While timing exactly when the rebound will happen is impossible, Marshall Auerback, director of Pinetree Capital, believes now is the time to pay the gold market renewed attention. In this exclusive Gold Report interview, he explains why the gold market is more interesting than in the recent past and shares what he would do if he were chairman of the Federal Reserve.
The Gold Report: Marshall, in a July 12, 2012, post on the Pinetree website, you suggest that some central banks may have forward-sold their gold against their initial positions, thereby eliminating them altogether. Can you tell us more?
Marshall Auerback: I have seen these central banks in action and have met with people from several of them. They would contend it was their obligation to maximize the yield on any of the assets they had in their reserves, including gold.
Back when gold was in the low $300s/ounce (oz), the Bundesbank considered gold nuclear waste from the old gold-standard era. There are some suggestions, based on Roger Lowenstein's work, that the Bank of Italy lent out some of its gold to long-term capital management as a funding source. The point is that these banks have been a major source of flows into the market. These flows have had the same impact as de facto sales, in that they make available gold to the forward market and help fill the gap between supply and demand.
This is significant that the Bank for International Settlements has talked about reclassifying gold for commercial banks from a Tier 3 to a Tier 1 asset, which effectively means that gold will have 100% weighting, as opposed to 50%. This reflects a change in how the official sector views gold.
The second phenomenon is what has been happening in the Eurozone. A fiat currency is vaporizing before our eyes. A number of central banks hold a substantial amount of euros in their foreign exchange reserves that may be worth nothing. Some central banks may have gold holdings, but not as much as they claim, because of forward sales. There is most likely a structural short in the market from the central banks.
A decade ago, the mining companies would have been selling forward production, and the private sector would have had the structural short position. Today, nobody is selling forward gold, because companies are much more optimistic about the price, and nobody wants to borrow it right now. As usual, the central banks are on the wrong side of the trade.
TGR: Are you willing to speculate about which central banks are shorting gold?
MA: From what I have heard, it would not surprise me if the International Monetary Fund and the Bank of Italy have done it. The Bank of Spain and the Bank of Portugal have sold a lot of their gold and may be lending the rest; also the Bundesbank.
A lot of these sales took place many years ago when the price of gold was $500-1,000/oz. My point is that the actual holdings these banks retain are much smaller than what appears on their balance sheets. Of course, they would want to get that gold back to spare the embarrassment if the euro blows up. This is why I have suggested that even if there is one more selloff in gold, the declines will be cushioned because the central banks will be bidding to buy back what they sold forward.
TGR: Could this information create a spike in the gold price?
MA: Many thoughtful people would see the demise of the euro as very bullish for gold, along with the possibility of higher inflation in China and all of the qualitative easing introduced by the Federal Reserve lately. Yet, gold has gone nowhere.
If one measures the position of traders reports on the Comex and then factor in that the Over the Counter market [OTC] is about 5-10 times the size, the net long position of speculative interest in gold is huge. That said, net positions have been reduced substantially in the past several months--several hundred tonnes would be my guess--and yet the price hasn't declined that much, which suggests that there is a bid in the market. The official sector, perhaps?
I would say there could be another 400-500 tons liquidated, which would easily be absorbed by the central banks. Ultimately, this slow, ticking time bomb will resolve itself with a much higher gold price.
TGR: Is Pinetree Capital increasing its overall exposure to gold equities due to your theory?
MA: I think we have increased it from a few years ago, but I do not know if my theory has had an impact.
Our general feeling at Pinetree that gold is slowly being re-monetized has driven our investment decisions. Relative to the metal, gold equities are at such valuation extremes that it makes it a much more compelling valuation relative to copper, iron ore or some of the base metals. But we've been bullish on gold since the early 2000s, based on the positive supply/demand fundamentals. All of those factors are part of the decision to increase our overall exposure.
TGR: How much of Pinetree's resource pie was dedicated to gold-based equities on March 31, 2012, versus March 31, 2011?
MA: We remain at 40-45%. The percentage is much more significant than it was two years ago. We have been bullish on gold since we started investing back in 2002. However, it is important to point out that we are talking about shifts within valuations relative to copper and iron ore.
TGR: How do you explain the recent disconnect between the performance of gold and gold equities?
MA: One reason is the very strong rally in 2010. When you have a strong rally, a digestive process seems to follow. The market gets loaded up with paper and it takes 18-24 months to resolve before a new cycle starts. At this point, a lot of paper has been digested and the sellers have mostly gotten out of it.
There also is increasing resource nationalism. Mines operating in politically sensitive jurisdictions have been derated for that reason.
