Commodities and Gold

by Dr. Stephen Leeb The most vexing problem currently facing the world is finding affordable commodities. When push comes to shove, if oil still traded in a cyclical fashion at around $20 per barrel and copper averaged about a buck a pound, todays debt problems would be much more tractable, and growth would be much easier to accommodate. Indeed, a strong argument can be made that the 2007-08 bubble occurred due to consumer borrowing to keep even with falling living standards. And living standards continue to fall as corporations resist higher wages in favor of cost controls especially costs related to commodities. Historically one of the strongest correlates of corporate profits has been core commodity prices. The reason: commodities are the first assets to respond to greater demand. But in todays world demand from the developed nations has been flat, while commodity prices continue to rise given their scarcity and demand from emerging economies in the developing world. The Western wage earner, therefore, pays two-fold: stagnant wages (meaning decreased purchasing power) and higher prices for lifes essentials. These are not problems that are fixable though new regulations, more government spending (as opposed to investment), or false assurances that the worlds financial institutions remain sound. Warren Buffetts recent guarantee that U.S. banks are sound merely provides more evidence of how desperate our situation has become,

especially in view of the huge loss at J.P. Morgan (and who knows how much larger it could have been?), massive financial sector layoffs, and the still looming prospect of a major economic recession. Essentially, economics are dragging us, kicking and screaming, into a new world and no one wants to face the problem frontally. Of course, it is not surprising that those who have succeeded so mightily in the old economy would fight so hard to resist inevitable and probably very painful changes that will accompany the new. We have argued before that Buffett (and many others who accept his words as gospel), is talking his book big time when he calls gold a relic and asks a purportedly rhetorical question which would a sane person prefer, farm land or gold? Actually, Gold is a currency. It can be used to buy farm land, and as a currency has appreciated far faster than other currencies (nearly 50-fold versus the dollar over the past 40 years), not to mention far faster than farm land. Unless a person were minutes from starvation, the sane individual with a long-term perspective would take gold over other ways to buy farm land. Moreover, even if one wanted farm land as a hard asset, simply to exchange for something else in future, gold would still be a preferable choice. We fully concede that in the old world of plenty, with hegemony of financial assets, Buffett was among the best. Any market group or stock he selects, we have often studied and followed. His stock, Berkshire Hathaway (BRK.B) remains one of our favorites. But his advice, as we transition into a new world of resource scarcity, is more likely to lead to catastrophe than wealth. Investors of all stripes must own a healthy dose of precious metals in their portfolios to stand any chance of navigating the turbulent journey upon which we have already embarked. The Bank of International Settlements (BIS) has often been called the central bank for central banks. One reason: The BIS makes global regulations concerning bank reserves and liquidity regulations designed to assure that the banks which as 2008 proved are highly interconnected will not set off a systemic worldwide crisis. But 2008 also proved that BIS regulations have not been effective. Now the group is attempting again, with a newer set of regulations named Basel III that may take effect a few years hence. So far, the only more or less definitive part of Basel III released in the first week of 2013, dealt with a single aspect of what promises to be a full and complex new set of bank standards.

The particular rule the commission proposed termed the liquidity coverage ratio (LCR) provides timetables and guidelines for bank liquidity standards assuring that they have sufficient liquid assets (assets easily converted into cash) to last at least 30 days. That arbitrary time frame is deemed sufficient to address whatever problem would have led to a bank run, thereby necessitating the need for liquidity. This may all sound highly technical, but we think it boils down to a vast misdirection away from the primary condition going forward in todays world: Ultimately few if any liquid or more precisely, trusted assets, remain to be had, and the BIS must tip toe around the elephant in the room to preserve any semblance of systemic financial normalcy. Normalcy here is a worldwide financial system in which reserve currencies what Basel refers to as cash are largely composed of the dollar, and, secondarily, other paper currencies including the euro, yen, British pound, and several more. Actually, the LCR document was noteworthy for what it did not mention. While banks will be allowed to satisfy some new liquidity requirements with assets like stocks and the lowest rated (BBB-) nonjunk corporate bonds, Basel III no where mentions gold or any other precious metal. While gold may be needed later on, for now the BIS and the West does not want to do anything suggesting that gold is indeed a currency. This can only be characterized as bizarre, since central banks around the globe have been steadily accumulating gold. Its especially bizarre given that the volatility of gold throughout the 2007-08 financial crisis was considerably lower than that of stocks. We project that once the BIS asserts that gold is tantamount to a currency even a currency in the same sense as low-rated bonds and stocks, that must be valued at a discount to its actual value to count toward liquidity then the yellow metal could be off to the races. With any such move, the BIS would then undercut Buffett and virtually all the Western bankers reliant on the dollar as their exchange medium. Potentially there could be a virtuous circle in which individual gold purchases would lead to higher gold prices and higher gold prices would encourage banks to buy an asset not easily debased and, that therefore, could satisfy liquidity needs. Suddenly bankers and individuals alike could face a choice between currencies undergoing debasement and one fixed in quantity.

