Why I’m Pessimistic on the Economy . . . and Optimistic on Gold
The following rather lengthy post is the full text of my June 9th speech, unabridged and unedited, to the Mines and Money Conference in Beijing, China:
To begin with my conclusions, I believe we will continue to see gold generate lofty returns for years to come. By year-end, I expect we will see gold hit $1500 an ounce — and sometime in the next few years $2000 seems very likely . . . with $3000 or higher quite possible. And, in my mind, these are quite conservative forecasts.
At the crux of my bullish outlook is this:Â History demonstrates time and again that excessive government spending, rapid money supply growth, and negative real interest rates are always accompanied or followed by rising gold prices.
And these are precisely the conditions that have characterized the U.S. and European economies for the past few years . . . and why gold prices have been and will continue to trend higher.
But even with “gold-neutral” macroeconomic policies in the older industrialized nations, there are good, solid reasons to expect much higher gold prices for years to come.
Just so you know where I’m going, let me quickly list the top nine bullish factors that support this forecast — and then, in turn, discuss some of these bull points in more detail.
- First, as I just mentioned, inflationary U.S. monetary and fiscal policies — past, present, and future — along with the coming second dip in the U.S. business cycle.
- Second, Europe’s intractable sovereign debt crisis, which has greatly undermined the euro’s appeal as an official reserve asset . . . and is pushing the European Central Bank to pursue inflationary monetary policies.
- Third, moderate, well-managed rates of economic growth in the “gold-friendly” newly industrialized or emerging economies . . . especially, and most importantly, in China and India.
- Fourth, continuing — if not growing — interest by the official sector, principally the central banks of a number of newly industrialized or emerging nations to diversify official reserve assets.
- Fifth, rising private-sector investment demand in the “western” older industrialized nations reflecting fear of inflation, currency depreciation, and a loss of confidence in governments to deal effectively with today’s economic challenges.
- Sixth, rising long-term saving and investment demand for gold from India, China, and other gold-friendly nations enjoying healthy growth in household incomes — growth that is likely to continue for the next several years.
- Seventh, the continuing maturation of what I call the “gold-investment infrastructure” — in other words the development of new gold investment products and channels of distribution in many important geographic markets.
- Eighth, the continuing long-term downtrend in world gold-mine production for at least the next five to ten years or longer.
- Ninth, the relatively small size of the world gold market compared to other capital markets — such as equities or currencies — so that even small shifts in portfolio preferences away from currencies, or equities, or real estate, for example, may have little price effect on these big markets but will have a relatively large, indeed profound, effect on gold.
Let’s look at some of these bullish factors more closely . . . beginning with the U.S. economy.
Despite relatively favorable data on retail sales, industrial production, and consumer prices over the past half year or longer, I believe the economic statistics will soon indicate a renewed cyclical downturn, an end to the recovery seen by most business and government economists along with rising price pressures.
What I see down the road for the United States and Europe is an extended period of stagflation — much like the 1970s, with below par business activity and continuing high unemployment along with above par price inflation led by rising prices for oil and other key commodities.
Stripping away the contribution to GDP growth resulting from the temporary federal stimulus programs (like the just-expired tax benefit to first-time home buyers) and the positive effect of inventory accumulation during the fourth quarter of 2009 and the first half of this year, leaves a gloomy picture of an economy that is dead in the water.
As Washington’s stimulus programs wind down — and with the inventory cycle not longer contributing to growth in Gross Domestic Product — the U.S. economy will stall . . . and, very possibly, sink back into recession.
In addition, there are other good reasons to fear a renewed business downturn and years of sluggish growth with higher inflation.
The United States economy depends on consumer spending — spending that typically accounts for about 65 to 70 percent of Gross Domestic Product. But, American consumers are in no shape, mentally or fiscally, to continue spending at the pace of the past decade or two. Here’s why:
Savings rates are rising as consumers spend less and save more to rebuild household balance sheets after years of excessive borrowing . . . and, as a precaution in uncertain economic times. To be sure, high unemployment, the increasing duration of unemployment, and fear of future unemployment is enough for many households to cut back.
