SEMI-MONTHLY FISCAL/MONETARY UPDATE – THE CORONAVIRUS PRICKS THE CREDIT/DEBT BUBBLE
First, from myself and my administrative partner for over thirty years, Michael Heyward,
we are hopeful that you and your loved ones are surviving this ordeal as well as
possible. Michael and I and our respective families are unharmed so far. Michael is
working out of his NYC apartment and I am with my wife and daughter in Southampton,
where my daughter had already been living and working. We can always be reached by email (firstname.lastname@example.org) or phone. Our office phone will be forwarded to my cell phone. This letter is longer than I usually like to provide, but I’ve got the time to write it, and you probably have the time, for a change, to read it. It helps me organize my thoughts, is probably therapeutic for me, and I like all of you to be as well informed as possible.
Our world, in many ways, has changed for the foreseeable future. Unprecedented
measures are in place from a healthcare standpoint, and financial remedies are being
undertaken that are even more uncertain. All of this has created unprecedented
volatility, with equity markets often moving 5-10% per day. While gold bullion, as
a safe haven was actually up a bit for the month, the gold mining stocks acted
like stocks (as discussed below), and were down with the general equity market.
It is worth noting that most of the largest mining companies are paying dividends.
While the average return is about 1.5% (more than twice that of a 10 year US treasury note), the amounts are increasing and could become much more meaningful as earnings reflectthe higher gold price and lower operating expenses. As an example, in late 1929 the
value of Homestake Mining stock was about $80/sh. During the next six years
Homestake paid out a total of $128/sh. in cash dividends, including $56 per share in
1935 alone. Many of today’s mining companies have demonstrated a willingness to
share profits with investors by way of dividends.
I’ve often said that “hope is not a strategy”, and a dramatic recovery of gold mining
stocks is not just a hope, but continues to be a well considered expectation. The stocks
are a huge bargain under just about any scenario and there is no place I would rather
be for a still large part of my family’s liquid net worth.
WHY THE RELATIVE WEAKNESS IN GOLD MINING SHARES?
Even the modest year to date increase in the price of gold bullion has not reflected the
unprecedented creation of paper currency by the Federal Reserve Bank and the multi-trillion fiscal stimulus from the government. Furthermore, the dramatic relative weakness
of the mining stocks seems to be due to a number of short term factors.
(1) The gold mining stocks are “stocks”, in brokerage accounts, and subject to margin
calls as portfolios depreciate, as opposed to physical gold, which is usually paid for in full and generally stored in presumably safe places. Physical bullion is accumulated worldwide, including by Central Banks, while mining stocks are owned largely by North American investors who are not nearly as committed an “uncorrelated safe haven” or a “money substitute”. In a panic phase, stock investors sell “what they can, rather than what they want to”.
(2) Eight to ten years ago, quite a few mining companies did a poor job allocating
resources and managing balance sheets, particularly with acquisitions. In many cases,
corporate management has changed and/or learned from experience. Operating profits
were also reduced until just recently by the high cost of energy, partially offsetting the
higher gold prices. Balance sheets are now generally strong. Operating results have
been excellent for most established miners in the last year or so, vividly demonstrated in Q4’19, as gold production is sold for prices $200/oz. more than in ’18 and energy costs started to come down.
(3) There have been a number of mines closed temporarily due to the Coronavirus. This
is obviously not a short term positive, but this has not been widespread so far, the
money is still in the ground, so the long term value of the companies are intact.
(4) A great deal of daily trading is still dictated by computers, responding to short term
trading patterns, so price weakness begets more selling, for no particular fundamental
CURRENT FINANCIAL OVERVIEW
Fundamentally, the Coronavirus has quickly created the financial desperation that has
been inevitable in the wake of forty years of financial folly, especially the last twenty
years, most especially in the last ten. Since ’08, the $3.5 trillion of money creation and
growing operating deficits, accompanied by suppressed interest rates have allowed for
tens of trillions of mis-allocated capital, as investors “reach for yield” in various forms.
The unpredictable surprise is that the financial “chickens would come home to roost” as
a result of an internationally contagious virus.
