The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: David, today we join you as you are passing through the airport in Newark on your way to New Orleans. You are there to meet with people, you do this once a year – Lewis Lehrman, Van Hoisington, Pierre Lassonde – guys who don’t normally just give presentations, who come together once a year and talk about these things. David, I know you have to catch a plane in a few minutes, but I’d like to grab a few thoughts on what you have heard today.
David: Kevin, I have the belief that iron sharpens iron and there is the need to rehash certain assumptions that you may have, and assess them from a different vantage point. Whether that is hearing information or viewpoints that conflict with ideas that you may hold dear, or listening to experts who you perhaps do agree with, both are important, and sharing ideas, asking questions, with a number of the gentleman that you just mentioned. I have had conversations with them today, and listened to presentations relating to the bond market, relating to the gold market, relating to the equity market, and some fascinating observations that I have distilled from those conversations, and just listening.
We mentioned this in last week’s commentary. Lewis Lehrman wrote a book on restoring the gold standard. This is where he is particularly critical of our monetary system, the way it exists today, looking at living through an age of inflation, starting in 1914 and the end of the European State system when we went into World War I. The world had to finance its new expenditures. Wartime financing could not have been done on the gold standard and so the world left it for the first time since the 1860s.
I’m kind of covering old territory here because that was the majority of our conversation here in recent weeks, but really, what was interesting from this conversation was his moving forward in time and saying, “Listen, we are the creator of problems.” The U.S. system, the monetary system, based on the U.S. dollar, is responsible for transmitting destabilization around the world, and we need to own that before we start casting aspersions on the Chinese, or assuming that they are responsible for instability in the world monetary system. Let’s look at our balance of payment deficit and let’s look at the amount of inflation we have transmitted around the world.”
Clearly, one of the observations made, perhaps more relevant to us today than observations relating to 1913, 1922, 1932, 1933, and 1944, all dates that we discussed in detail here recently, is inflation, which has been a major issue around the world and has led to the Arab Spring. He certainly was dogmatic about the fact that this had nothing to do with some sort of humanitarian plea on the part of someone in Tunisia setting themselves on fire. It had everything to do with food and fuel inflation. This had everything to do with instability that is created by our world reserve currency status and the transmission of inflation via these dollarized markets.
Kevin: David, wouldn’t you say that a lot of that is caused because 75% of the world has to use dollars? We can print our own and that makes it so that we are basically borrowing from ourselves, but other countries, as we print that money, really are affected by the inflation, and that is the majority of the world.
David: You are exactly right, because it is food and fuel that 75% of the world references to the dollar in terms of buying and selling, so clearly, whatever the dollar does, we are seeing those real goods and services repriced. In other words it takes more dollars to buy the same stuff needed.
This is particularly relevant to subsistence economies. This is particularly relevant to less developed countries, or emerging markets, in that they are on a knife’s edge anyway, because they are spending greater than 50% of their income on these two items, food and fuel. Even a marginal increase in those, given the inflation that we transmit via our very aggressive monetary policies is destabilizing politically, because if you can’t feed your family you tend to take to the streets and protest and say, “Hey, listen, this isn’t quite right. I am frustrated.”
There, at this point, is no dollar alternative in the world monetary system, but there certainly is a growing desire for something to change because it’s not working. It’s working just fine for us, but all that is to say, there is a large swath of the world that it’s not working for because they are at the end of something that feels like social injustice, and they may not be connecting the dots between what they are experiencing in a dollarized world, but this is what Lehrman was pointing out. This is what they are responding to.
Kevin: We are about to go into 2013. If we were to roll back 100 years from 2013, there was a critical document that John Maynard Keynes wrote that probably changed the course of history over the last century. I know Lehrman has pointed this out in the past, but would you elaborate?
David: Sure. In 1913 an article was published called Indian Currency and Finance, and this is what Lehrman was discussing. In this paper, John Maynard Keynes anticipated what would be the intellectual stance taken in 1922 at the Conference of Genoa. He said, “It’s a matter of comparative indifference,” this notion of having gold or foreign exchange as a part of the reserve assets. In other words, it just doesn’t matter. You can have gold, you can have British pounds, you can have U.S. dollars, which is exactly what they adopted in 1922, but the intellectual backdrop for that 1922 decision came from 1913.