In addition, the declining value of household assets — including home prices and retirement savings invested in stocks and mutual funds is also discouraging consumer spending — something we economists call the “wealth effect.”
Consumer spending will soon take another hit when the tax cuts enacted nearly ten years ago under the Bush Administration, tax cuts that favored upper income brackets, expire later this year.
It’s not just consumers who are spending less: State and local public-sector budgets are also in crisis across American. With most states and cities legally prohibited from operating in deficit, falling tax revenues are beginning to trigger public-spending restraint — including layoffs, reduced benefits to workers and retirees, cuts in social programs, and so on.
Next we have the continuing squeeze on small- and medium-size businesses resulting from the reluctance of banks to offer credit and financing to this important segment of the economy. Small- and medium-size businesses are the engine of economic growth and expanding employment — but they are dependent on lines of credit from America’s banks to run their businesses. And, many banks have been and continue to be reluctant or unable to lend to this important sector of the economy.
And, let’s not forget the impact of Europe’s sovereign debt crisis — which is pushing a good part of the continent into recession or sluggish growth. Just as in America, heightened uncertainty is causing consumers and businesses to curtail spending and investment . . . while attempts at fiscal restraint in some countries will cut directly into spending by households and businesses.
Europe’s downturn — aided by the fall in the euro against the dollar — will soon, and for some time to come, reduce the contribution to U.S. economic activity from America’s international trade.
You may be asking: “What does all this have to do with gold?” Well, a lot, actually!
Disappointing U.S. economic activity will have serious detrimental consequences for the Federal budget deficit, for Treasury funding requirements, and for the U.S. dollar — all of which will benefit gold.
This “double-dip” scenario of renewed recession or merely slower than expected activity means:
First, the Federal Reserve, America’s central bank, will maintain near-zero interest rates for longer than most market participants generally anticipate.
Second, future U.S. Federal budget deficits will be significantly bigger than now expected as projected tax revenues fall short. This will erode confidence in the dollar among those central banks and institutional investors who have traditionally bought our debt and financed our deficit — leading to higher medium- to long-term interest rates in the United States.
Third, even more pressure on the Fed to monetize a growing share of Treasury debt.
All of this will produce more inflation — and more demand for gold.
In the interests of time, I’m going to skip over a more detailed discussion of the European sovereign debt crisis — except to highlight three brief points:
First, the crisis has created fear and uncertainty about the future viability of Europe’s common currency, the euro.
Second, it has created and fear and uncertainty that some of Europe’s biggest banks, banks that have invested heavily in now-questionable sovereign debt, will be pushed to insolvency or require government bailouts.
Third, the euro — which had increasingly been viewed by central bank reserve managers a legitimate diversifier to reduce dollar dependence — has suddenly been tarnished and discredited as viable alternative reserve asset.
Together, these fears and uncertainties have touched off a gold rush of demand for physical gold investment products — small bars, bullion coins, and gold exchange-traded funds — by private investors, not only in Europe, but around the world.
This brings me to the official sector — and the increasing interest among some central banks to hold gold as a reserve asset, dollar alternative, portfolio diversifier, and investment asset.
Even before the euro’s sudden and surprising demise, some central bankers began to take a fresh look at the yellow metal . . . and, last year, a few countries even began adding to their official reserves.
After two decades of selling, at an average annual rate of some 400 tons per year, the official sector became a net buyer of gold in 2009, adding more than 425 tons to total official-sector holdings. I believe the official sector continues to be an important net buyer of gold — and could easily add another 150 to 300 tons or possibly more this year with sizeable net purchases continuing for years to come.
As you know, last year the People’s Bank of China (PBOC) announced that it had purchase 454 tons of gold from domestic mine production since 2003 . . . but it did not include these acquisitions in its official reserve accounts until last April.
I believe that China continues to buy gold discretely from domestic mine production — but chooses to hold this metal “off the books” so to speak as periodic announcements of PBOC purchases and inclusion of this metal in its official reserve accounts would probably result in higher world market prices making subsequent purchases that much more expensive.
