The deflation-versus-inflation debate emerges as the flavor-of-the-day as we set out on what's likely to be a bumpy ride toward recovery, says Jon Nadler, Senior Metals Market Analyst and Investment Products Manager for Montreal-based Kitco Bullion Dealers. For the time being, Jon expects a spell of continuing deflation before any real inflation sets in. That makes gold's price performance a tough call, he tells The Gold Report, because we have no history to help us understand how gold behaves in a real deflationary environment.
The Gold Report: Could you give us your bird's-eye view of what you see ahead for the economy and its impact on gold?
Jon Nadler: It depends on whose headlines you look at. A fairly substantial amount of conflicting reporting as to the status of the global economy is still coming out. But that said, I think the amalgam of data that came out of the U.S., Japan, Germany and France in August suggests an "almost all-clear" signal on economic recovery. The corollary was the IMF announcement that, in fact, the global economy has turned the corner and that the recession is finished as far as they're concerned. They see tenuous conditions in unemployment and some fallout from the last two and a half years, though, so it's a recovery that may not feel like much of a recovery.
TGR: And how would that play out in the gold markets?
JN: A lot of investment attitudes we've witnessed over the last few years probably will be in line for some adjustment. As far as investment perceptions within the gold market, the gurus first argued that gold would be a sure moon shot on account of the falling apart of the global economy, and that the financial crisis and resulting depression was going to be the catalyst for several-thousand dollar gold. Their tune has now changed, and they're calling for the recovery to be the principal cause for the same moon shot, because it will bring hyperinflation to our door.
Unfortunately I don't think they can have it both ways. It's more likely a case of either/or. I am afraid that the best we can hope for gold to do in a serious depression is to fall less in value than other assets might. A falling price environment across the board will not spare gold. On the other hand, if you see a return of the Weimar Republic-style cycle of soaring prices, then it would be reasonable to expect gold to do its own soaring. Reality, thus far, has been nowhere near either extreme. Just one reason we have not had a collapse in gold back down to $500 or less, or the aforementioned moon shot to $2,300 or $5,000 either. So if you're looking at this turning of the global economic corner, the only debate left is basically deflation versus inflation. I think that's the flavor-of-the-day now.
TGR: So you agree that we are past the threat of global meltdown and that the economy will start a recovery, albeit a slow and choppy one.
JN: I'm still leaning more toward the Elliott Wave view that there's potential for deflation to possibly take hold. But even that wouldn't be the obituary for the global economy or the dollar as the world's reserve currency. We've already had manifestations of deflation and we could go through a period of further falling prices.
The bigger questions concern inflation. At what point do we get some inflation? How much do we get? Is there reason enough for people to run out, sell everything, and completely overload on gold in anticipation of some Zimbabwe-type hyperinflation? I just don't see that for the U.S. or Europe or Asia in the cards. It's a totally different thing to have 231,000,000% inflation per month as Zimbabwe had.
I would, of course, prefer for the world not to go into extremes of either deflation or inflation because the social costs in either case could be enormous. Extreme wealth erosion or extreme job losses will both motivate people to do radical things.
TGR: Aside from the Elliott Wave, what points to deflation continuing?
JN: Look at some of the statistics that keep coming our way. Germany saw producer prices dropping at the highest rate in 60 years in July. That's clearly some signal that deflation continues. A Bloomberg article showed that prices fell at nearly 0.75% in July from a year ago in the Euro region. And I think housing prices in the U.S. are a clear indication of the continuing trend. People are learning that a popped balloon does not leak air slowly. The "price adjustment" period continues. Probably the only exception has been the U.K. where mild inflation is still persistent.
The Bloomberg article also argued that deflation itself may not be the kind of threat that it is normally thought to be, and that periods of deflation actually may end up being a "cleansing" or "healthy" thing for those economies it affects, after all is said and done.
We have to be careful not to apply 19th century thinking to modern central banking policies, though. As difficult as this crunch has been, central banks have shown not only the unified resolve but the ability to jointly navigate through it and bring the world economy back from the brink. People castigate and vilify them for the injections of liquidity, but was there another choice, really? And will there be another choice, eventually, when stability takes hold and the central banks start mopping up this all of this excess money by raising interest rates and taxes?
