Which Time Is Different: Gold or Sovereign Debt Levels?

by: Generation Consulting

I was in an unfortunate internet debate (that I regret) with a poster of the future value of gold and he remarked something to me that made ponder my initial stance. I argued that sovereign debt levels are unsustainable and he highlighted the perceived astronomical price of gold as he sarcastically exclaimed, “Please, pile away into the trade…. This time is different! It has to be!”

Though I remained entrenched in my position, I confess that this made me reevaluate my initial views (as I believe any good trader/investor constantly should). I asked myself: “Am I falling for TTID syndrome?” As gold prices hit nominal record highs such as did oil in 2007, and sovereign debt levels reach their own absolute record highs, I was forced to wonder, which of us is falling for TTID syndrome? After careful study of both sovereign debt levels and the price of gold, I am further bullishly convinced on gold. In my article, I will attempt to demonstrate that the risk of sovereign default (or something similar) remains extremely high and that the price of gold is currently undervalued.

To begin, debt-to-GDP levels are high- not only in nominal terms but in historical relative terms, using the United States for example.

As you can see, debt levels are reaching historical peaks that have not been encountered since World War II. However, in contrast to that period, we no longer have a mobilized economy, a young, burgeoning population, and a massive trade surplus. But, does this scenario necessarily invoke the possibility of sovereign debt crisis? Is this time different?

Fortunately, to help the settle the debate, there actually a book called “This Time is Different” recently released by Carmen M. Reinhart and Kenneth S. Rogoff. The book is a dry, academic book, heavy on charts, graphs, and mathematical formulas; it has been called a “Masterpiece” by the Financial Times and “Essential Reading” by the Economist and has been wonderfully enlightening to me.

The book is 463 pages long, so no, I will not summarize but the following graph is something that is extremely troubling.

click to enlarge images

Wow. Now, pretending we don’t currently do not know anything about the state of the world, if only there was some kind of mathematical formula if certain countries were at high risk of default. Fortunately, Reinhart and Rogoff offer one. They split the countries of the world into three groups: Club A with continuous access to capital markets, Club B with limited debt tolerance (where the fun happens), and Club C with no access to capital markets. Club B is then split into four subcategories with “Type IV countries” as the most debt intolerant. For the sake of brevity, I will only focus on Type II, III & IV (quasi-debt intolerant and debt intolerant countries)

Countries are ranked on their Intuitional Inventory Country Credit Ratings (to factor in perception) and a ratio of external debt to GNI (to monitor sustainability). A score below 47.5 in the IIR and a percentage of 35% or above are considered extremely healthy, and at risk for default. It took me awhile to find the data from II, WB, and IMF and here are some of the winners:

  • Hungary: 56.9, 122%
  • Portugal: 62.6, 227%
  • Italy: 70.4, 133%
  • Ireland: 67.5, 1,424% (yes, that is correct)
  • Greece: 43.9, 175%
  • Spain: 66.7, 171%
  • UK: 81.5, 404% (thrown in for fun)

The external debt-to-GNP levels over 100 “run a significant risk of default” and the average ratio of defaulters in recent history (during and since the debt crises in the early 1980s) has been 69.3 for middle-income countries (though one could fairly argue that a country that defaults, is predisposed to defaulting, and thusly, would most likely default at lower ratios). Russia (1998) and Argentina (2001) defaulted at rates of 58.5 and 50.8 respectively. Ladies and gentleman, we are one oil shock, one Israeli bombing run, one major terrorist attack, one North Korean playday, one failed bond auction, and one developing world revolution from fiat currency hell (including an unimaginable amount of other inconceivable blacks swans); the international financial system is at a precipice.

Furthermore, even if nations avoid outright default, many have chosen to pursue inflation, devaluation, or debasement. Niall Ferguson, author of The Ascent of Money, a must-read, outlined six possible reactions to unsustainable debt levels. Invariably, with only one exception, countries have chosen to either inflate/devalue currencies or default on debt.