Fast forward, as you were saying, 100 years, and we have as a direct result of a dollarized system, incredible instability in the world. One of the things that Lehrman pointed out was that on about a 30-month lag you have, following rapid expansion of the world dollar base, major moves in oil, and his assumption is that sometime in the next 12 months, maybe even sooner, we do see prices start moving up.
If we are talking about a 2013-2015 time frame, think of the implications, because massive moves in oil will reprice almost every good and service, because if you just simply want to buy cucumbers at the local store, guess what? Those cucumbers, and any other produce, have to be delivered, and if they are delivered, the transportation costs matter, and if transportation costs increase, tied to an increase in oil, this is actually very relevant, the things that you would take for granted.
Why are things more expensive at the grocery store? Yes, indeed, this lag of 30 months between rapid expansion of the world dollar base, a minimum of 2, but as much as 3 trillion dollars, and that is already baked into the cake, leads to a major move in oil prices. I think that is relevant for investors, I think it is relevant from a growth thesis, I think it is also relevant from an insurance thesis, one of the ramifications in terms of political volatility and social volatility as a result of inflation driven by an increase in oil prices, and really the root cause is that rapid expansion of the dollar base.
Kevin: There is something that is confusing. The markets are throwing confusing signals. We have signals that show that we may have oil inflation coming, and we may have higher interest rates, but there are other things that we have to consider. If we have higher interest rates after this hundred years of debt expansion, we know that the government can’t afford the interest payments already. We have talked before about if interest rates were to go up. You have listened to someone today, Van Hoisington, who laid out the possibility of another multiple years, maybe 3, maybe 5, or more, of low interest rates being artificially held low, but not actually going up.
David: The presentation by Van was the best presentation I have ever heard supporting a deflationary case, and, very simply, this is a guy who has been long the 30-year Treasury bond since 1990 and has made money, not every year since 1990, but if you averaged out his track record, having been long the 30-year Treasury, he has done quite well.
What he is looking at is the notion that U.S. private and public debt as a percentage of GDP in the United States is north of 350%. There is a massive overhang of debt. In fact, when you get to these kinds of levels, it takes a long period of time to unwind what is essentially an over-leveraged, over-extended balance sheet. This is really the issue. He views this period directly ahead as very similar to what we have had the last couple of years – reduction of rates. He thinks rates can actually go lower from here. The 30-year Treasury, at roughly 3%, he thinks can go even lower. In fact, he thought if the Fed were to get out of the way, the market would take rates lower.
I have to tell you, out of 30 pages of notes that he has shared with us, I simply haven’t heard a better case for deflation. Of course, as you are quaking in your boots thinking of the greater implications of deflation in the context of owning gold or owning silver, we will address that in a minute, because one of the other presentations was from Pierre Lassonde, someone who I consider to be one of the geniuses within the gold space, and he completely rebutted what Van Hoisington’s position was, insofar as it is negative on gold. We could, in fact, have a scenario in which we have a very deflationary outcome, and it is not negative for gold, and the combination of these two presentations back and forth I think was absolutely brilliant.
The assumption from Van Hoisington is that we see slow growth for a very long period of time, in fact, slow growth for the foreseeable future. Is that 3 years? Is that 5 years? Is that 7 years? But essentially, the federal government is completely written out of the script. They can do nothing to increase the money multiplier. They can do nothing to increase velocity. There is nothing that fiscal policy can do, and nothing that monetary policy can do, at this point. What we have had, in Hoisington’s view, is slow growth and an unwind of debt and too much leverage in the system.
Kevin: Even if we have a deflationary outcome, we are still seeing quantitative easing having some effect. It is bailing banks out and we have seen stock prices rally whenever Bernanke announces more quantitative easing.
David: And these were stats that Van shared with us. It was fascinating. QE-1 led to a 36% increase in the S&P and a 30% rise in gasoline prices, QE-2, a 24% increase in the S&P, 36% increase in gasoline prices, and as soon as each one of these periods of quantitative easing was ended, then the CPI resumed the downtrend and equity prices resumed a downtrend.
