U.S. domestic growth is….” They would say, “Our economists believe, and therefore, we see…,” and they would talk about gold in the context of something that was predetermined by the house economist’s view, but that house economist’s view is dependent on what many in China, and we here in-house, would view as a dubious set of statistics.
Kevin: David, in the years that I have done this with your family, almost three decades, I tend to look mainly at investment demand and central bank demand. That is my interest. That, to me, shows the economic picture. But really, jewelry is still very dominant in the demand picture for gold, and I don’t want to neglect that.
David: Yes, if you want to look back at the last decade, 2003-2013, in 2003 Chinese and Indian jewelry demand was roughly 600 tons, and believe it or not, the U.S. and Europe were only slightly less than that. So we were running neck and neck in that one category, jewelry demand. Now the U.S. and Europe demand is less than 200 tons. That’s a two-thirds decline in U.S. and Europe jewelry demand, and China and India have nearly doubled to 1,000, or thereabouts, combined. This is just the jewelry demand segment. But we are seeing differences in terms of who is doing what in this space.
Kevin: And like I pointed out before, the difference, also, in the type of gold buyer who goes out and buys an ETF, he is just buying a piece of paper to play the price. When we sell ETF stocks, physical gold actually does come available, that’s the whole backbone of an ETF, but it sounds like it’s all going to China.
David: And many are concerned that the ETFs have no gold in them. I would just offer as exhibit A the 697-760 tons of gold which was liquidated from ETFs by institutional investors and physically flown to China and India. Not only did the gold exist, it does exist. To be able to come up with 760 tons of gold with the click of a mouse when the U.S. government can’t come up with half of that amount, in terms of the German gold requested by Germany early in the year, and promised on a delivery basis over seven years? Who has it? Who doesn’t? I think that’s very clear at this point.
Kevin: Dave, if we were an eye in the sky, when we go back and read history books, we are looking from centuries perspectives, and we are saying, “Wow, look at the power shift that occurred, let’s say, between the Netherlands and Spain and England.” Those take a long time. But looking from a bird’s-eye view, this looks like a centuries’ worth of power shift that is occurring in a matter of a couple of years.
David: I think this is one of the things that, as I sat and discussed these issues with a number of experts in the field, I had chills run throughout my body on a number of occasions. You have institutional liquidations feeding Asian consumer demand, which is growing, and this is key, because you are talking about a very sticky kind of a buyer. It’s not gold that will come back to the market with higher prices. Further liquidations from ETFs, they could pressure gold prices lower, which in turn would stimulate Asian consumer demand, where cheaper is better. But consider the return of investor demand.
Kevin: Yeah, when it happens.
David: When it happens.
Kevin: Because it’s not “if.”
David: So maybe inflation expectations increase, maybe tail risk or hedging against a black swan event returns as a priority, or even concerns over geopolitical relations, draw investors in the West back into gold. Remember, that the tons which had been available via the ETFs are now off the market.
Kevin: Some of it forever.
David: Then contrast what happens in a short period of time in terms of a turn in investor sentiment. Recall that after the collapse of Lehman, gold was up 22% in 20 days. Or the Greek government debt crisis in April of 2010. That drove gold, in euro terms, up 23%. Last, but not least, we had the downgrade of U.S. debt in July of 2011. That was followed by, 60 days later, a record gold price. I guess what I’m saying is that events do matter, and investment demand, while it’s negatively biased today, can turn on a dime.
Kevin: Sure, we’ve seen that, not only in gold, we’ve seen it in stocks, currencies, what have you.
David: Yes, and the market, in contrast with the 2007-2011 period, is not as well supplied with excess gold tonnage. So the next price rise will represent a supply squeeze never before witnessed, because you have millions of investors who will be chasing the market, which is now driven by hundreds of millions of gold consumers in Asia.
Kevin: Okay, lest we are saying that all of a sudden gold is just going to go up here in the next month, I’ve talked to a lot of clients who are becoming weary with the price being down, Dave, so give us the worst case scenario. Rather than us saying, “Hey, by December this thing is going to be… or January….” Let’s don’t do that. Let’s say, “What’s the worst case scenario?”