Thus, we return to the question: “Is this time different?” Does the rate of sovereign debt crises remain forever flatlined like the Fed Funds rate (i.e. free money to banks!) or should we come to expect future sovereign debt issues that put enormous pressure on fiat currencies vis-à-vis gold? Where does this leave countries not supported by Germany in the eurozone? Even within the eurozone, do the new financial regulations recently proposed include stipulations for an “orderly default” as Angela Merkel, the savior of Europe, has suggested?

In addition, although this throws off the flow of my argument a bit, I would like to address some counter-points.

First, for someone who sees the 2003-Present blip on chart 2 and argues, “well, there are bound to be some sovereign defaults but I am sure it will not hamper the entire global economy”. These are probably the same people that saw the chart for real estate prices and consumer debt levels in 2005 and argued for the “soft landing” (funny how no one talks about that anymore), or who saw the subprime mess “contained” (ditto). Reinhart and Rogoff argue that sovereign defaults depend on a country’s willingness. That is why countries such as Turkey (1978), Brazil (1983), Argentina (2001), and Russia (1998) can default on relatively benign levels (compared to now) levels of external debt-to-GNI of 21.0, 50.1, 50.8, and 58.5. Though “Europe” or other countries can maintain every intention to stave off default, if one country is forced into default due to any number of black swan scenarios, it creates a “moral hazard” that weakens other countries’ willingness to take the pain and suffering to satisfy their own debts. That is the “contagion effect”, and why we refer the phenomena as a “wave” or as “dominoes”, and why the second chart looks like a metropolis skyline. If Greece defaults, why shouldn’t we?

Secondly, for someone that argues the industrialized nations will be able to recover economically in time and straighten their budgets and implement significant austerity before there is an issue (“significant” and “issue” purposely chosen), is underestimating the precariousness of the central banks’ position. Because private investment and lending has not increased, pulling government spending too soon will lead to a “deflationary death spiral”. If this were not the case, why would Obama, Geithner & Co. fully aware of the fear surrounding sovereign debt that has been priced into Greek bonds and gold, choose to match record national debt with a record budget deficit? Tightening too soon would drive us into a massive depression ala The Great Depression, which would make the debt untenable in its own right, forcing governments to keep spending high and liquidity rampant.

Also, what exactly is austerity? When each Greek citizen owes $250,000 dollars to pay government liabilities when debt and pensions are included, is only borrowing 300% more than the legal limit outlined by the Maastricht treaty count (3% deficit to GDP), can this really be called austerity? Although the United States’ external debt is still quite manageable, the United States government (not including public debt) owes $130 trillion including Fannie/Freddie, states’ debts, and unfunded pension, Medicare, Medicaid, and Social Security liabilities (on 4.4 trillion dollar revenue, with an already $1.47 trillion dollar annual deficit). I argue that the extent of the liability and the polarized, poisoned climate in Washington almost necessitates a debt crisis, whether real or imagined, to give politicians enough political capital to make government expenditures reasonable. Do you think either Republicans or Democrats want to be the party that killed your pension, your Medicare, your Social Security?

This, I believe, is an almost a logical proof that we will be forced to hear US debt crisis in the news before politicians muster enough will and political capital to make the necessary and drastic structural changes. When sovereign debt comes to a head, which I hope I have inevitability and historical unsustainably, whether the outcomes is a deflationary death spiral, massive inflation, or outright default, either scenario will drive the price of gold bonkers.

Returning to gold, is this time different for the precious metal? Is gold massively overpriced?

I’m sure most Seeking Alpha readers have read the articles by Cullen Roche and Henrique Simoes that boldly declare that gold is heading for a correction. The Nomura chart is particularly striking.

Cullen calls the move into gold “irrational” and Simoes writes:

Gold looks expensive relative to stocks and to agriculture commodities on a historical basis. My view is that there is a great risk in opening new gold long positions at these price levels and the risk of a sudden, large market correction is quite high.