Probably not, but people like to say that this time around, it's "different" and they will go so far as to proclaim that the U.S. dollar will die a violent death, and that the U.S. will cease to exist as a nation because of these liquidity injections. But at 5% or 6% inflation, most central banks will pull the trigger. Certainly back in the late '70s/early '80s, Paul Volcker pulled both triggers—interest rates and taxes in order to sterilize the effects of excess liquidity. We actually had 20 or 30 years of stability and sub-5% inflation after that little trick.
TGR: It seems that neither deflation nor inflation can push the price of gold through the roof. What's your viewpoint on what we might expect for gold prices?
JN: I often question why is it that people keep wishing for gold to go through that roof, to begin with. Don't they realize that such an extreme feat spells disaster for their own personal wealth? I am not sure about you, but I know of no one who has placed 100% of their money into gold with the firm conviction that Armageddon is upon us.
Now then, first off, we don't really know how gold behaves in a truly deflationary environment. The last time around that this happened, the price of gold was fixed vis-à-vis the dollar. I don't consider the Newmont Mining Corp. (NYSE:NEM) share price yardstick as a valid indication of what gold does in a deflation. In an asset-liquidation scenario that normally occurs in true deflations, gold cannot be immune from the "sell-everything" syndrome. People sell all kinds of assets. You saw it last year, from July through October. Everybody sold everything in order to raise cash. There was then, really, no reason for gold to abandon the $1,033 per ounce price it achieved in the early stages of the liquidity crunch and collapse to $680 by late October—just when the crisis reached mushroom-cloud proportion. Except, of course, the fact that cash—dollars—became the demanded asset. Not stocks, not bonds, not commodities, not even gold. About $9 trillion still remains in cash on the sidelines; it is skittish money that is unwilling and not yet ready to participate in any of these markets.
Asset liquidations can and do take place, absolutely. Gold usually goes with them. It would be nice, though, if gold may turn out to be a reverse hedge. It would please me—and most of the gold bugs—to say gold might fall less than stocks, bonds, real estate and so on. If the Precther (Elliott Wave) followers are right and some unforeseen liquidation wave has yet to come, gold might well fall back to the $500 or $600s; but, again, that might be less in percentage terms than some other assets. Thus, even in such a case, a valid argument can be made for the presence of gold in a portfolio.
TGR: The obvious question here: How much of a presence do you advise?
JN: The same as everyone else at Kitco, I have always advocated making sure that you have 10% or 15% of "life insurance" holdings in gold regardless of the conditions you expect down the road. You want to be sure you don't overload for the wrong reasons however, or pay too much in premiums for physical small coins, driven by scary, barter-in-the-streets type of scenarios.
Back in 1980, some of the most aggressive Swiss money managers recommended as much as 20% to 25% in gold for their clients. Conditions are different today, however, and our opinion remains that about 10% to 15% remains the outside top range, and it's possibly between 7% and 10% for a lot of more conservative people. I disagree with financial advisors whose recommendations include little or no gold, or who substitute a gold foundation with oil or other currencies or commodities.
That said, a highly respected gold advocate, James Turk, recently wrote that gold is "not an investment." I totally agree. You should not think of gold as a "money-making" tool. It is simply a savings device. As such, it always has a valid place in a well-diversified portfolio. Although we don't know the precise formula, we hope it falls less than other assets if we tilt into serious deflation.
If we go the other way, but not follow Zimbabwe's path, well, it's a pretty difficult argument for gold because, if you look at the track record for 34 or 35 years, gold returned 2.7% net year-on-year (according to a Forbes article this spring). That's not enough to pay for average custodial and reselling costs. The slow, grinding type of inflation we have had over that period was not mitigated by gold ownership. Ask anyone who ran out to buy (too much) gold at $845 in 1980 if they ever broke even. They will not do so unless and until gold rises to $2,312—its inflation-adjusted price. An awful long time to wait for anti-inflation benefits.