David: The worst case scenario is we have continued weakness in 2014 as you work off further ETF hot money. By hot money I’m saying, people that really didn’t understand the gold market to begin with, but they thought they should have an allocation in case the world falls apart, and so they bought an ETF, which probably wasn’t the best way to get an insurance policy, but that’s the way they did it because they could buy it today, sell it tomorrow, with the click of a mouse. You have those hot money gold-holders who could sell an additional 300, 400, 500 tons of gold. Look at it this way. You have a few strong hands in the hedge fund community, which have sold, and sold out, and may sell out their additional holdings. They’ve been replaced in the market by millions of consumers.
Kevin: Over on China’s side.
David: Actually, an even stronger and far less volatile base of gold-holders. So, ultimately, this is quite constructive for building a base of near-permanent holders in the market, you see?
Kevin: And here’s what is interesting. You’re not making a prediction that in 2014 this will happen. You’re just saying, “Worst case scenario, yes, maybe there will be more tonnage that will come into the market, but it ain’t coming back.”
David: It’s not coming back, which sets the stage, I think, for a 2015-2018 time frame in which we scratch our heads and say, “How does it move that fast again?” And we will have forgotten that you can move 22% in 20 days, following the Lehman collapse. Those kinds of things happen and we can make up for lost territory very, very quickly in the gold market, particularly when you are talking about supply and demand dimensions.
You have inelastic supply. You have had an extreme deterioration in the number of new gold finds around the world. We are talking about 5 million-ounce deposits, or greater. You used to find 5 or 10 of those a year back in the 1970s and 1980s. In the last year we found 1. And if you look at the last 10 years it has been in steep decline. It is not like we have a mining infrastructure which, on the basis of increasing demand, will somehow be able to come up with more product to meet it. That is, I think, where people don’t realize how supply-constrained the market is.
Kevin: These mines are having to shutter their doors and their windows, as well, because they can’t afford to open, but China, they’re the largest producer at this point, and they are not selling a single ounce of what they produced to the rest of the world.
David: Isn’t that interesting? We’ve changed a lot in the last ten years. China has become the largest gold producer. They are also the largest gold consumer, 400 tons this year, up from 300 tons last year. 1,000 tons is what is needed to meet consumer demand in China. So you have 1,000 tons, less the 400 which they produce, that is a 600-ton shortfall, which explains a good deal of the imports this year. However, the year-end totals were on track for 1,000 tons imported, versus the 600 tons which they need to meet consumer demand. It suggests that the central bank may well be adding to stocks quietly, their own stocks, the PBOC stocks, under the cover of increased consumer demand.
Kevin: Yes, because if you look at the ETF, you were talking about the amounts coming out of ETFs, that’s almost exactly what the deficit is that they need to make up as they are buying gold.
David: We estimate that the central bank has doubled its holdings already since its last announcement in 2009, to approximately 2300-2500 tons. That would be several hundred tons a year bought quietly as they’ve gone along. They will likely exceed the German holdings of 3,390 tons before publicly announcing again. Think of that notion of displacing, and in this instance, when they announce and come above that 3,390-ton level that the Germans hold, they will have displaced everyone on the list. This is official central bank gold-holders. With the exception of the United States, they will rank #2 in the world, and remember, this is what legitimizes a currency.
Kevin: I was just thinking this. I was thinking, going back to the 1970s when people were talking about the Trilateral Commission and redistributing the wealth, if you think about it, Dave, we’re the number one gold-holder, supposedly, we are assuming Fort Knox has what they say that they have, 8200 tons. Germany right now, which, really, you have to say is the financial center of the European region, and has been for a long time, is the second-largest holder of gold. If China comes in and displaces Germany, I think what we are seeing is that, whether it is Trilateral, or whether it is a redistribution of wealth, we are seeing the power complex of the world truly changing, because your dad was right. He who owns the gold makes the rules.
David: They’re jockeying for a position on the world monetary stage, and it’s gold backing which adds weight to the equation. Just for a frame of reference, that 1,000 tons we mentioned, as the 2013 imports, compare that to current mine supply. It’s basically half of all current gold production. That’s going into India. Half of all new mine production is going to China. That doesn’t include India. They are almost the other half of new mine supply. The only thing that is making up the difference is scrap gold, and this is where I think you look at demand in China. In our view, it will continue to increase.