Clearly the BIS is fighting a losing war. More importantly, its resistance to gold gives China the time it needs to accumulate gold to partially back its currency. Even China can no longer hide the fact that it is accumulating as much gold as possible without creating a worldwide market buying frenzy. In 2012 China likely imported about 800 tons of gold through Hong Kong, which along with what it produced domestically suggests that the country added well over a 1,000 tons to its gold stockpiles. Could there have been other imports? You bet but just stick with 1,000 tons and in a single year its imports and accumulations exceed gold reserves in all but four other nations. China last announced its total gold reserves in April 2009, nearly four years ago. Since then, the country consistently has been the world's largest gold producer an enormous feat that required production of nearly 40 percent of defined reserves in a year. Recently China has also been a rapacious buyer of gold from all other sources. It would come as no surprise then if China's gold reserves were already number 3 or even number 2 in the world, at more than 2,500 tons. In 2013, Chinas plans for the yellow metal promise to be even more grandiose than in all earlier years. The Shanghai Gold Exchange, which five years ago was equivalent to a curbside affair, has morphed into a full-fledged exchange for spot gold and derivative trading. Indeed, it will serve two purposes: allow for smooth accumulation of gold, and attract foreign investors, lubricating ever more yuan-based transactions. And theres more. The Chinese are close, if not finished, with due diligence on gold ETFs. And what easier ways to accumulate massive amounts of gold than through ETFs? In other words, the Chinese accumulation of gold is arguably becoming exponential. Sooner rather than later such buying will probably have a much bigger effect on gold prices. In the end, if the BIS continues to resist gold as a qualified bank asset, the Chinese will simply use gold-backed yuan as their paper candidate. We imagine that virtually all the banks that can will join as well. The key point and one that should be underlined over and over again: In a world of scarce resources, countries or individuals will not exchange critical minerals for paper. Already we see phenomenon growing in the trend toward resource nationalism.

We think this situation creates an exceptionally rare point of inflection for investors; despite a 12-year run for gold, arguably the bull market has not yet even begun. Indeed, gold reserves as a percent of paper reserves have been nearly stagnant since the 21st century started. Central bank buying has aimed only at keeping gold at its low 1-plus percent of total reserves. So it is a monumental understatement to say that gold has enormous upside potential, and that mines with strong asset bases have even better prospects. In the 1970s the gold miners on average climbed 18-fold, while the metal jumped 20fold. Those numbers could be dwarfed in what is yet to come. In addition to various ETFs such as the SPDR Gold Trust (GLD), iShares Gold Trust (IAU) and iShares Silver Trust (SLV) the analog for silver, the one metal that might even outperform gold there are the miners, which have so lagged the underlying metal. In many cases this situation is even more bullish for gold, in that the major miners have dug up most of the high-grade stuff, but are having a devil of a time maintaining production. And this means that the future likely lies with the juniors, especially those such as NovaGold (NG) and First Majestic Silver Corp. (AG), whose operations are in secure locations like North America. For plays that will provide diversification through a group of silver or gold miners, two of our favorite ETFs are the Market Vectors Junior Gold Miners (GDXJ) and Global X Silver Miners (SIL).