Unfortunately, what is really unhealthy, when you are looking at the S&P and the stock market today, is this dependence on Fed money-printing – Quantitative Easing 1, 2, 3 – although, as we have said in the past, Quantitative Easing 3 really hasn’t gotten out of the box yet. They have talked about it, they’ve announced it, they’ve said we are going to buy 85 billion dollars worth of mortgage-backed securities on a monthly basis from here until the cows come home, but they haven’t actually got started with that.
One of the things that I think is critical is that in spite of the Fed pushing up prices, real output has actually gone down. They are not doing anything to recover the economy, to create growth in the economy, and so there is really not the desired effect, in terms of growth in the economy. All it is doing is passing through the particular asset prices. So, asset price inflation? Yes. But recovery in the economy? No. And the big 800-pound gorilla in the room is that you can’t grow an economy through fiscal policy measures or monetary policy measures when you are essentially at the end of a credit cycle. I think that was what Van Hoisington was getting at.
Kevin: David, I know you have gone and talked to these guys year after year, and sometimes there has been a clear direction, it seems like there was a clear theme, but it sounds like there is a tug-of-war right now, that we are not getting a real clear signal as to what this next year entails. You spent time with one of the world’s greatest hedge fund managers ever. The guy is worth 4½ billion bucks, himself, much less the money that he managed before he got out of the business.
David: What is interesting to me, Kevin, is the number of really sophisticated hedge fund managers who are hanging it up, who are deciding that in the environment of Dodd-Frank, in the environment of re-regulation, that it is very unclear what the capital markets are going to look like a few years from now, and it is simply not worth taking the risks, that it is better to just move to the sideline. This doesn’t mean they are moving to the sidelines entirely with their own money, it just means that they are not going to be responsible for other people’s money because they don’t see wind in the sails.
I think that is very critical. Bruce is an interesting guy, because in 30 years of running a hedge fund, he has done a couple of interviews, but very private, very secretive. It was an honor and a privilege to be able to interact with him today in a larger group audience, of course, but this is a guy who actually would take Van Hoisington to task and say, U.S. Treasuries are the clearest negative bet in the world. You just have distortion in price. You don’t have equilibrium represented in the current price in Treasuries. You have the whole world dependent on unhealthy levels in terms of interest rates, and we should see mean reversion.
Kevin, if you go back to what the Japanese have done, if was so clear in the first 3-4 years of treasury manipulation or the equivalent of treasury manipulation in Japan. Everyone was betting against Japanese bonds, assuming that rates were going to go higher. This became known as the widowmaker trade, where you were betting against bonds, and the question is, how much money did you ultimately lose betting against Japanese bonds, because rates went lower and lower and lower, and have stayed lower for 20 years?
Kavner, taking Van Hoisington to task on this, and this really is an intellectual battle, if you will, says no one knows when it’s going to happen, when the Treasury market comes unwound. That it will happen eventually is inevitable, but the time frames involved are not exactly clear.
I think one of the things that was interesting, just looking at Kavner’s background, is that he is a global macro-manager. In other words, he really does care about the big picture, and it’s harder and harder to manage, because there are policies involved which are unpredictable, changes with the current election, and so many things that represent headwinds to managing assets.
It was fascinating. Kavner studied political economy at Harvard, and it really is with some philosophical basis that he reflects and says that this is a very tough environment. Judgments being made on Wall Street today are very much like in Plato’s Republic, where you walk into the cave, you are looking at the shadows dancing on the walls, if anyone is familiar with Plato’s Republic. At best, you are dealing with some sort of fabrication or distant reflection of reality.
This is really what sets a money manager apart today, in his opinion. What would give someone an edge today is being able to separate signal from noise. You and have I talked about this over the last few months – being able to take the sheer amount of information and data and not be distracted by the sheer volume, but to be able to find a very clear signal. What is happening? What is your judgment? Doing the hard work to figure out what, in fact, is driving the market, not particularly obvious, and that was one of the things that was discussed very openly today.
Kevin: The person that I am most interested to hear from, of everyone you talked to, is someone who has proven himself through many years, watching him, through the years, manage and buy gold-mining companies and run them – a man named Pierre Lassonde. In the industry that is almost a legendary name. Pierre Lassonde always seems to bring a point to the table that other guys have not thought about. What were his thoughts today?
