FISCAL/MONETARY REPORT – LARGEST INTEREST RATE INCREASE IN 28 YEARS, TOO LITTLE TOO LATE
The inflation, represented by the rise in prices that the worldwide economy is experiencing, is not the result of supply chain bottlenecks or the war in Ukraine or too little drilling by the oil companies. It is the result of at least twenty years of money printing by Central Banks combined with too much government spending. The rise in prices is the predictable and obvious result, of the less bothersome dilution of value of the unbacked (therefore unlimited in quantity) supply of colored paper that is used in the exchange of goods and services. When a substantial amount of currency (something like $20 trillion over ten years) is provided by worldwide central bank without a corresponding increase in the availability of goods and services, it doesn’t take a PHD in economics to understand that the price of those goods and services will increase. For the last ten years or so that was mostly represented by an increase in asset prices (stocks, bonds, homes, art, gold bullion, etc.), within the last year finally spreading to energy, food and other consumer goods.
Another important aspect of the unprecedented fiscal/monetary accommodation provided by governments and their central banks has been the suppression of interest rates to near zero levels for more than ten years. Interest rates control economic reward and risk, and when that “regulator” of economic activity is disabled, capital is mis-allocated as investors “reach for yield” in all kinds of risky ways. That is why hundreds of stocks were selling for thirty or forty times estimated SALES, companies were able to raise billions of dollars at virtually no cost and the cryptocurrency market (Bitcoin and Tether and Ethereum and almost twenty thousand others) could amount to over $3 trilllion (that’s a lot of money) at its peak. In short, a multi-faced asset bubble has been created, which has just recently begun to deflate.
Almost every observer agrees that the fiscal/monetary trends of the last twenty years cannot go on. The deficits and the debt and the related economic distortions are too large to be tolerated. At some point the books have to balance. Booms are followed by busts and the longer the party lasts the worse will be the hangover. An overriding corollary is that “you cannot have a sound economy with a sound currency”. If the public does not believe in the medium of exchange paid for their services, they will have less incentive to apply an effort in that direction. This generalization could be playing a part in the lack of work ethic exhibited by so many young people who have become disillusioned with today’s political class. Because politicians, since time began, are almost always (George Washington being one exception) primarily driven by their own re-election, they do what they can to enrich their constituents. That process has inevitably included creation of as much “support” as possible. This is why there has never been an unbacked (fiat) currency that has survived. It is only a question of time until the politicians of the day dilute their currency into oblivion, and today’s crop of leaders are clearly no different. A US Dollar, as it existed in 1913 when the Federal Reserve was established to control inflation, is worth about $0.02 today, and the future does not bode well.
FWIW to our new readers, this is not a new subject for us. A multitude of previous articles can be accessed by the SEARCH function on our Home Page (“fiscal/monetary”)
THE CURRENT SITUATION
The Chairman of the Federal Reserve, Jerome Powell, announced yesterday the largest interest rate increase, 75 basis points, since 1994, twenty eight years ago. The objective of this first step is to reduce the unacceptably high inflation rate, up about 8% year over year, as measured by the Consumer Price Index (CPI). It should be noted that the CPI has been materially adjusted over the last several decades, each time to understate the actual change in consumer prices. We have reminded our readers repeatedly that the 8% number, calculated on the same basis as in the 1970s when it peaked at 13.5%, would be in the mid-teens.
An essential element of keeping inflation under control is to have positive “real” interest rates, defined as the nominal short term (two to five year) rate less the rate of inflation. The consumer believing that prices will rise faster than the low risk interest rate return on capital will be encouraged to spend today, in essence pulling consumption forward and driving the price of goods upward. Conversely, a rate of inflation below the interest rate will encourage savings, because the goods will be getting cheaper over time in real terms. This is why a balanced economy usually has interest rates a couple of points (200 basis points) above the inflation rate. When real interest rates are materially negative, as they have been for most of the last ten years, inflation is inevitably part of the equation, in this case showing up in asset prices, as we discussed earlier. Over the last year or so, as the (understated) CPI provided a rate in the 5-6% area, and interest rates were in the area of 1%, the negative 4-5% real rate was extremely inflationary and that has only gotten worse most recently as the CPI was reported at 8-9%.
Recall that the legendary Paul Volcker, hired by Jimmy Carter in 1979 and backed by Ronald Reagan after his November, 1980 election, moved the Federal Funds Rate to 18.5%, providing 5% real return against the 13.5% CPI inflation rate. It worked, but the US economy had to endure a serious recession from 1980-1983. Based on today’s reported CPI, Jerome Powell would have to move short term rates to at least 10%, a very long way from the just established 1.75% and the two year objective of 3.75%. One can only imagine how serious a recession would result compared to the 1980 experience. FWIW, the annual operating deficit for the US was about $100B in 1980, and the total debt was about $1 trillion, respectively versus $2 trillion (20x) and $30 trillon (30x) today. That is another order of magnitude of a problem, even in an economy that is 5x as large. In addition: social security, medicare, medicaid and other entitlements were immaterial in 1980 versus today’s long term (and unfunded) obligations.