We pointed out to you just last month that the current trading pattern is likely to be a
repeat of ’08 and early ’09, when gold and the gold miners went down with the general
market. Once the markets stabilized, gold quadrupled over the next two years and
the miners did even better. The difference this time is that gold bullion has held up
relatively well, so the gold miners are even more of a long time bargain. Of course, the
money printing and fiscal stimulus now being provided is an order of magnitude larger,
so both gold bullion and the miners should make proportionately even larger moves than
in ’08 to ‘09.
INFLATION OR DEFLATION – GOLD WINS EITHER WAY
The unimaginable amounts of currency that are being created will have two possible
general consequences. There could be the desired “save” of the economy, and the
potential very inflationary consequences are far down the current list of worries by our
leaders. Workers will go back to their jobs, restaurants will reopen (in many cases),
sports events will take place (with appropriate care) but it is hard to picture “old times”
any time soon. As a middle ground (e.g. the 1970s) we could have “stagflation”, which
especially affects the middle class. The other extreme is a 1930s type deflationary
downturn, as the government stimulus fails to turn the economic tide, and economic
distress for almost everyone.
The best demonstrations of the inflationary influences on gold bullion and gold
mining stocks comes from the 1970s and the period from 2000 to 2012.
Setting the stage for the discussion of the 1970s: recall that the Bretton Woods
Conference in 1944 established the US Dollar as the world’s “reserve currency”, with
worldwide trading to take place in “King Dollar”. The US had the responsibility of
backing the Dollar with gold, at an exchange rate of $35.00/oz . That conversion
option would presumably control the natural political instinct to produce paper
currency at excessive rates, in essence spending to satisfy electoral constituencies.
The program worked adequately well until the mid-sixties when spending increased under the influence of Lyndon Johnson’s Great Society and the Vietnam War. Foreigners realized that operating and trade deficits were on the horizon and reduced the US stash of gold between 1969 and 1971 from over 20,000 tons to 8,400 tons, which hasn’t changed since then. President, Richard Nixon, closed the gold window in August, 1971, eliminating the conversion privilege. His speech, which you can find on YouTube, assured us that this move would be for the best, and help the US economy. The gold price took off immediately, peaking at $850/oz. nine years later. The economy went into “stagflation”. The stock market reflected the economic malaise, climaxing in 1973-1974 with the collapse of the highly valued “nifty fifty” growth stocks (FANG of the 1970s). Inflation went up steadily, peaking at about 12% as theFederal Funds Rate went to 18% late in the decade. Gold stocks, mostly South African mining companies did well, though hardly any are still independently trading and it is difficult to find price histories through the decade. We did find that the Gold Mining Index, composed of ASA (a mining stock mutual fund), miners Campbell Red Lake and Dome Mining, appreciated more than 260% from its 1973 low (40) to its 1974 high (147). So during the most severe portion of the 1973/74 bear market, while
stocks lost half their value – gold mining companies almost quadrupled.
Starting in 2000, after about twenty years of relatively controlled government spending
and three years of budget operating surpluses (can you believe it?) at the of Bill
Clinton’s presidency, government spending took off. This was the result of coping with
Y2K, the aftermath of the 9/11/01 terrorist attack which included two wars, and the
collapse of the stock market dotcom bubble. Alan Greenspan’s Fed papered over the
problems, which helped to produce the ’08-’09 financial crisis. In the course of
preventing an economic collapse ten years ago, we all remember TARP, Cash for
Clunkers, and other government programs which cost something like a trillion dollars. At
the same time, the Fed embarked on an interest rate suppression experiment, taking
their balance sheet from about one trillion to $4.5 trillion to buy fixed income securities,
including those issued by the US Treasury.
The US balance sheet has also become increasingly burdened with debt as a result of annual operating deficits. The US federal debt more than doubled under GW Bush to about $11T, grew to about $20T under Obama, is now $23T and accelerating in a major way. As a percentage of GDP, it has been just under the peak when we were conducting WW2, and will shortly exceed that. Gold was trading around $300/oz. in 2000, peaked at $1850-1900/oz. in 2011. Gold mining stocks did even better. As a proxy, the Tocqueville Gold Fund went from $10 to $90. All the influences that provided this performance are back in place today. The only difference is that gold mining shares are even less expensive, relative to the price of bullion, than they were in 2000, and the positive factors we have discussed are much larger. There is a lot more paper currency being created, zero percent interest rates
were not even conceivable in 2000, operating deficits are much larger, and a “safe
haven” has hardly ever been more of a need for investors.
