Roughly 15 months ago, for the first time in my career, I became very bullish on gold. At that time, I gave four reasons, all of which continue to be valid. Now, several new forces have emerged that are likely to contribute to an even stronger advance for gold over the next several years, with a big head start developing in 2017.
The four points I raised in my initial recommendation are at this point worth revisiting.
First, — and most basic — after an astonishing six-fold rise from 2000 to 2012, the precious metal dropped over 45% through the end of 2015. It then had a pretty impressive 28% rally in the first half of 2016, but gave most of that back in the second half.
Now, gold is on the rise again, and has rallied 9% since mid-December. Still, with this modest recovery, gold remains down 34% from its all-time high of $1923 hit in 2011. The S&P, on the other hand, has doubled since gold peaked, and home prices have climbed almost 40%. So, a simple “BUY LOW/SELL HIGH” approach would inspire one to take a closer look.
Fiat Money Debasement
My second reason was the historic 21st century debasement of fiat money. Following the global financial crisis, major central banks around the world resorted to an unprecedented balance sheet expansion to prevent their respective economies from plunging into a deflationary spiral. In the U.S., the Fed more than quadrupled its balance sheet by buying U.S. Treasury bonds and lots of other debt backed by real estate securities. Other major economies have followed suit in varying degrees, most notably Europe and Japan. Indeed, the ECB’s balance sheet may surpass the Fed’s at some point this year.
Since the U.S. Treasury moved off the gold standard in 1971, the value of gold and other precious metals has not grown anywhere nearly as much as the quantity of debt and base money that it once legitimized. Precise quantification of the degree to which gold has lagged debt and money creation is complicated by the fact that the price of gold was fixed at $35 an ounce from 1933 until 1971 while the cost of living more than tripled.
It should be noted that the price of gold rose above $35 in the period from ’68 to ‘71. In the immediate aftermath of its floating, the price soared to $180 in just four years, in effect catching up with the inflation of the preceding four decades and the early 70s’ inflation surge.
As shown, gold is now priced at nearly 29 times its 1971 price, while the monetary base is up a whopping 54 fold over the same period. Gold’s hypothetical price — if it had followed the trend of the monetary base — would now be close to double the recent level. The relevant series that has increased the least is the CPI. The inflation that might have been expected to result from this massive money printing has not shown up … at least, not yet. In our view, it is on the way with a vengeance.
Rising Rates Winner
Third, the conventional wisdom continues to argue that rising rates would lead to lower gold prices. The Federal Reserve has now raised the Fed Funds rate by a quarter of a point once in December 2015 and once again in December 2016. Per the FOMC’s Summary of Economic Projections (SEP), the Fed expects to raise rates three more times this year. The price of gold, meanwhile, is up, not down, from its level just before the first hike.
Nonetheless, the prospect of rising rates is often offered as a reason why gold will not go higher but, rather, will be hurt in the year ahead. Indeed, conventional wisdom is that rising interest rates is going to hurt gold. Yet, that reasoning defies the lessons of history: it is clearly not axiomatic that when rates are hiked, gold slumps. More often, that has not been the case.
Indeed, while perhaps counterintuitive, the historical evidence points at times in the opposite direction from conventional wisdom. Since gold was freed from its fixed value in 1971, there have been nine tightening cycles. Gold rose during eight of the nine. Also, it should be remembered that during the 4 years following its 2011 peak, gold lost almost half its value in the face of zero interest rates and the easiest monetary policy in modern history. Conventional wisdom must have been on an extended vacation during this period.
The FX Factor
An extraodinary period of strength in the U.S. currency may now finally be ending, marking the bottom for gold and reversal of its performance going forward. Similar to gold, the conventional wisdom seems to be that higher nominal U.S. rates will push the dollar higher. But after decades of following the movement of currencies, I have learned that it is not merely nominal rates, but it is inflation-adjusted short term rates that matters. They are already moving sharply negative, which will derail the dollar rally over the course of 2017 and beyond.