POWELL IS, putting it charitably, UNCONVINCING
Jerome Powell, at his press conference yesterday, suggested that the consumer, and the economy, are strong enough to withstand higher interest rates, and there is at least a chance of a soft landing in the economy even as interest rates move up to the range of 3.75% over the next 18-24 months. He didn’t talk about consumer confidence being at an all time low, credit card debt at an all time high while household savings are back to pre-covid low levels. Higher mortgage rates (6.25% versus the low 3% level a year ago) are starting to affect housing values and auto sales are rolling over with higher finance charges. Trillions of dollars of stock market wealth has evaporated (including $2 trillion in crypto-currencies alone), along with lower house prices so a negative wealth effect now comes into play. Retail sales are weakening while producer prices (a leading indicator) are still hitting new highs. The acceleration (the 2nd derivative) of labor cost may have peaked but are still rising (the 1st derivative) and lots of manufacturers have yet to pass cost increases on to their customers. The Atlanta Fed, usually optimistic, and prone to downward adjustments over time, just lowered their estimate of Q2 GDP growth to zero, from 0.9%, and 1.5% just a couple of weeks ago. A recession is defined as two consecutive negative GDP quarters, which looks increasingly likely and the first half of ’22 will be negative in any event.
Powell’s commentary included his belief that the 3.75% Fed Funds rate objective is essentially a “neutral” rate, based on a long term 2% inflation rate. Do we need to point out that the current inflation rate is a long way north of 2% and will remain so for years to come? There is no chance that 3.75% will put a serious dent in the current inflation rate. We accept the fact that the CPI could come down a bit, perhaps to the area of 5%, as demand destruction from higher interest rates combines with abatement of the supply chain situation and perhaps a cessation of hostilities in Ukraine, but short term rates would still have to be 7-9%, double the 3.75% current objective. To provide some context regarding the real rate of inflation, as opposed to the CPI version: year over year import prices in May were up 11.7%, and export prices were up 18.9%, without including shipping costs. Since US consumers have to buy goods that were made either here or there, the average of about 15% is much closer to the real rate of inflation than the CPI the Bureau of Labor Statistics (BLS) “cooks up”.
Powell did provide a somewhat “dovish” possibility, saying that future rate increases could be reduced if a reduction of the inflation rate persists over a matter of months. That willingness to back off the current tightening plan increases the likelihood that the Fed will back off prematurely, most likely leaving in place only a 5% inflation rate. Five percent sounds a lot better than what we’ve got right now, but destroys 40% of your purchasing power over 10 years.
THE RESULT in CAPITAL MARKETS
Capital markets have been resilient for over ten years because investors, both in stocks and bonds, were convinced that the Federal Reserve was providing a “put” which would, as European, Japanese and Chinese central banks have periodically done, “do what it takes” so keep stock and bond markets from going down.
Powell’s stated dedication to calming inflation, even tolerating a recession if that would set the stage for healthy long term growth, might have been expected to calm the stock and bond markets, both of which have been very weak lately. Most stock market pundits were in fact calling for the 75 bp rise which he delivered. Based on the apparent first step in a constructive direction, after his remarks yesterday afternoon both bond and stock markets rallied strongly. Unfortunately, the strength has evaporated today, with the Dow down 700 points on Thursday. Investors are apparently losing confidence in the logic, the timing, and/or the outcome of the Fed’s newest policy.
CENTRAL BANKS…..AND GOLD
It’s often been said that the attractiveness of gold related assets is inversely correlated with the credibility of Central Banks. Gold, used to limit the central bankers’ ability to create unlimited amounts of currency, is essentially in conflict with the banker’s career path. Eight or nine years ago, sitting next to Paul Volcker, I asked him: “What do you think of gold?” His answer: “I’m a central banker so I don’t like gold!”
It seems to us that the credibility of Central Banks has steadily diminished over the last 109 years, from 1913 when the Federal Reserve was established, to 1933 when FDR precluded US citizens from owning gold and 1934 when he changed the exchange rate from $20.67 to $35.00/oz. (devaluing the Dollar), to 1944 when the Breton Woods Conference established the US Dollar as the Reserve Currency (to be backed by gold), to 1971 when Richard Nixon eliminated the Dollar’s convertibility (at $35/oz.) into gold, to 1980 after gold had just peaked at $850/oz, to 2022 while gold bullion sits at $1830/oz.
