Debt Growth And Capital Consumption - Precious Metals Supply And Demand

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Includes: AAAU, BAR, GLD, GLDM, IAU, OUNZ, PHYS, PSLV, QGLDX, SGOL, SIVR, SLV
by: Keith Weiner
Summary

Consumer prices are not rising as a consequence of monetary policy.

In the long term, the price of gold will move as the people (not merely leveraged speculators amped up on the latest Internet rumor) perceive that the dollar's demise draws near. Or as the utility of gold grows, after an 85-year government-imposed hiatus.

From the peak in 2008 until now, earnings grew by 120%. But the debt that finances these earnings grew by 264%. That is a big increase in leverage.

A Worrisome Trend

If you read gold analysis much, you will come across two ideas. One, inflation so-called (rising consumer prices) is not only running much higher than the official statistic, but is about to really start skyrocketing. Two, buy gold because gold will hedge it. That is, the price of gold will go up as fast, or faster, than the price of gold.

CPI monthly since 1914, annualized rate of change. In recent years, CPI was relatively tame despite a vast increase in the money supply. However, relative prices in the economy were massively distorted as a result of the latter - and this is driving ever larger boom-bust cycles. [PT]

Well, consumer prices are not rising as a consequence of monetary policy. If they are rising, it is despite the falling interest rate, and due to the government constantly forcing producers to add more and more ingredients to the production of everything.

So why would we expect the price of gold to rise to match the never-ending addition of compliance costs to milk and cars and petrol and pharmaceuticals?

In the short term, speculators can bid up the price of gold in response to a rumor of inflation, of de-dollarization of an economy, of Fed policy changes, etc. But sooner or later, if that's all it is - speculators front-running a rumor - the price will quickly revert. In a long-term graph, the blip will disappear into the noise.

In the long term, the price of gold will move as the people (not merely leveraged speculators amped up on the latest Internet rumor) perceive that the dollar's demise draws near. Or as the utility of gold grows, after an 85-year government-imposed hiatus.

Both trends are marching forward. In order to achieve this post-2008 boom, central banks have pumped out enormous amounts of credit in every currency. How much? We came across this graph that illustrates the problem in a space not typically analyzed: small-cap stocks.

US small caps: debt growth vs. earnings growth - a dangerous trend. [PT]

Look at the incredible growth of debt and the modest growth of earnings. From the peak in 2008 until now, earnings grew by 120%. But the debt that finances these earnings grew by 264%. That is a big increase in leverage. Or, alternatively, we might say that these 2,000 companies are consuming their investors' capital.

To put this in perspective, in 11 years, these companies collectively added $387B in debt. But they grew earnings by only $98B. The marginal productivity of this debt - here used to mean change in EBITDA per dollar of added debt - is $0.25. This not only makes these companies more brittle, but also more vulnerable to a downturn.

But, there is another problem. Each one's added debt comes to other companies (including many Russell 2000 companies) as revenues. This means that when credit tightens again, revenues will drop as a direct consequence of one firm's cessation of borrowing to buy the products of another (or pay its employees' salaries, which are spent on the products of another).

There is a synergistic effect at work here. It is great fun on the way up (and politicians all around the world love to take credit for it). And it will be great pain on the way down.

Fundamental Developments

The prices of the metals were all but unchanged this week. Perhaps a great April Fool's joke was played by The Cartel?

Anyways, let's look at the only true picture of the supply and demand fundamentals of gold and silver. But, first, here is the chart of the prices of gold and silver.

Gold and silver priced in USD

Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio (see here for an explanation of bid and offer prices for the ratio).

Gold-silver ratio

Here is the gold graph showing gold basis, co-basis and the price of the dollar in terms of gold price.

Gold basis, co-basis and the USD priced in milligrams of gold

The scarcity (i.e. co-basis) as measured by the June contract rose a bit. However, the gold basis continuous dropped a bit. So this week there was some selling of metal and buying of futures.

The Monetary Metals Gold Fundamental Price dropped quite a bit, to $1,456.

Now let's look at silver.

Silver basis, co-basis and the USD priced in grams of silver

The temporary backwardation in the May contract increased to over 1%. However, the silver basis continuous shows a move in the opposite direction.

And the Monetary Metals Silver Fundamental Price was down 11 cents to $16.18.

Charts by: St. Louis Fed, Société Générale, Monetary Metals

Chart and image captions by PT

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.