David: I find Pierre Lassonde to be incredibly intriguing. Just as Van Hoisington has spent 40 years in the bond market, Pierre has spent 40 years in the gold market. Arguably, Hoisington is an amazing guy when you are looking at 30-year Treasuries, but if you want to know something about gold, there is probably no one better to be making inquiries of than Pierre Lassonde. I had a conversation with him, and I asked him about when he was with Newmont Mining, because he has a long history – Euro-Nevada, Franco-Nevada. Franco Nevada was bought out by Newmont Mines.
Newmont ultimately looks at their royalty business, and what they have in oil, and some of their royalties in gold, decide it is not a core asset and they spin it off. Later, Pierre comes back, revives Franco-Nevada and buys those assets. I asked him, “Why in the world would the current CEO of Newmont do this?” He just kind of shook his head, and smiled, and I am considering what’s in the back of his mind, and translating the silence as, “One man’s trash is another man’s treasure.” Now you have a company that was worth a few hundred million that is now worth 8 billion dollars in market capital, and Franco-Nevada is a very interesting, going concern.
All of that is prologue to say that what is happening in the gold market today is beyond the U.S. market, is beyond Hoisington’s concerns about deflation, and here is why: The opening comments from Pierre were that we, in the U.S., view the gold market from a very U.S.-centric perspective, and that if you take a more worldly view on the gold market, in fact, what you find is a dramatic shift in demand dynamics.
Kevin, you and I have talked about this. It was about 18 months ago that we were talking about a shift from the U.S. and Europe to China, and to the Indian subcontinent. And, lo and behold, this is what all of Pierre’s comments were resting on. Supply and demand are what are driving the gold market, and this has to do with very little new supplies coming onto the market, but with expanding demand dynamic, particularly from central bankers, and particularly from investors the world over, and frankly, the U.S. investor doesn’t even factor in – not important.
So, when we are concerned about U.S. monetary policy, or U.S. fiscal policy somehow being a drag on the gold market, or even the deflationary dynamics of the U.S. debt system, and the deflationary overhang which Van Hoisington is so concerned about, it is a secondary issue. It is the sideline compared to the supply/demand dynamics globally, which have been driving the price of gold from $250 up to $1900 and change. A couple of the points that he made, I think, were very interesting.
Kevin: David, we talked about inflation and deflation, but Pierre Lassonde is saying it doesn’t matter, we are talking about supply and demand. Why don’t we go ahead and start on the supply side. What does Pierre Lassonde feel that the supply picture looks like? Are we able to produce a lot more gold now that the price is rising?
David: No, and the problem is that we haven’t had major finds since 1993. The last 15 million-ounce mine that was put into motion was Yanacocha. That is, of course, a Newmont asset. But the reality is, we are finding smaller and smaller ore bodies, but nothing that has scale, and that is a significant issue, particularly given, with any ore body, small or large, the amount of time that it takes to bring them on line.
It used to take, in the early 1980s, and Pierre was very specific on this, 2-4 years to bring a new project into full production. Now, with environmental concerns, and feasibility studies, 10-12 years is a minimum, and a number of the projects that the major miners are bringing on line are taking up to 20 years to put into production. The amount of money that you have to spend before you earn even a buck out of a given mine is astronomical. The profitability, obviously, is tough for the miners – and we’re talking here about margin compression and other issues relating to that particular area. But really, the issue is, you can’t snap your fingers and make new supply dramatically or magically appear.
Kevin: It doesn’t look like supply side is going to increase dramatically. The demand side, though, and we have talked about this a number of times, is shifting to the East, and away from the West, and it just looks like it is increasing. What was Lassonde’s view on demand?
David: This is where it gets even more dramatic, because central banks play a major role in this. If you look at the amount of ounces – or tons, frankly – that they were selling all through the 1990s, and even through the first part of this decade, and then all of a sudden in 2009 that turned around. European banks, considering themselves very sophisticated, and not needing this “barbaric relic,” have sold, and actually he was the first to point out that Canada’s was the first central bank to liquidate assets in the form of gold back around the turn of the millennium, and then the British, which was, of course, the most notorious, and then the folks in the Netherlands, on the third time around.