In contrast, Russia and recently Kazakhstan have bought gold from their own domestic mines — but unlike China have chosen to publicize their purchases each month, perhaps as a matter of prestige or to improve their appearance of creditworthiness in world financial markets, something that China and the PBOC need not consider.
Last year, India bought 200 tons “off the market” directly from the International Monetary Fund, which has a one-off program to sell 403 tons over several years to fund its own operating expenses and benefit its poorest members. Sri Lanka and Mauritius also purchased small amounts last year from the IMF. All three, like Russia, announced their purchases to benefit from the publicity and prestige that comes with owning gold . . . and, in the case of India, perhaps to make a statement that they’ve arrived as a big-league economic power.
The IMF has some 152.8 tons remaining to be sold under the existing program, having announced sales into the market this year of 38.5 tons through April. Quite possibly some or all of this gold found its way into the vaults of one or another central bank preferring anonymity. In any event, this metal was easily absorbed into the market without detrimental effect on the price.
In another twist, the China Investment Corporation, China’s largest sovereign wealth fund, announced purchases early this year of about 4.5 tons. While not a central bank, it is likely that the investment had the blessing of the PBOC. Interestingly, the CIC purchased this gold via the SPDR Gold Trust, the NYSE-listed gold ETF.
At the very least, even if a one-time isolated purchase, it further signals China’s very positive “pro-gold” official attitude . . . and gives private investors greater confidence to buy gold for their own saving and investment programs.
Another very important factor — one that has been especially apparent in recent weeks and months has been rising private-sector investment demand for gold from across the old industrialized world.
Private investors in the United States and Europe, both individuals and institutions, are buying more gold reflecting the same concerns and fears that are driving central banks to accumulate the metal.
They are increasingly concerned about the huge deficits and debt of governments on both sides of the Atlantic . . . and that accelerating inflation and depreciating currencies will eat away at their other savings and investments.
Just as the European sovereign debt crisis has gathered steam, we’ve seen a substantial rise in physical investment demand across Europe — from Germany, Switzerland, France, the United Kingdom and other countries — like the United States. And, just as we’ve seen on earlier price advances, mints (like the United States Mint, the Austrian Mint, and others; refineries (that manufacture small investment bars); and precious metals dealers report very strong demand from retail investors, so much so that premiums on small bars and coins have risen in recent weeks.
Importantly, as in earlier big advances in this gold bull market, these are mostly long-term investors — and their purchases, unlike those of traders and speculators, are not likely to return to the market anytime soon.
Similarly — and perhaps even more important to the long-term outlook for gold — we have seen rising long-term investment demand from India, China, and other newly industrialized nations.
Gold has historically been a preferred medium of savings in India, China, and many of the other Asian countries. As incomes rise, as more people enter the middle class, and the numbers of truly wealthy increase, it is only natural to see some of this money flow into gold.
Both India and China, because of their huge populations and the movement of millions of people each year from poverty to middle class, and from rural areas to the cities, have tremendous potential in terms of the volume of gold investment that will be purchased in future years.
For gold savings and investment demand in these countries to grow requires only moderate growth in personal income. Inflation or financial market uncertainties are not required, though their presence may encourage even more savings-related demand.
I believe the economic outlook for in these countries is propitious for gold. Cautious measures to counter excessive speculation (in real estate or equities, for example), prevent overheating, restrain inflation and will keep these economies growing at moderate rates that will benefit gold demand in the years ahead.
Let’s take a closer look at each of these countries so important to the very bullish long-term outlook for gold.
As long as I can remember, Indian gold demand has always been extremely price sensitive — with rising prices quickly restraining purchases and often evoking a return flow of old scrap as holders of gold seek to take profits. As a result, the ebb and flow of India gold interest has often had a significant effect on the world market — stopping strong rallies when Indians think the price is too high and establishing floors when they think prices have fallen enough.