TGR: You couldn't call that the perfect inflation hedge.
JN: No. To say that gold is the perfect inflation hedge, I'm afraid not. It is a dream inflation hedge if you're talking about inflation of the type and scope we had from '79 to '80 or Zimbabwe's experience. Then, of course, gold can shine brilliantly. But those are one-off or perhaps twice-off events per half century. They don't last for prolonged periods of time, and the central banks of today can and do address those issues and then act accordingly.
TGR: Why are there such incredible premiums on coins—not only gold but silver—if these are more savings than investment vehicles?
JN: The problem here is two-fold. I think the first issue is last year's production glitches in various mints on the blanking side of round and square products. It was not a shortage of raw material required to make these investment items. There are ample supplies of gold bars and silver bars from which to make one-ounce coins and distribute them to the public. However, because of the 20-odd years of bear markets, none of the mints around the world have invested in equipment, manpower or capacity to put out more than they normally sold in an average year, which was somewhere around 300 or 400 thousand ounces of gold.
So when it came to a post-Bear Stearns and post-Lehman situation and everything else that has taken place, investors began demanding more like 600,000 to 800,000 ounces. The mints found themselves simply incapable of ramping up fast enough to supply the market. Distributors, middlemen and wholesalers seized upon that immediately and started ratcheting up premiums on these coins.
By the way, anecdotal evidence from most of the bullion dealers I speak with suggests that their sales have tapered off and the phones are not as active. They're flat to down from last year. So the legacy of what happened with those punitive shortages went away as soon as supplies improved. We were actually selling Canadian Olympic Maple Leafs for 5% retail for several months this spring and summer. We are still selling gold Philharmonic coins from Austria for 5.5% and Olympic Canadian Maple Leaf coins for 5% above spot gold. You can also buy silver Philharmonics today for $16.34, which is basically about $2.30 cents over spot silver.
TGR: You alluded to a second factor affecting premiums. What's that?
JN: People insist on the physical take-home product with the anticipation of some Mad Max scenario, which I'm rather convinced will not materialize. We heard the same arguments prior to Y2K and they were equally ill-advised. These items will be of no use in trading for milk and bread, because it is unlikely the gold market would be open under such dire circumstances either.
There are, however, safe and inexpensive alternatives to physical possession. The Perth Mint certificates and the Kitco Pool accounts, for example, all offer the same exact physical gold, albeit it in the form of a large bar of which you own a portion, but at prices that are much, much superior vis-à-vis small coins or bars. In terms of dollars per ounce, ounces for your dollar, there is no comparison when you can buy your Pool silver for 10 cents over spot. It's still a 1,000-ounce bar; you still own your portion of it. Obviously, it's in safer hands than your bank can provide. We are talking about firms such as Brinks, or ViaMat—specialists in the business of safekeeping valuables. Some people however, are convinced that somehow the only thing in this post-Madoff era is that bird-in-the-hand or the gold in your pocket, and that nothing else will do.
If you're really a serious investor and you're putting in 10% or 15% of your assets into gold and silver, you don't want coins or bars in your dresser drawer or your bank, which is uninsured for such purposes. You want instantaneous liquidity, the ability to sell your gold or silver with a phone call or a mouse click.
So I think these premium issues will definitely abate in due course because—let me put it this way—if a mint can sell a one-ounce coin into the primary distribution channel between 3% and 4% over the price of gold, it will be very happy to do so, obviously. It's a nice money-making vehicle for them. They will find a way, as some mints have in North America, for instance, of contracting out parts of the production process to other mints of fabricators that say, "We can do it for you; we'll make the blanks. Just give us the gold and we'll take care of the rest if you're pressed for capacity." And, of course, then you will see these reflected in not only the Kitco price charts of particular products, but at other vendors as well.
At the moment, I think anybody who still charges 8% or 9% for a one-ounce gold coin at retail probably has to pay 6% or 7% for that coin in the secondary channel. Your objective should always be to get the most gold for your money, regardless of what bird or animal is stamped on that coin. Gold is gold no matter whose picture appears on the coin.