In addition, gold has been securitized. Ten years ago, we didn't have a gold exchange-traded fund as such. A lot of people simply buy these synthetic indices instead of junior stocks. But once you get a strong rally in the gold price, people inevitably come back.
Finally, there are liquidity preferences. People tend to buy the bigger stuff first and if the rally sustains itself, as I think it will, they will move into the smaller stuff.
TGR: When do you anticipate that rebound?
MA: Autumn would be my guess, sometime in the next three or four months.
Initially, market volatility will increase fairly dramatically. You might get one more sharp spike to the downside, as the result of euro-related selloffs and the drive for dollars. These movements start with what I call the "algo monkeys," traders whose computer programs use algorithms to trade mechanistically, independent of any kind of fundamental backdrop.
I expect a substantially higher gold price four to five months from now. A year from now I would not be surprised to see gold above $2,000/oz.
TGR: You also are a proponent of further public-sector deficit spending to create jobs and reduce private-sector debt.
MA: Yes, and it has nothing to do with Keynesianism; it is Accounting 101. In any accounting period, total income in an economy must equal total outlays, and total savings out of income flows must equal total investment expenditures on tangible assets.
The financial balance of any sector in the economy is simply income minus outlays or its equivalent, savings minus investment. Any sector, whether it be the government, external, import/export, private household or businesses sector, can run a deficit or a surplus. In aggregate, they all have to balance, but any one can run a deficit providing someone else is prepared to run a surplus.
If the private sector, in the aftermath of the recession, is trying to pay down debt and re-establish a level of savings, you have to prevent a major contractionary spiral. That means either substantially increasing exports or running a larger government deficit. The latter facilitates private-sector deleveraging and helps sustain economic growth by putting a floor on demand.
Everyone who promotes cutting back public spending is effectively advocating private-sector debt. A private-sector debt bubble got us into this mess, not profligate government spending.
TGR: You have accused Ben Bernanke, chairman of the Federal Reserve, of "talking out of both sides of his mouth." What would you be doing if you were in his shoes?
MA: The first thing I would do is be honest. Mr. Bernanke has quite rightly warned of the dangers of the U.S. falling off a fiscal cliff at the end of 2012 if there is no agreement between both houses of Congress and the president to prevent $1 trillion in budget cuts, and I applaud him for that.
But then he goes on to say, longer term, we have to pay down these bills because they are fiscally unsustainable. I think that is totally wrong. Fiscal sustainability is a meaningless concept. A country that issues its own currency and issues debt in a free-floating, nonconvertible currency can always create more of its currency to sustain its spending. Mr. Bernanke should be honest about this, but central bankers always emphasize the virtues of monetarism. There is no evidence that their tools work. The impacts of monetary policy, as opposed to fiscal policy, are much more diffuse. It is akin to doing surgery with a butcher's knife rather than a scalpel.
TGR: Do you advocate targeting certain areas of the economy versus broad-based bond buying?
MA: Bond buying via quantitative easing accomplishes nothing. It simply constitutes an asset swap on the Fed's balance sheet. When the Fed buys a bond, it replaces the bond with reserves in the banking system. You are swapping something that yields 2% with something that yields 0.25% at current rates.
There is nothing inherently inflationary about the process, as it is only spending per se that creates inflation (and that assumes that we are at full real resource usage). Monetary policy per se does not contribute to overall increases in aggregate demand or spending power. There is actually an argument that it reduces it, because as you are presumably helping borrowers, you are robbing savers and pensioners of income by keeping rates low.
I think it is more important to get money into the hands of regular individuals so they can spend. A lack of spending power is creating the conditions for sluggish economic growth.
TGR: What would you do besides being honest?
MA: I would like to see the federal government implement more New Deal-style programs, as we had under the Works Progress Administration and Civilian Conservation Corps. I would have a government job guarantee [JG] program as a permanent feature of government spending, to act as a buffer stock the way gold did under the gold standard system. Government as employer of last resort would not be introducing another element of intrusive bureaucracy into our economy, but simply better utilizing the existing stock of unemployed, now dependent on the public purse-especially the chronically long-term unemployed.
The current system we have relies on unemployed labor and excess capacity to try to dampen wage and price increases; however, it pays unemployed labor for not working and allows that labor to depreciate and develop behaviors that act as a barrier to future private sector employment. Social spending on the unemployed prevents aggregate demand from collapsing into a depression-like state, but little is done to enhance future growth and demand, which can be done via the JG program by providing them with employment, greater education and higher skill levels.