Ignoring that Simoes is only pointing out the obvious (“gold looks expensive relative to stocks…”), this is cheap, cheap, cheap analysis and neither tells us why these graphs are particularly important. I, in my limited knowledge, will attempt to argue that these graphs

First, oil is traded in US dollars and one would expect that any weakness in the dollar to be reflected in oil prices, which in turn, would be reflected in the oil to gold ratio. However, while a level of risk of dollar devaluation is priced into oil, oil is currently trading on supply and demand issues. The appreciation of gold-to-oil is a natural reflection of gold’s rise to dollar. Furthermore, gold-to-oil is trading at a ratio of 16x’ lower than in the 90s, and higher than in the 2000s, a period of the great bull market in oil, and before the real risk of sovereign default was priced since 2008 (due to a causes as the doubling in two years of the US national debt)

Secondly, the chart comparing gold to corn is misleading. From June 2008 to June 2010 (the end of the chart), corn prices have fallen a whopping 50% So the recent run up of corn vis-à-vis gold may have more to do with corn than it does gold.

Third, the S&P suffers from the same problem as oil as it is also traded in dollars so any weaknesses in the dollar would be inherently reflected in the gold-to-S&P chart. While one could hypothesis that the threat of devaluation and inflation could be reflected in the S&P stocks (in this case, vis-à-vis equities of companies), I would argue that it would be extremely difficult to predict the effect of a loss of faith in fiat currencies would have in stocks. In all likelihood, sovereign debt issues would make stocks weaker, as reflected in the markets during the 2010 European sovereign debt crises and the Chilean hyperinflation to name some examples. Furthermore, the stock market has proven time and time again its inefficiencies and misallocation (see: Nasdaq Bubble 2000; 2008, all of).

I argue that the Nomura graphs which Simoes and Cullen present are as useful to predicting the value of gold as a milk-to-gold chart, or even a “how Steven Levinson feels on Sundays” to gold chart, or any chart other than what has been driving the price of gold recently: sovereign debt and currency fears... Cheap, cheap, cheap analysis.

Here are charts that I believe are more useful that show gold is cheap. I would also like to link Stephen Loeb’s article.

Real price of gold:

Basically, from the charts, I want to convey that gold is not extremely overpriced in nominal terms, and its recent increases only track the increase in the money supply (which has been on steroids since the early 1990s, and is now blasting off in search of stars). Furthermore, it appears that the threat of sovereign default or currency devaluation, which appears likely in historical context and nominal terms, is yet not fully priced into the precious metal.

If I may add personal opinion without charts, graphs, stats, and links (ignore if you’re a financial empiricist like me); Everything we have seen appears to be caused by the excessive liquidity and borrowing beginning in the early 1990s; and that the financial pain has slowly moved one rung up the ladder since the middle of the decade: the American/European consumer (2006-7), the Countrywide, Golden West type banks (2007-2008), the big banks Lehman, Wachovia, Bear Stearns, etc. (2008-2009), PIIGS-type countries (2009-2010), and the big countries (2010+). The debt, quite simply, needs to work itself out. The recent Greek bailout by the European Union can be compared to the Countrywide Financal firesale to Bank of America (NYSE:BAC): indicative of deeper problems, and good money thrown after bad to “shore up” the financial system.

If the situation comes to a head, and it appears it inevitably will, there will be a rush to the hardest of the hard assets (things countries fight wars over: bullion, oil, food, profitable land). As the system restructures and rebalances, someone in these assets will be able to cash out and snatch up depressed assets such as equities in solid companies.

If I may conceptualize a bit (also feel free to ignore), imagine the present is 1913. You are a Parisian discussing geopolitics and global economy, with no ideas the economic and material devastation that awaited you in the 20th century. As you take a long drag from your cigarette, you remark upon the world around you; how the telegram (internet) has facilitated cross-continental communication, how unprecedented levels of trade have bound countries together – especially between the superpowers UK and Germany (Chimerica), how innovative and extraordinary federal intervention by the American government in response to the Panic of 1907 to create the Federal Reserve makes future financial panics extremely unlikely, how Argentina- the world’s largest emerging market- has railroads now and is now the world’s 5th largest economy, how the destructiveness of weaponry born in the 2nd Industrial Revolution makes warfare extremely unlikely, and just how interconnected we all our and that, as far as you could see, things just appear so darn settled.

Disclosure: Author is long human emotion, human history and the ultimate store of wealth in an uncertain time (GLD, AUY, KGC)