Consequences of the Debt-Extension Resolution for Commodities

by: Dr. Stephen Leeb

One of the ironies of the current debate about taxes – that is, whether raising taxes should be used to reduce the deficit – is that the argument overlooks a form of taxation that’s much more pernicious than any tax that Congress could ever come up with.

These pernicious taxes, known as implicit taxes, are the result of higher resource prices. The fact is that any rise in oil prices and other resources – and especially those that are not related to higher U.S. consumption – reduce consumer incomes in the same way income or sales taxes do.

But there is a huge difference. Taxes we pay to the government can theoretically be used to reduce debt or make investments. Not so with implicit taxes, where the only beneficiaries are those national economies and governments that control the resources in question.

Indeed, implicit taxes are the worst headwind an economy can face. Not only does this type of tax reduce growth, it also adds to inflation. In addition, it increases the wealth of rival nations and leaves our country with much less money to organize programs that would limit the future implicit taxes. In a sense, such implicit taxes create a classic vicious circle. For a case in point, consider how the deficit agreement resulting from the recent debt-ceiling extension debate will include less spending for alternative energies.

Admittedly, in some cases implicit taxes can be a welcome ancillary to a growing economy. For example, if your country is using more of a group of resources to build out the infrastructure necessary to transition to an economy not dependent on those same resources, you are not going to gripe about the higher prices you are (temporarily) paying for them.

But that is hardly the case with the U.S. at the present time. With housing starts bumping around half a million and oil use near a five-year low, there is no bright side to the implicit taxes we are paying in the form of high prices for metals and energy. Indeed, the extent of these taxes can be seen by looking at any multi-year chart of commodities.

Now, back to the budget agreement coming out of the debt ceiling extension crisis, which actually will cut research spending on alternative energies and probably slow U.S. economic growth even further. What effect will this agreement have on implicit taxes? You guessed it: It’s going to raise implicit taxes. Lack of research on renewable resources speaks for itself.

Moreover, unless the economy enters a full-fledged depression, the slower growth should have little effect on the trajectory of resource prices. Less resource usage by America will translate into greater resource consumption by the emerging economies. That’s because resource prices will be lower than they otherwise would have been had American consumption been higher. And this means that implicit taxes will proportionally take an ever larger piece of our economy. Not a pretty picture.

For policy makers – and the only policy maker that counts right now is the Federal Reserve – it virtually assures that additional steps will be needed to offset both implicit taxes and actual cuts in government funding (which, of course, even in the worst cases have added to economic growth – what little there has been of it). In other words, QE3 is virtually assured. And if oil prices move up further, then no one should rule out an RE2 (i.e., a second round of resource easing by the International Energy Agency, repeating what it did on June 23 by dumping still more of the strategic oil reserves on the market).

For investors this means that commodities – and especially gold and precious metals – should now be weighted even more heavily than before. It also means that investments in countries that are resource rich should also be favored – and in this regard we include Australia, Canada, and even Russia. Not only stocks in these countries but their currencies should get special attention, as the dollar is certain to become further debased.

We've previously talked about how to participate in China and concluded that two favored American plays are Apple (NASDAQ:AAPL) and Wal-Mart (NYSE:WMT), among a very small group that would likely benefit for the next several years. We would also repeat the suggestion that the Canadian rare earth deposits merit a look (albeit a very speculative one), in the form of Avalon Rare Metals (NYSEMKT:AVL), which is our own favorite, and Quest Rare Minerals (NYSEMKT:QRM) and Great Western Minerals (OTCPK:GWMGF).

But as the dollar and euro race to the bottom, you again have to emphasize gold and even the currently lagging gold miners, both juniors and seniors. Among the former, we especially like NovaGold Resources (NYSEMKT:NG) and Pretium Resources Inc., which we believe merits a far greater valuation than its current price indicates. As for the latter, our current favorites include Barrick Gold (NYSE:ABX) and Goldcorp (NYSE:GG). You can also conveniently own the metal via the SPDR Gold Shares ETF (NYSEARCA:GLD).

A word here on the notion bandied about on the internet and other media recently, that the run up in gold prices represents a “bubble.” A bubble occurs when prices get out of line with fundamentals; that’s the defining quality of every financial bubble in history. So what are the fundamentals in the case of gold? What’s been driving it up are essentially factors like the growth in the money supply, the decline of the U.S. as a major economic power, the weakening value of currencies worldwide as a matter of government policy, and of course fears of inflation.

If anything, all of these factors that have been driving the price of gold higher over the past decade are still accelerating. So where’s the bubble? If the market price of an investment went up a stunning 10-fold while its earnings went up even more staggering 20-fold, you wouldn’t call that a bubble; you’d say it’s an undervalued investment – and an opportunity. That’s what I think gold is today.

We are also very bullish on silver, which is not only a store of value as a precious metal but also a critical industrial resource. And I don’t use the word "critical" lightly. Unlike gold, there are no substitutes for it in a number of key industrial usages. To mention one example related to alternative energy: Most solar panels require silver, and there’s not likely to be enough of it available to build out the energy infrastructure we need. China is certainly aware of this; it appears to be accumulating silver already and is likely to increasingly do so. Regarding the investment possibilities here, our current choices remain First Majestic Silver (NYSE:AG), Tahoe Resources (THOEF) and the iShares Silver Trust ETF (NYSEARCA:SLV).

As for the issues concerning China and gold: China is likely to accumulate, between its populace and central bank, about 1,000 tons gold in 2011 – up about 40 percent from 2010 levels. While growth won’t remain at 40 percent, it will continue at a brisk clip for many reasons. For one, gold that goes into personal savings is well protected from the problem that most troubles the Chinese right now: Inflation. There’s no question that China (and to a lesser extent India) are desperate for gold right now.

All this makes me think of that old saying that "You can’t fight City Hall." In today’s economic world, it seems more and more the case that "City Hall" is now China.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

About this article:

Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here