As we look upon yet more unprecedented times in financial markets, the debates about outcomes of inflation and deflation still rage. We are not necessarily wedded to either of these, taking the view that only policy responses from the financial authorities will reveal what lies ahead. It seems most market participants wait with baited breathe to see how different policy responses in different jurisdictions will play out. In very general terms it appears the Fed is still more liquidity happy and ideologically aligned to stimulus and the Europeans (although often contradictory in their lack of consistency) are less keen on the printing press, with the Germans still haunted by memories of Weimar hyperinflation.
Whilst we as staunch Austrians would prefer less liquidity provision and more allowance for markets to naturally self-correct and deleverage, we are not encouraged by many of the authorities (maybe the Swedes and Norwegians are closest to getting it right though). We suspect that as markets try to self-correct, the authorities generally will be forced to print more and more; it is the easiest course for them to take and the typically all too human option. Our thoughts returned to this issue as we were treated to the pre-release of a very thought provoking film called the "Four Horsemen" last Tuesday. This film is certainly worth watching when it is officially released and our thanks to Ross and Megan Ashcroft for the kind invite.
Nonetheless, here we are and we face a European banking system nearly 3 times more leveraged than the U.S. banks, and surely bereft of any remaining equity. As such we look once more at how inflationary and deflationary outcomes might affect precious metal investors.
Inflation and perhaps hyperinflation.
An inflationary, and possibly hyperinflationary, scenario is naturally an outcome we are lead to by desperate authorities becoming locked into the printing press as a policy response. We believe Bernanke is pretty much backed down this road now, as should he try to flip-flop back to austerity as a new response his previous raison d’etre would be completely undermined and his legitimacy busted. We believe this month’s announcement by the world’s leading central banks to act collectively to provide essentially unlimited liquidity to the financial system is further consolidation towards this collective policy response. We continue to urge investor cynicism with the inflation figures reported by the authorities who naturally have their interests to protect. Note the differences found in the official American data, and the data released by John Williams’ Shadow Government Statistics. When it comes to managing our portfolios and returns, we would prefer to use Mr. Williams’ inflation in-puts.
In such a scenario when the inflationary genie starts to emerge further and further from the monetary lamp, and as the world’s savings and purchasing power are depleted, the precious metals should shine. In this scenario as we experience higher and higher price discovery for gold and silver the price limits for these metals can only be assessed in relation to how much money the authorities print. The upside is only limited to how enthusiastically the authorities increase the money supply. More adept forecasters than us, the likes of James Turk, Jim Sinclair and James Rickards, look for gold prices of $10,000, $10,000, and >$5,000/ounce respectively. As fans of Nasim Taleb’s musings on human powers of prediction, we are less keen to offer price targets, but the aforementioned market participants have exemplary records and are certainly worth listening to. Nonetheless we find gold and silver fundamentally undervalued today in relation to recent levels of money printing and the attendant risk in the financial system, so should easing become the general global policy response gold and silver are set to move significantly higher.
Within this scenario we would also see the mining shares rewarding investors richly. In fact we like Jim Sinclair’s hypothesis that the precious metals miners will become the most significant dividend payers and will thus become the ‘utilities of the future’. The use of the term ‘utility’ in relation to the gold and silver sector might be a new way of thinking for some, but should gold and silver return to the heart of the monetary system, these miners are essentially supplying our money. They would be supplying an essential commodity, not that different to water or electricity. We are sympathetic to this prediction, and the gold miners are thinking more intelligently about the issue of dividends, admirably lead by Newmont Mining (NEM). It would be the precious metal miners acting as such dividend payers and utility stocks that would start to bring in some larger more long term focused investors that have as yet remained on the sidelines; the pension funds. So far pension funds have had minute allocations to the bullion and the miners.
This is where our analysis will perhaps become more controversial, because we believe that a significant deflation in today’s financial system will also be positive for precious metal investors.
Although we feel precious metal investors would be rewarded in this scenario, this may occur more slowly than in a significantly inflationary scenario. We would suggest that deflation would gradually put unbearable pressure on banks’ balance sheets, and bank failures would become more and more common. Fiat currencies, working hand in hand with a highly leveraged reserve banking model, have conspired to deliver us to our current situation. Investment banking failures might not capture the immediate attention of Main Street, but as this contagion spreads to commercial banks, savers would open their eyes further to the potentially risky nature of keeping cash in a bank. As Eric Sprott continually reminds us, ‘keeping money in a bank is a risky investment’. We have also looked at this issue previously, and find the recent example of Dexia’s bankruptcy, only judged a safe and stable institution by European stress tests a few months ago, extremely illuminating. Given the degree of leverage still at work in the banking system a domino effect of failures is not difficult to imagine.
The depositors of the world would then increasingly have to reconsider what vehicle is more apt for holding their savings. The market will simply have to find a new savings mechanism in which to contain its money and liquidity. Where would the market turn to in this reallocation of capital? Well, the market has typically chosen gold and silver as money throughout the history of human development. As gold and silver’s almost unique properties are more widely appreciated once more, the fact that these assets are no-one else’s liability will again be greatly appreciated.
Within this deflationary scenario, we also see the mining shares rewarding investors, and find the case of Homestake Mining during the 1930s in America a useful guide post. Amidst a wider deflation of significant proportions, pretty much the only capitalist endeavour one could get financing for was for a gold mine. During this decade there were close to 100,000 gold mines in North America. The share price of Homestake went from $80 in October 1929 to $495 in December 1935, but this capital appreciation was not the only reward for investors. During these six years Homestake paid out a total of $128 in cash dividends, and the 1935 dividend alone was $56 per share. A 70% dividend yield pay-out (basis year 1929) in only one year is pretty exceptional in a wider deflation. It is for these reasons we are so encouraged by Newmont Mining’s previously mentioned moves regarding dividend pay- outs. As John Hathaway at the Tocqueville Gold Fund comments, these mining stocks are going to be growth stocks.
Some readers may be wondering about how silver miners might perform in this scenario given silver’s industrial demand component. We are bullish on silver and thus quality silver miners, in such a scenario because of our previously articulated analysis of silver’s fundamentals.
This analysis may be high level, macro, and contain some premises which are new to readers, but it is because of our opinions above on gold and silver’s potential performance during inflation or deflation that we are so attracted to these asset classes. This is why we find gold and silver bullion as an excellent place to hold some of your liquidity or money (gold first, then silver as a more speculative allocation), and the precious metal miners as one of the best places to allocate your investment capital.
One should note the key difference between liquidity and investment within this.