But, importantly, we’ve seen the Indian gold buyer adjust to higher and higher price levels. A year ago, reflecting India restraint, the world market had difficulty moving higher when prices neared $1000 an ounce. Today, Indians are still buying at $1200 an ounce. I see this behavior continuing — but at higher and higher price levels over the next few years.
But it’s not just prices that matter to the Indian gold buyer. Indian demand is now picking up and momentum improving thanks to the country’s strong economic recovery, growth in personal incomes, and — as I’ll explain later — new distribution channels that are gradually “westernizing” India’s gold market.
Last year, in 2009, gold demand was hurt, not just by resistance to rising prices, but from poor monsoons, low crop yields, and greatly diminished demand from the gold-friendly agrarian sector for whom gold has always been a traditional form of personal saving.
Now, weather forecasters (who have a much better track record than even the best gold forecaster) are predicting good monsoons and more than adequate rainfall this summer, with abundant harvests this fall, and healthy gains in personal income . . . some of which will, as it always does, find its way into gold jewelry and investment products.
What can we say about China?
After more than five decades of prohibiting private gold investment, China’s government legalized private gold investment only some three years ago . . . and today private gold investment is not just legal, it is encouraged and endorsed.
Five decades of pent-up and unrealized gold demand, the development of gold spot and futures markets, the evolution of a national gold-investment distribution system through banks and other retail outlets, the growing Chinese middle and rise in wealth across the population, inflation anxieties, and the country’s long-standing cultural affinity to gold assures that China will have an increasingly important influence on global gold supply and demand trends — and a powerful positive effect on the metal’s price for years to come . . . and this doesn’t even take into account the on-going “official” or “government-related” purchases that I’ve already mentioned.
We also see some very important institutional and structural developments occurring in the world of gold. New gold investment products and channels of distribution are making gold more readily accessible to more investors, both individuals and institutions, in more markets around the world.
For example, gold exchange-traded funds, that allow investors to purchase gold via an equity-like vehicle, were introduced only six years ago. Now there are more than 18 such funds traded on many stock exchanges around the world — and a new gold ETF is just now being launched in Japan. Since their introduction, the total quantity of gold held on behalf of ETF investors has grown to more than 1900 tons. This is more than is held by the central banks of all but four countries.
Another example: In China, private gold investment was legalized only three years ago after five decades of proscription. Now, not only is gold investment legal, it is encouraged by the central government. Five national banks have been authorized to trade gold and make gold investment products — small wafers, bars, coins, passbook programs and accumulation plans — available across China. In addition to these banks, physical gold is also available to investors at stand-alone gold investment retail shops and at department stores.
Similarly, in India, we are seeing the introduction of new products in the past few years, including a gold ETF traded on the Mumbai Stock Exchange, as well as online physical investment products offered online by a number of financial service firms. Beginning in September the postal service there will begin selling small coin-like medallions at post offices in rural agrarian communities where there is great interest in gold but a paucity of banks and financial firms for savers to purchase the metal.
These new products, distribution channels, and other advances in the gold investment infrastructure are resulting in a permanent upward shift in the demand curve for gold — so that the average price of gold, stripping away the big cyclical swings, will in future years be much higher than most of us would now imagine possible.
Well, I think I’ve already talked too long but I do want to make a point about declining world gold-mine production.
Global gold-mine production has been in a downtrend for decades. Despite a small uptick last year and possibly again this year, the fall in world mine output will continue for at least for the next five years . . . and probably for years longer.
The ebb in mine production reflects many factors, including the depletion of existing deposits, the continuing drop in ore grades, the decline in operating depths at many mines, the rise in energy and labor costs, the expense and time required to meet increasingly restrictive environmental regulations, unfriendly government attitudes toward foreign investment in some gold-producing countries, and the lack of financing available to many gold-mining exploration and development companies.
Even if the expected leap in the price of gold triggers much more exploration and development . . . and even if new significant economic deposits are discovered . . . it can take five to ten years or longer to bring a large discovery into sizable production.
So there you have it, my reasons and analysis behind my positive outlook for gold.
