 Markets
at a Glance
Cash or Gold?
Eric Sprott and Sasha Solunac
Sprott Asset Management
posted Nov 6, 2008
Allow us to preface this article
by saying that we'll be making no mention of the 'manipulation'
of the price of gold. Let's put that issue aside for now because,
in the long run, it just won't matter. We are in the midst of
a financial crisis - not just any financial crisis mind you,
but arguably the worst and most pervasive the world has seen
in almost a century (second only to the Great Depression... thus
far). In the sea of financial assets and currencies that are
being decimated the world over, the one true safe haven continues
to be gold.
During these times, it is understandable
that the prevailing investor sentiment is fear. People
are fearful of their savings, fearful of their jobs, and especially
fearful of risk, having just witnessed how quickly a bear market
can decimate portfolios. The other major factor currently affecting
markets is deleveraging. As we all know by now, the 2002-2007
credit bubble was all about leverage. Leverage in housing and
real estate. Leverage in the banking system. Leveraged hedge
funds. As long as all asset classes continued to go up, then
leverage was the winning formula. Although such a myopic strategy
paid handsomely in the short run, the premise of the preceding
sentence is, of course, false over the longer term. Thus, the
winning strategy of yesteryear is now a ruinous one, leading
to a vicious circle of deleveraging that is gutting the value
of almost all assets. In this respect, gold is proving to be
no exception. On the flip side of deleveraging is the frenetic
buying of what was on the short side of the leveraged trade,
namely, US dollars and Japanese yen. As currencies with low interest
rates, they were borrowed to effect the leverage and are now
benefiting from what is essentially short covering as leverage
is unwound. This is another reason that the price of gold, in
US dollar terms, is down over the past month - albeit, not nearly
as much as other assets that were on the long side of the leveraged
trade.
That said, we must confess
to being perplexed (although far from discouraged) by the recent
price action of gold. It is not behaving the way one would expect
it to behave during times of financial crisis; namely, as the
consummate safe haven asset of choice when all other assets are
being shunned. Mind you, gold isn't performing badly by any means.
In Canadian and Australian dollar terms the price of gold is
at or near all-time highs. Such is the case in most of the world's
currencies. Even in Euro terms, the price of gold is within 5%
of the high it reached earlier this year. But gold has yet to
catch a wind under its sails in all currencies. Is it really
the 'barbarous relic', rendered obsolete by the stability and
prosperity of the paper-based fiatcurrency global financial system?
Laughably, this argument was once used by anti-gold proponents
as the main reason not to own gold. How quickly things have changed!
Today's financial system, with the institution of the central
bank at its foundation, has proven to be anything but as stable
and prosperous as once thought. For the first time in a long
while, the very foundations of capitalism are being put into
question. Once infallible central banks of developed nations
have become almost irrelevant. The financial markets, even the
stock markets, are completely ignoring them. Central banks have
shown, to their chagrin, that they can only solve one problem
by causing another. The system is in such a state of disarray
that the leaders of many of the world's developed countries,
including the US, Britain, France and others, are now proposing
some sort of massive overhaul in the way the world does finance.
How it will all play out remains to be seen. Certainly it will
involve greater government involvement and therefore greater
waste and inefficiency. But be that as it may, we would not consider
any paper-based asset as 'safe' right now. Especially not currencies,
as we will explain shortly. When the markets realize this, the
outcome should be highly bullish for gold.
One of the key features of
gold, and by gold we mean physical gold (not ETFs,
not futures), is that it is one of the very few assets that has
no one else's liability attached to it. We believe this point
is particularly relevant today. At its heart, this financial
crisis is all about the systematic lack of trust in the liabilities
of others. Everybody is worried about default/counterparty risk.
One example, yet to fully play itself out, is derivatives. The
fallout in this area could be disastrous, as we've written about
several times in the past, adding fuel to the fire of the global
financial rout. But the problem, clearly, is by no means only
relegated to derivatives. It's the problem with all financial
assets, even the traditionally safest ones. Banks don't want
to lend to each other because they don't want an asset that is
another bank's liability. The money markets seized up because
nobody wanted to own another business's liability, even over
the very short term. Even bank deposits, traditionally one of
the 'safest' assets around, is some bank's liability and therefore
a newfound cause for concern. Like it or not, in the financial
world everything is someone else's liability and every financial
asset has default risk. Even cash under the mattress is someone
else's liability... it's the liability of the central bank. Which
is why nobody should be breathing a sigh of relief that central
banks are now guaranteeing everything. They guaranteed all bank
deposits. They guaranteed money market funds. They guaranteed
interbank lending. But at what cost? As they are wont to do,
they only traded one problem for another. For what does a government
guarantee really mean? It means they are the buyer of last resort
for other people's liabilities. It means they are ready, willing,
and able to print money in any quantity to back the guarantee.