In our view, gold bullion, should be more appropriately priced at somewhere between $7,000 and $10,000 per oz., and this is relative to the amount of paper currency that is circulating, as well as the amount of “equity”, assets minus debt, that important trading nations own. Gold has protected purchasing power for three thousand years, for 230 years since Alexander Hamilton’s Coin Exchange Act established gold and silver as the only legal tender in the US, since Y2K just before the dotcom bust and the two wars began, and for 13 years since the Obama administration accelerated government spending, While true that stocks and bonds and cryptocurrencies have outperformed gold as an asset class during the last decade, we believe there will shortly begin a dramatic catch-up phase. The amount of gold that sovereign nations own relative to their paper currency outstanding is at a comparable level to 1971, just before gold bullion went up over 20x in value.
GOLD MINING STOCKS – COULD BE A GENERATIONAL OPPORTUNITY
The price of gold bullion should be a lot higher, currently four to five times where it is, and even higher over time. Even more compelling is the opportunity in gold mining stocks, with an upside that is a multiple of the move in gold bullion itself. Physical gold bullion is largely bought by the Chinese, Indian, Russian, and European public, as well as their Central Banks. The public in those countries understand how fickle paper currency can be, and the central banks can see how the US is abusing its role as a Reserve Currency by creating trillions of new Dollars. Worldwide Central Banks, with the notable exception of the US, have increased their collective holdings of gold bullion every year since 2009, absorbing about 12% of total worldwide production. Central Bankers may not “like” gold, as we pointed out above, but they collectively buy over 400 tons of it each year.
Gold mining stocks, because they are stocks, are largely purchased by North American stock investors, who have not had the personal experiences of Europeans, Chinese, Indians or Russians that demonstrated the utility of gold as a “safe haven”, a “store of value”, and a “medium of exchange”. Since North American Investors have been otherwise distracted in recent years, we anticipate that the current weakness in the stock and bond markets will bring them back to gold and gold mining stocks in particular. While gold bullion is essentially flat in ’22 and the gold mining stocks are flat to down about 5%, this asset class has in fact proved to be a relatively safe haven in a treacherous stock and bond market.
Gold mining stocks, based on their historical price relative to the price of bullion, should be something like two or three times higher than they currently trade. Gold bullion is down about 15% from the all time high, and the gold mining stocks are down over 50%. Moreover, they also represent VALUE by many measures, including a comparison to other commodity producers as shown below. Highly regarded Incrementum, whose charts we have used below, published a 390 page report in late May, making the case that commodity producers in general and precious metals in particular, are just entering a long term expansion of sales and profits.
We have already entered an extended period of Stagflation, which could, depending on fiscal/monetary developments, segway into a serious recession. Jerome Powell and his Federal Reserve have very little chance of maneuvering the US economy into a soft landing as inflation is tamed. Indeed, his approach seems to be overly optimistic, at best, disingenuous, misleading, or ignorant at worst. Viewed more charitably, he did not create this mess, and can’t be expected to control the outcome. Alan Greenspan started the process in 2001, spending the Dollar into oblivion as he tried to protect the economy from the effects of Y2k, the dotcom bust and the economic fallout from waging two wars. Ben Bernanke, Janet Yellen, and now Jerome Powell, have proceeded in turn to “play it as it lies” and “kick the can down the road”, just so….”it doesn’t hit the fan on my watch”.
The precious metals complex, and gold mining stocks in particular, should be an effective way of at least protecting one’s purchasing power in a challenging economy, while at best making 5-10x return on investment. A material (i.e.5-10% of one’s portfolio) invested in this asset class has proved to enhance long term capital returns through an investment cycle. Considering that gold mining stocks (1) have not kept pace with the general market over the last ten years nor (2) kept up with the price of bullion that has doubled over the last twelve years and (3) represent statistical value by many investment measures, they represent the opportunity for very substantial capital gains. The credibility that the Federal Reserve is in the process of losing is supportive of far more demand for gold related assets as a means of protecting purchasing power and generating exceptional capital gains from current levels.
P.S. Roger Lipton is General Partner, Managing Partner, and the largest investor (Limited Partner) in RHL Associates, LP, an investing Limited Partnership that is 100% invested in gold mining equities.The minimum investment is $500,000, funds can be invested the first of any month, withdrawn (with no minimum holding period) at the end of any quarter (with 30 days prior written notice). The fee structure is “1 and 10” (1% annual fee and 10% of gains). This notification should not be considered an offering, which can only be made by provision of a full Offering Circular.