The plunge in real rates will only get worse as the year-on-year percent jump in energy prices filters through the numbers in February and March. It might be called easy comparisons if one were looking at a company’s earnings. But, this base effect will be a huge factor in boosting CPI numbers even higher; and real rates will only drop further into negative territory. As a result, MRP expects the dollar to come under additional pressure. A falling dollar would reinforce our bullish position on gold and gold miners.
Six Newer Positives
These original four arguments in favor of gold are now supported by six more: inflation is breaking out; changes in Islamic finance rules, central banks still buying; gold production is peaking; short-term economic disturbance in China and India will give way to strong long-term demand; and Trump’s presidency seems to be increasing global uncertainty.
The year-on-year change in the consumer price index has already risen from 0 to 2.5%. When one looks at the breakdown of the CPI, the inflation pressures are even more alarming. Interestingly, the core index is up 2.2% year-on-year. But, core inflation would be a lot higher if it weren’t for deflation trends that have been in place, for some time, in goods prices. Services prices, on the other hand, have been soaring at a 3.1% rate for the last several months. As the dollar rolls over, good prices will start to perk up and the overall inflation reading is going to be much stronger.
The explosive rise in debt and base money has not been reflected in a comparable rise in the general price level over the last 10 years. During this same period the U.S. economy grew at a substandard rate and there was substantial excess capacity both in the labor force and in the physical plant and equipment in the U.S. But that output gap has been gradually closing, and the unemployment rate has fallen to under 5%. The excess capacity absorber of all that extra money is on the verge of ending. Wage growth has begun to accelerate and inflationary pressures are already evident.
Islamic Finance Game Changer
In the short-term, there have been several other variables likely to influence the price of gold. One is the change in Muslim Shari’ah Law. In December 2016, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Muslim governing body that creates Islamic financial standards, concluded that Muslims across the globe (1.6 billion people who are said to hold close to $2 trillion in assets) were now allowed to purchase and possess gold according to newly minted addendums to Shari’ah Law.
The new ruling has been described as a gamechanger representing a huge potential increase in demand. The World Gold Council has said that the new ruling could stimulate demand for “hundreds of tons” of gold as retail investors and Islamic banks shore up gold in their portfolios and balance sheets.
Central Bank Buyers
Third, over the past seven years, central banks have consistently been net buyers of the yellow metal. Though the reasons for central bank buying range from inflation hedging to tail-risk management, it represents a change in behavior that is beneficial to overall demand and gold prices. Although they bought less last year than in 2015, net purchases are likely to gain some this year. Reportedly, 56% of central banks are planning to raise their gold reserves over the next three years.
Next is the notion of “peak gold production” or the maximum rate of gold production. Year-on-year gold production has been declining despite technological advances in extraction techniques. The lack of new discoveries and decreasing volume of output by existing mines coupled with the failure to replace reserves in the face of rising demand supports higher future prices.
Demand from Asia is poised to strengthen. Recent economic events in India and China have had negative short-term effects on gold demand. These two Asian countries make up more than half of overall consumer demand and play an important role in the global gold market. Prime Minister Modi’s decision to demonetize large rupee notes, a significant portion of overall circulating currency, sent gold jewelry demand tumbling. India, until recently overcome by China, held the title as the world’s largest gold consumer. Meanwhile, in the long-term, demand is expected to return to pre-demonetization levels. In China, gold demand was down 14.8% year-over-year in the last quarter, attributed to a slowdown in overall economic growth. Still, the World Gold Council expects Chinese gold demand to grow by 20% in 2017.
Global Political Uncertainty
Finally, the surprise election of Donald Trump adds additional luster to the metal. A faster growing economy will generate even worse inflation pressure. In addition, many fear that some of Trump’s policies will create a great deal of uncertainty, driving the worried into gold to hedge away political risk.
In conclusion, our original four reasons are now joined by six more. Taken all together, I believe they add up to a compelling case to be long the precious metal commodity, and shares of the miners in particular. We believe the bullion price could double over the next few years, but the gold-mining producers, which have reportedly cut production costs sharply, could rise by twice as much!