TARGETED “SYMMETRICAL 2%” INFLATION
Overriding all of the inflationary or deflationary possibilities, Central Banks, which were
created to control inflation, are desperately trying to stimulate inflation, lately targeted by
the US Fed at a “symmetrical” 2% rate. This means that a rate of over 2% (no doubt
substantially over) will be tolerated because we have been well under 2% for so long.
Inflation is necessary to encourage consumers to spend today, before prices go up,
and to allow everyone, from individuals to countries, to liquidate their debt for less
valuable currency. Above all, deflation is the ultimate curse, because consumers won’t
spend and the debt at every level becomes more of a burden.
DEFLATION – A COMPARISON TO THE 1930s
The other possibility is to allow the markets to “clear” in the course of a deflationary
depression. It hurts me emotionally to even use the word, but it has happened before and it will happen again at some point.
The magnitude of the current monetary and fiscal support is unprecedented. According
to historical accounts, the Federal Reserve Bank, while active in the 1920s, essentially
ceased open market operations in 1934, so did not play a meaningful role. However, the
FDR administration, over seven years from 1933 through 1939, provided $41.7 billion,
which translates into about $700 billion in today’s dollars. The increase in the federal
debt during that time was 30%. The cost per capita, in today’s dollars, was about $5,800
per US person. The $41.7 billion represented about 40% of the 1929 GDP.
At the moment, the Federal Reserve Bank has committed to creating $1.5 trillion, to
purchase all manner of securities, backstopping money market funds, various ETFs,
and mortgage securities, among others. Last Friday, the federal government passed a
$2.2 trillion stimulus bill, with a promise to do a lot more, as needed. The combined
“down payment” of $3.7 trillion amounts to over $11,000 per US capita, almost double
the seven year New Deal. Almost everyone expects many trillions of dollars to follow.
The effect on the US balance sheet, already at a level that has impeded growth, is
similarly dramatic. Previous expectations were that the current year’s deficit would be
about $1.2 trillion, and the debt would go up by about $1.5 trillion (including off budget
items, funded by borrowing from the social security trust fund). Those numbers were
expected to go steadily upward in the 2020s, assuming steady GDP growth of 3%,
which was always questionable. It is clear now that the current year’s deficit, ending
9/30/20 will be at least $ 2 trillion and a lot more in 2021 with the absence of capital
gains tax receipts, as well as lower personal and corporate taxes. The current federal
debt is above $23 trillion, already over 100% of GDP, so it is easy to picture federal debt
well over $30 trillion seven years from now, an increase of a lot more than the 30% of
the 1930s. This is important, because a higher debt burden impedes productive
investment and growth, for a family, a business, or a country.
The last comparison is the stimulus and spending relative to the nation’s GDP. The New
Deal spending was about 40% of the nation’s 1929 output. GDP in fiscal 2019 was
$21.4 trillion, so 40% would be $8.6 trillion; a number which we believe will be exceeded
before the dust settles. It is important to note, however, that the federal debt/gdp ratio
was only 16% in 1929 and 33% in 1933 (before the creation of social security and
Medicare and other entitlements), and stayed around 40% through the 1930s. This
compares to over 100% in the US currently (without including unfunded entitlements).
The US in the 1930s was therefore at a much more manageable starting point, more
able to spend 40% of GDP in an attempt to save the economy.
An argument can be made that gold mining firms do even better during a deflationary
depression than during an inflationary depression (or stagflation). Profit margins are at
their best during these conditions because labor is cheaper and operating costs are
lower. In particular, energy costs to drive earth moving equipment amounts to 20% or
more of variable expenses and drilling rigs are more available. One of the reasons gold
mining stocks have underperformed other commodity stocks over the past few years
was because the cost of production was rising so dramatically.