Kevin: One of the goals, Dave, even though it is still murky what they came up with, but one of the goals of the Third Plenum in China is an increase in income. To put in perspective, the income here in America versus the income in China, we’re talking about this incredible demand, but isn’t the per capita GDP in China less than $8,000 U.S. dollars a year?
David: This is what is intriguing to me. Many Western analysts see, not only does China displace Japan as the #2 economy, they are now the #2 economy, Japan is #3. You have the U.S. in the sights, and many of these analysts think that by 2020 the Chinese economy could be larger than the U.S. economy. GDP per capita in China is $7,958 dollars. That is one-fifth of the U.S. on a per capita basis. And it’s assumed that a marginal increase to between $8,000 and $8500, again this is per capita GDP, is sufficient to drive gold demand in China significantly higher.
Kevin: Because they may be savings dollars.
David: These are extra dollars. This is a critical point, particularly when you consider the deliberate effort to increase the household income share of GDP in China. You are driving consumer choices, and a consumer economy. That is the goal of the Third Plenum. That is the goal of the Five-Year Plan from March a year ago, and gold is in the mix.
Kevin: And let’s just look at how the incomes have risen so far, just in the last four or five years.
David: Between 2008 and 2012, rural incomes rose 70%. The currency has been appreciating, which obviously empowers purchasing power for anyone with any money coming in, and wages across the manufacturing complex have risen at double-digit rates for several years in a row. Again, this is all empowering a consumer. Know your audience here, and if you know your audience, you can see why gold is so much in the mix, and why demand has been increasing.
Kevin: We mentioned before, Dave, we’re not earning interest here on our CDs, but they’re not earning interest over there, either. Remember the Summers-Barsky thesis that you bring up all the time. If interest rates are high enough, people will move away from gold to get those interest rates, but they are very low in China.
David: And it’s not just a function of high rates, it’s a function of real rates, which factors in, not only inflation, but taxes. The Chinese real rate, that is, net of inflation, was deeply negative by about 3% from 2010-2011, and now again, here in 2013, are slipping into negative territory. So that investor component, we talked about the 240 tons of gold increasing to 350 tons from last year to this year, that’s bar demand in China. Why is it increasing? Why is there an investor segment that is looking more at gold? Well, it’s kind of obvious, for the same reasons that anyone else in the world does. If you are looking at CDs as certificates of confiscation, if you are looking at government bonds as certificates of confiscation, rather than a deposit which will maintain wealth and keep it safe, gold becomes a default, according to the Summers-Barsky thesis.
Kevin: The only way, David, we can look forward, if we look forward in 5-year, 10-year, decade types of periods, is to actually go back and look at history, because we don’t know the future without the memory of the past, and the beauty of working for the McAlvany family is, there is a memory of the past just by the four decades you all have been in business. And so, let’s go back to the 1970s when your dad saw that the decline of the dollar was going to be a real issue, and he started a gold firm when gold was still illegal to own, and we don’t have to go into that because there were ways of legally buying gold back then. But what forethought, Dave. He started a firm when gold was $35 or $40 an ounce, and it rose in the 1970s to over $800, but that certainly was not without declines on the way up.
David: And there were macro-economic factors in the late 1960s which were still in place all throughout the 1970s in spite of the ebbs and flows of the price, and I think this is very important to realize, that the declines in the 1970s, you had a first decline of 14%. Your next decline was 29%. Your next decline was 28%.
Kevin: And there were huge rises between these declines.
David: Of course. But your next decline was 47%!
