Rick Rule is director, president and chief executive officer of Sprott U.S. Holdings. He leads a highly skilled team of earth science and finance professionals who have deep experience in many resource sectors including agriculture, alternative energy, forestry, oil and gas, mining and water. Rule is a contributor to Sprott's Thoughts, a free educational resource for investors. HAI Managing Editor Sumit Roy recently caught up with Rule to discuss the outlook for commodity markets, and particularly gold.
HardAssetsInvestor: I've heard you talk about the possibility that we could see a black swan type of event, perhaps in the near future. It's been awfully quiet in financial markets, with stock markets near record highs, and seemingly no worries on the horizon. Should investors be more vigilant?
Rick Rule: Yes, they should. I'm not trying to suggest there is a black swan that's imminent. But investors need to be vigilant about the premise that is driving this market and this alleged recovery. That premise is that short-term liquidity is a substitute for solvency.
The fact that central banks around the world have primed the pump with incredible amounts of very-low-priced, short-term liquidity in the financial services systems makes the investment community and the voters themselves less concerned about the obligations that Western societies have encumbered themselves with. But these obligations are clearly unsustainable from a mathematical point of view, over any period of time. And that's really the risk I see that needs to be addressed by investors.
HAI: You're talking about the federal debt that we have; the Social Security obligations, etc.?
Rule: Well yes, among others. The $17 trillion in on-balance-sheet liabilities at the U.S. federal level is certainly a concern, as is the $70 trillion-and, by the way, this is their estimate, not mine-of off-balance-sheet liabilities.
If you overlay on top of that the chronic underfunding of public and private pension systems in Western Europe and the United States, and the state and local deficits, there are plenty of reasons to suggest that liquidity is not a substitute for solvency. That's something investors need to think about.
Rule (cont'd.): We are complacent about the federal government deficit, which is now $1 trillion a year, down from $1.4 or $1.5 trillion. We are only able to borrow in capital markets three-quarters of that deficit, or $750 billion. We pay for the other $250 billion through a process they call quantitative easing (QE). If you and I did it, it would be called counterfeiting.
We conjure up currency from thin air and use it to buy paper that we can't otherwise float in the market. I'm not forecasting what, if any of these circumstances, will cause the economy to blow up in the near term. But I certainly think the premise that liquidity is a substitute for solvency is a very, very flawed one.
HAI: You just touched on QE. Of course the Fed has been slowly ratcheting that down. But even in the face of that, gold has been acting pretty well. Do you see this rally continuing?
Rule: What I suspect is that the sell-side pressure in exchange-traded funds such as GLD [the SPDR Gold] and in the futures market is out of the gold market. I expect we'll see a lot less sell-side pressure in the futures market and in GLD than we saw last year.
The unwinding of the forced selling from leveraged financial institutions like hedge funds has given the market some room to go up. Last year you saw this incredible dichotomy between the almost surreal strength in physicals markets, and the continued weakness in futures markets and in the ETFs.
I commented at the time that the phenomenon we were witnessing was the classic bear market bottom, where assets moved from very weak hands, in this case, leveraged long financial institutions, to strong hands, in this case, retail buyers for cash in the physical markets.
We also saw a move from overextended, overpromised Western central banks to underleveraged central banks in frontier and emerging markets. That's an absolute classic sign of a bear market bottom, a wholesale movement of assets from weak hands to strong.
HAI: Typically, during these cycles, do we see a period of consolidation near the lows before we can head back to the record highs? How long does it take before we can make big moves again to the upside?
Rule: There are so many potential exogenous circumstances that it would be very difficult to forecast that. While there is lots of bullish potential in gold, principally to do with the debasement of fiat currencies, you also have a situation where you have central banks that become increasingly desperate for cash.
Rule (cont'd.): Still, the fundamentals point to the upside. There's two very telling data points that your readers need to pay attention to. One is the unbelievable circumstance surrounding the Germans' request for repatriation of 1,200 tons of gold that they held abroad, and the response that it would take seven years to deliver that gold.
If you held some gold on my behalf, and I demanded the return of that gold, and you told me it would take seven years, I'd call the police. That suggests that this gold has been hypothecated, re-hypothecated and hypothecated again, and that you have a chain of parties obliged that will take several years to unwind.
The other circumstance, which is equally telling, is that six months ago, when it looked as though a dysfunctional U.S. Congress might default on U.S. obligations, the global market's response was to bid up the price of U.S. sovereign obligations and U.S. currencies. When a currency supported by a government has $70 trillion in off-balance-sheet liabilities, $17 trillion in on-balance-sheet liabilities, and $1 trillion-a-year-annual-deficit increases relative to its competitors despite the threat of default, that tells you that there is no viable alternative.
The contest now comes down to precious metals and U.S. Treasury securities; in particular, the benchmark 10-year Treasury. And I would ask your readers to compare and contrast the two. The U.S. 10-year security now pays around 2.6 percent. That implies that U.S. inflation, as measured by the CPI, is 2.1 or 2.2 percent. I would question that.
Whoever constructs their basket of goods and services does not shop where I shop. When it's convenient for them, their index does not include food or fuel, which would be OK if I didn't eat or I didn't drive, except that I do. And finally, the idea that you construct a cost of living index that doesn't include tax is farcical. If I didn't have to pay the tax, as I've said many times, I wouldn't complain about the index. But I do.
It is my belief, and this is supported by John Williams over at Shadow Stats, that the underlying depreciation of the purchasing power of the U.S. dollar is more like 6 or 7 percent compounded.
If that is true-and of course your readers will have to draw their own conclusions based on their own spending experience-the value proposition put up by the U.S. 10-year Treasury, where it pays you less than 3 percent, and your purchasing power declines by about 6 percent, is not very good. The promise that the U.S. Treasury is putting up in world capital markets is, we absolutely promise to depreciate your purchasing power by more than 3 percent compounded, for the entire length of time you own this bond.
Jim Grant has famously described this as return-free risk. So I would hold out to you, irrespective of what happens in the next two months or three months or 12 months, that the contest really comes down to the 10-year U.S. Treasury security, the benchmark store of wealth on a global basis, relative to precious metals. For me, that contest is an absolute no-brainer.
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