The JG program would allow for the elimination of many existing government welfare payments for anyone not specifically targeted for exemption, and would command greater political legitimacy, as society places a high value on work as the means through which individuals earn a livelihood. Minimum wage legislation would no longer be needed, as it would be established via the JG. Labor would welcome the safety net of a guaranteed job, and business would recognize the benefit of a pool of available labor it could draw from at some spread to the government wage paid to JG employees.
Additionally, the guaranteed public service job would be a counter-cyclical influence, automatically increasing government employment and spending as jobs were lost in the private sector, and decreasing government jobs and spending as the private sector expanded. It would therefore remain a permanent feature of our economy, in effect acting as a buffer stock to put a floor under unemployment, while maintaining price stability whereby government offers a fixed wage, which does not "outbid" the private sector, but simply creates a stabilizing floor and thereby prevents deflation.
When the private sector wants to retrench, the government would step in and offer jobs at a certain rate for anyone willing and able to work. That would resolve this old canard about how much unemployment is voluntary versus involuntary. The point is, not to outbid the private sector for workers, but to keep workers trained and working until the private sector is ready to hire. Otherwise, capacity restraints appear much earlier among the long-term unemployed, because their skills erode substantially.
I also would introduce revenue sharing with the states so they would not have to use the contractionary fiscal policies that they are introducing now. This would be done on a per capita basis for all 50 states.
In addition, I would like to see large infrastructure projects undertaken. All you have to do is drive through New York City to realize that $1T could be spent revising that city's infrastructure alone. That would generate growth, employment and higher incomes, and you would have a substantially lower public deficit as a result.
My point is that you do not want credit-based policies. You want policies that increase employment and income.
TGR: Are Western economies headed for another recession inside of two years?
MA: They could be if the mania for fiscal austerity, particularly in Europe, continues. What is happening in Europe is misconceived and destructive. If you are in a hole, the first rule is to stop digging. The risk of the U.S. falling off a fiscal cliff is reduced if Obama is re-elected.
And while it has slowed down, I see signs that China is responding with another big ramp-up in fiscal expenditures, through state-sponsored, fixed-investment projects that are financed through expansion of bank credit and money.
The Shanghai Securities News reported that China's four biggest banks issued around ¥50 billion, about $8B worth in new renminbi loans in the first half of July. That is double the same period in June. The article also suggests that China has been speeding up infrastructure, project approvals, spending subsidies and offering tax breaks for smaller businesses. This is significant because some fairly pronounced domestic inflationary pressures remain in China. Renewed money and credit expansion will increase the rate of growth of nominal incomes, and that will go more into price inflation, as opposed to real growth, which has been the case in the past.
TGR: With everything we have talked about in mind, is this the time to invest in high-risk mining projects?
MA: We are closer to an inflationary inflection point than a lot of people realize. In addition to what I've described in China, you have the dynamic of a possibly evaporating euro. You have political pressures in Japan for a monetary policy that pursues a positive inflation target. Eventually, the Fed will try another gimmick to shift private portfolio preferences toward assets like gold.
Add all of those things together, and you have a very gold friendly environment.
At first, this will manifest itself in demand for the bigger companies, but many of the smaller companies have very compelling valuations. I look at them as long-day, gold-call options.
Timing the entry points is never easy, but I think we are closer to the beginning of the end of the down cycle. The gold market is more interesting than it has been in three or four years. Now is the time to pay it renewed attention.
TGR: Market conditions have taken a negative turn this summer. What's your advice to retail investors today?
MA: Patience, patience, patience. To acquire strategic positions in this market sector, you have to get in early and sometimes sit with your positions. It can be very frustrating, and you cannot time these things perfectly.
Markets tend to gap up very dramatically, sometimes on very limited volumes. We would rather be in position when the move comes. People know that when they invest with us, they will be getting the full, maximum leverage. We are not trying to be market timers. We may be a little bit in the relative valuation business, in terms of preferring one sector to another, as we do with gold right now.
When you have good macro combined with strong valuation considerations, it is a good time to invest over any sensible medium- to long-term timeframe.
TGR: Marshall, thank you for your time and insights.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
This interview was conducted by Brian Sylvester of The Gold Report.
As Pinetree Capital's corporate spokesperson, Marshall Auerback is a member of Pinetree's board of directors and has some 28 years of global experience in financial markets worldwide. He plays a key role in the formulation and articulation of Pinetree's investment strategy. Currently, Auerback is a senior fellow at the Roosevelt Institute, a research associate for the Levy Institute and a fellow for the Economists for Peace and Security.
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