Kevin: (laughter)
David: Granted, we started at $35, and as you said, we ended at $875, but the next decline was 11%, the next decline was 12%, the next decline was 20%, 17%, and finally a 43% decline. And gold rose from $35 to $875. The macro-economic drivers did not change. The context did not change. The price trajectory did not change. But we had the volatility, the ebbs and flows, which, anyone looking at that price action would say, “I can’t stand it. It’s far too painful. I just don’t believe.” (laughter)
Kevin: Even your dad will tell the story that in 1975, 1976, I can’t remember exactly the year, but he hiked up to the top of a mountain in Aspen because he was soul-searching, himself. This was a gold bug of gold bugs who was thinking, “Wait, gold is down 47%. Am I wrong?” (laughter)
David: What is interesting is that was the fourth decline out of nine declines in the total span of the bull market. And the declines in this bull market, we’ve had a 22%, a 15%, a 29%. The fourth decline is right now, and it has been as great as 34%, nothing as bad as what we had in the 1970s, and we have yet to go the full trajectory of the bull market as we had in the 1970s. Yes, we’ve gone from $272 to $1250. I guess the bottom line here is that the corrections are normal. What is interesting is that the dialogue around the corrections always changes, and it is particularly with the Wall Street firms. I was fascinated. I got the last question in amongst these groups of industry leaders in Shanghai. I asked the question to the analysts at Societe General, who wrote the report the same week when they released the short recommendation by Goldman-Sachs.
Kevin: This is the Western mindset analysts.
David: Yes, correct. But this particular analyst from Societe General, a French bank, wrote a report saying, “Yes, we expect gold to go down, we would suggest you shorting gold, we think it’s going to $800. We think it’s going much lower.” That’s what he wrote the week that Goldman shorted in April of 2011. I simply asked him, “Mr. Barr, what were your price projections between 2000 and 2002? Right now your price projections are very negative. The price is trending lower and your price projections are lower. What were your price projections in 2000 and 2002?” To which, his response was, “Flat, to going nowhere. It had been 300 for two decades, why should it ever do anything more than what it has been doing?” And I asked him, secondarily, “What were your price projections in 2009 and 2010?” His response was, “Significantly higher, because that’s the direction the market was trending.”
And I guess the point was, they don’t have a clue. All they are doing is extrapolating off a chart trend line. Not only did they not see the bull market coming, but they assumed that from higher prices it would only go higher, and now with lower prices, it will only go lower. The point being that these corrections are normal and all they can do is try to wrap their minds around it and gather information to support the directional trend in the market at the time. They are not giving us any insight into the future.
Kevin: And you’re his son, so I won’t have to tell you the rest of the story, but the listener needs to understand that Don, when he was sitting on top of that mountain in Aspen, realized that not one fundamental thing had changed. It had nothing to do with the trend that he had recognized, like these analysts from Societe General. He understood why he was buying gold, just like the Chinese understand why they are buying gold. David, he came back down the hill inspired, even though the price was still down, just as it was before.
David: 47%!
Kevin: He called a number of friends and he said, “Guess what? I would have been the last guy out, because I’m a gold bug, but we have reached the bottom, because I was considering getting out.”
David: (laughter) And that was the fall of 1976.
Kevin: And that was the bottom before it went up eight-fold.
David: Well, very interestingly, from January of 2003 to the present, we have seen gold and silver diverge in price from the equities market and up to that point we had had the risk-on, risk-off, that was the standard conversation piece, and it was the inexplicable market relationship, because up to that point, it was assumed, again, before the risk-on, risk-off language was applied, that gold was noncorrelated to stocks. Well good news. We’ve regained the noncorrelated relationship here in 2013. Even if it is in the context of lower prices, we’re back to a normal relationship.
I ask the question of the UBS analysts recently, “What happens if equities fall 20-30%?” And the answer, of course, was, “We’d have to raise our price projections on gold.”
I think the merit of 2013, yes we’ve gone back to the noncorrelated relationship between gold and the equities market, we do see some weakness in the equities market moving forward, and whether that is a 2014 first-quarter, second-quarter, third-quarter, do we have a crystal ball? No, admittedly. But we do see that the fundamentals are still in place for a strong finish to a bull market, and if you appreciated the kinds of gains that you saw between 2000 and 2011, you might want to stick around, because the way this finishes will be very similar.
Kevin: So David, we’ve talked about fundamentals, we’ve talked about market direction, but lower prices are lower prices, and so, what actually would be the cure for lower prices?
David: The cure for lower prices is lower prices.
Kevin: (laughter)
David: We’ve got that. Believe it or not, that’s what sets the stage for the next rise in price.