It means they are trying to solve the problem of default risk
by causing the equally nefarious problem of purchasing power/inflation
risk. (Conversely they could tax their citizenry into oblivion,
but this would be much less politically acceptable than printing
money, especially in a debtor nation such as the US.) During
times of financial crisis, it is best not to trust anybody, especially
not the central banks. When even the safest counterparties can
no longer be trusted, gold should be the asset of choice. It
is the only asset that has absolutely no default risk whatsoever
and, in our opinion, it is the only true safe haven asset.
For now (though we believe
it a temporary state of affairs) the markets seem to believe
that cash is king. They are still content to own paper in times
of trouble, particularly US dollars and US Treasuries. But such
confidence is misplaced, for many reasons. In the current environment,
deflation à la the Great Depression is highly unlikely.
Ben Bernanke, the head of the Federal Reserve, is already on
record as saying deflation cannot happen, using the helicopter
drop analogy to prove his point. Under a fiat currency system
this is true enough, and made abundantly clear with the central
banks assuming the role of buyer and guarantor of last resort.
But regardless of what the central bank does, we believe the
fundamentals have never looked worse for the US dollar. On top
of the money to be spent bailing out the financial system (at
least $1 trillion... likely $2 trillion and more), there is also
the recession to deal with. Even during the best of times the
US government ran sizable deficits, in the worst of times these
deficits will go through the roof. Going forward they could easily
exceed $1 trillion per year. Then there are the social security
and medicare payments the US government has promised to baby
boomers, that will begin to escalate exponentially as they begin
to retire starting this year. The present value of these
obligations, according to the 2007 Financial Report of the United
States Government, is $41 trillion using a 75-year horizon and
$90 trillion using an infinite horizon. [ 1 ]
We stress that this is present value, which is like compounding
backwards. It is the amount of money that needs to be set aside
today in order to meet the obligation in the future. It's not
a long run problem anymore. It's here and now.
For the above reasons, we believe
the current flight to US dollars is a knee jerk reaction that
won't have staying power. When asset prices fall, people take
comfort in the fact that one US dollar will always be worth one
US dollar. But this stability is only illusory. The real question
should be, what will one US dollar be able to buy in the future?
Is a sub-4% yield sufficient to preserve wealth over the next
10 years? Much less, is a 2.7% yield likely to preserve wealth
over the next five? We find it highly unlikely, especially in
this environment where the Federal Reserve is throwing everything
it's got at the crisis. We believe the next leg of the crisis
will see people becoming fearful of cash and bonds. Although,
to date, the US dollar has fared relatively well versus other
currencies, in the long run we believe it'll fare relatively
poorly versus gold.
In other countries, people
would have done well, as this crisis was unfolding, to be fearful
of cash. In Iceland for example, where the krona has been devalued
by 80%, people are probably wishing they had owned gold. All
over the world, countries are experiencing violent currency movements.
The Brazilian real and the Mexican peso have lost a third of
their value in the past three months. Even in relatively developed
countries, like South Korea, the won has lost a third of its
value. There is a currency crisis unfolding in Eastern Europe
right now, with many currencies down 20% versus the Euro in a
single month. This is causing considerable hardship in countries
like Hungary, where people took out loans and mortgages in foreign
currencies in order to avoid high interest rates. [
2 ] The cost of repaying those loans is now significantly
higher than what they anticipated. There are huge swaths of the
world where cash has proven to be anything but safe. They are
all wishing they bought gold. We believe that holders of US dollars
will soon be wishing the same thing.
With gold coins in a physical
shortage and selling at a premium to spot, there is evidence
that investors are starting to flock towards gold. It won't take
much buying to catalyze the price of gold. At today's price,
the total amount of gold ever produced is worth only $3.5 trillion,
a mere drop in the bucket compared to the world's financial assets
which, financial crisis notwithstanding, still total somewhere
in the neighbourhood of $100-$150 trillion. If some of these
paper assets were to be redistributed to gold - nothing would
be more prudent - then the recent drop in the price of gold presents
a tremendous buying opportunity for the astute investor.
###
__________
1 "Fiscal
Year 2007 Financial Report of the United States Government",
US Government Accountability Office, www.goa.gov, p. 131-132
2 "Lean
Times, Tough Steps in Hungary", Wall Street Journal, October
23, 2008
Eric Sprott and Sasha Solunac
Markets at a Glance
October 2008
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