But that was marking the bottom of the market. We continue to see liquidations by central banks through 2009, and now, we are consistently seeing major purchases, and it is primarily of BRIC countries – Brazil, Russia, India, and China. Anyone who is sitting on massive dollar reserves, these were originally trade surpluses that now represent massive foreign currency reserves, mostly in the form of dollars.
They are not happy sitting in dollars alone. They would like a little bit more diversification, and we covered this with McAvity a few weeks ago. Relative to their reserves, they have a very small percentage sitting in gold. So Europe is sitting with 30, 40, 50% on average, of their foreign currency reserves, sitting in the barbaric relic. These emerging markets, or less developed countries, have closer to 2-4%, and they would like to see an increase.
This is where it gets tricky, because if Thailand, Indonesia, Taiwan, South Korea, Japan, India, and China moved in line to what the World Gold Council suggested originally a few years ago was a normal number, 15%, well under the European average, and well above the current developing market average, we would be talking about 17,000 tons. In just those countries that I mentioned, 17,000 tons would have to be purchased on the open market – kind of hard to get that done.
On the other side, there is investor demand moving up, and this is not people buying jewelry, it is people buying gold bars and gold coins for the purpose of offsetting losses. A lot of this does have to do with inflation, but there are other considerations, as well. Being in a negative real return environment, inflation is only one component of that. If you have a negative real rate of return, which is going back to Van Hoisington’s point earlier, if we are going to see low rates of return in the bond space for 3, 5, 7, or 10 years, and there is even a marginal rate of inflation, then your real rate of return is flat, or negative.
Going back to the Summers-Barsky thesis, that is the perfect scenario for investor demand to continue to increase. And the assumption there is that moving back to numbers that we saw in the 1980s in terms of investors buying gold as some sort of an insurance policy against inflation, against deflation, against geopolitical instability, current numbers are at about 3½-4%. This is looking at gold’s share of global allocations. It is very, very low. To go back to the 1980s numbers, or even earlier, the 1970s numbers, it was closer to 14%.
Gold used to play a very significant role in the European asset manager’s asset allocation model. It even became popular in the 1980s for U.S. money managers to suggest a certain percentage in gold, as much as 5, 10, or 15%. 14% was the average, coming into the early 1980s. We are currently at less than 3%. If we just bumped that number to 5%, says Pierre, we would be talking about demand to the tune of 66,000 tons.
So when he steps back and says, “Van, you may be right, we go into a deflationary scenario, rates are low for a long period of time, as we deal with too much leverage on the balance sheet. I don’t know that that is going to impact the gold market, given the fact that we have demand on the increase, and we have supply dwindling.” The supply/demand equation is ultimately what is driving the price of gold – end of story. It’s not inflation. It’s not deflation. It’s not geopolitical instability.
It is just a migration of already-existing assets, not newly-created bank assets, but already-existing assets that are either looking for a new home in the form of investment dollars, or central banks looking for a new monetary alternative without the same liabilities or credit risks or counter-party risks that are associated with other investment options that they have.
Kevin: David, you are probably boarding the plane right now, if I know you, just like your dad. You guys are always the last guys on the plane, so we are going to have to wrap this up, but I love when you meet these guys, I can hear the synaptic connections and the axons firing. It’s always stimulating, Dave, and I think it really adds to your ability to analyze, to be around these guys.
You are just about to hop on a plane to New Orleans. You are going to be speaking there. Could you give us just a couple of closing thoughts and let us know what you are going to talk about in New Orleans?
David: I’ll have to do it fast, or I’m going to miss my plane, but in New Orleans we will be meeting with a number of people, who sometimes we agree with, and sometimes we disagree with. Having dinner with Rick Rule, Robert Prechter, and a number of folks, that on the bearish side, and the bullish side, in terms of commodities, don’t see things eye-to-eye.
That’s the perfect environment to hash out ideas, and that’s the kind of environment in which I am favoring my philosophical roots and saying, “Let’s take both sides of the argument and argue as effectively as we can, and see what we come up with in terms of a conclusion. Again, thesis, antithesis, and synthesis – that’s what we are driving toward, and with that, Kevin, I’ve gotta go.
Kevin: Have a safe flight.