THE HISTORY OF GOVERNMENT STIMULUS PROGRAMS
Relative to the 1930s, it is well documented that the economy stabilized from 1933
through 1936, then endured a serious recession in 1937, blamed on the Fed who is
accused of tightening money markets prematurely. It wasn’t until after World War II,
when the soldiers came home and the US resumed normal activities (making babies,
buying autos and homes, etc.etc.) that the US economy, its GDP and employment
statistics, returned to pre-depression levels. Economists debate whether FDRs New
Deal shortened or lengthened the adjustment after the roaring twenties. We are in the
latter camp, partly due to our observations about more recent governmental
Following the Asian Financial Crisis of 1997, Japan fell into an economic recession.
Beginning in 2000, the Bank of Japan (BOJ) began an aggressive QE program to curb
deflation and to stimulate the economy. The BOJ moved from buying Japanese
government bonds to buying private debt and stocks. Between 1995 and 2007, Japanese GDP fell from $5.4 trillion to $4.52 trillion, so the QE program was obviously ineffective. Japanese government debt has continued to accumulate, now amounting to about 250% of GDP, but continues to fail in terms of stimulating inflation and better economic growth.
The Swiss National Bank (SNB) also instituted QE after the 2008 financial crisis. The
SNB has now accumulated assets, including US equities, nearly equal to annual GDP,
the highest in the world, relative to GDP. Even with the QE program, GDP growth has
averaged less than 2% for the last decade. Even with interest rates below zero,
the SNB has been unable to stimulate inflation, averaging under 1% for the last decade.
It is, of course, unclear, what might have been the case without QE, but the results have
not met targets.
The Bank of England (BofE), after creating 375 pounds ($550B) of new money between
2009 and 2012, in August 2016 announced a QE program to counteract “Brexit”. The
plan was to buy 60 billion pounds of government bonds and 10 billion pounds in
corporate debt. The object was to suppress interest rates and stimulate business
investment. From August 2016 through June 2018, the UK reported that capital
formation (a measure of business investment) was growing at an average quarterly rate
of only 0.4%, lower than the average from 2009 through 2018. It is, once again,
impossible to know what would have been the case without QE.
We have all lived through the various QEs that were created to deal with the
2008-2009 financial crisis. The Fed took their balance sheet from about $1T to
$4.5T and almost a trillion dollars was provided by government spending
(TARP, Cash for Clunkers, etc.etc.). Interest rates have been maintained at
rates close enough to zero that all kinds mis-allocation of capital has been the
result. GDP growth averaged a tepid 2.3% from 2009 through 2016. The last
three years, under a business friendly administration, have continued to
provide monetary and fiscal accommodation, but GDP growth has averaged
no more than 2.5%. Once again, while it is impossible to know what would
have been the case without government “help”, the results have been less
There is no reason to think that the programs being implemented will be successful in
re-igniting the US, or worldwide, economy by way of even larger credit and debt
creation. By the way, the US did not have a 3% GDP economy prior to the Coronavirus, as is being promulgated by the conservative media and more or less accepted by the liberal commentators. Last year was about 2.5% and Q1’20 was on the way to just over 1% before the Coronavirus reared its head.
Overall, one does not get out of a hole by continuing to dig. Even China has failed
to maintain their previous double digit growth rate by way of the rampant availability of
credit. The Chinese Communists are very smart and plan for the long term, but they
have not repealed nature’s laws of supply and demand.
We cannot predict to what degree the governmental intervention will succeed in
papering over the current healthcare challenge which is already becoming an economic
crisis. As described above, no matter which direction the worldwide economy takes,
gold should emerge as the best currency standing as well as the asset class that will best protect purchasing power. We cannot know the exact timing, or extent to which gold (and the mining stocks) will appreciate from today’s bargain prices. It is true that other asset classes have recently become better bargains as well. However, gold and the gold miners, especially at recent prices, represent the ultimate uncorrelated asset class, safe haven and most secure long term store of value. Accordingly, they should appreciate very substantially whether Central Bankers succeed, or fail, in their desperate effort to “save” the economy.
None of this is any fun but the above discussion should provide a template in terms of the possibilities. The investment partnership that I manage is 95% invested in gold mining stocks, and open to new investors 🙂
These difficult days move slowly, but we will all get through this. Stay
healthy and safe, and call or write any time you like!