TGR: Given today's price of around $1,000 and target high prices of $1,050 you've put out there, if 10% to 15% of an investor's portfolio belongs in what we'll call "life insurance gold," should the investor who hasn't been participating in gold start at these prices?
JN: Believe it or not, I would say yes. But that comes with one caveat. If you have no exposure to the asset class at all—no ETF, no mining shares, nothing at all to do with gold per se and you haven't even begun to construct your physical "core holding" then, yes, absolutely do so. But do so with the understanding that you're embarking on a savings plan. The best strategy you could avail yourself of would be to cost-average. If you are working toward a 15% allocation, buy 2% this month and see what happens next month. If the price goes to $880, pick up 4% next time. Let's say you give a full year to build up your portfolio this way. You will probably find that with regular purchases, regardless of the particular prices or timing, you'll end up with more ounces than your neighbor who tries to "astutely" pick the bottoms or tops that he thinks are the technical levels. Time and again, those neighbors usually miss the mark by 5% or 10% on average.
TGR: So it's a buy-and-hold strategy.
JN: That would be the ideal. That's exactly what you do with life insurance. Accumulation absolutely makes sense, because you're not buying for the upside potential. You're buying for an unforeseen situation. In fact, you should buy and hope gold does not perform. If it does, all of your other assets may be up in smoke. If nothing happens, consider your gold a wonderful legacy for the kids.
TGR: Is the gold ETF an important component of the gold market?
JN: It's become important. It's only four or five years in existence, but I don't think there's really any argument about its effect on the price of gold. My own feeling is that it has contributed at least $150 to what gold prices would have been otherwise.
TGR: Is that a function of plays by some of the hedge funds in the ETF markets?
JN: You cannot ignore the ascent of a central bank-sized entity suddenly landing on the scene and accumulating 1,100 tons. The rise of such an entity from a zero balance clearly has had to affect the price of gold—wonderful and all good. Of course, we should also bear in mind that this has been a largely one-way, accumulation vehicle. I say this because from its incipient balances to those record highs of nearly 1,100 tons it held in June, hardly any sizable liquidations entered the picture. We don't know what it would or could do in a flat to sideways to downward phase in the gold market cycle.
Curiously, since early June this vehicle has remained largely static and has even lost about 6% of its holdings. I think that's in the makeup of the beast. It's largely participation by hedge fund-type buyers, not exactly the long-term loyal money that a physical gold buyer generally represents. These are speculative plays, and we've seen evidence of that. They can come and go.
This recent selling does not to hark back to the generalized asset and commodity liquidation of last July to October; it's just a function of profit targets being achieved and at what point someone pulls what sales trigger. If we figure that a lot of these funds accumulated gold at $400 or $500 or $600, why wouldn't they be tempted to sell at $800 or $900 or $1,000? What I'm saying is we do not know what happens when outflow from this entity reaches the level of 200 or 300 tons.
TGR: Now that we're getting some more positive economic news, do you feel more hedge funds will start driving a massive liquidation of their ETF investments?
JN: It's a possibility. I don't know that I'd say "massive," but even if 30% comes out, that's 1,100 tons, that's sizable. In this rather small gold market overall, certainly when you start talking about 200 or 300 tons and start equating what central banks do in aggregate over the course of a full year, which becomes a significant tertiary source of supply to the gold market. No longer is the gold coming primarily from mines or secondarily from scrap, but the ETF becomes the provider of supply back into the market. Again, this is a situation that has not previously existed in the gold marketplace of yesterday.
The old reliable model—mine supply, scrap supply, central banks buying or selling, fabrication demand, investment demand and industrial demand—now has an additional component. I don't think a few years of ETF history is enough to say we know how this component works. Having said that, there is no way it cannot affect prices. We know it helped the market on the way up, when balances were buying accumulated. Could it also accelerate a decline in already falling gold prices if people find greener pastures in stocks, real estate or some other niches? You bet it could. Recall that the ETF is under no Central Bank Agreement sales limits. If holders wish to redeem, then redeem they will—en masse, occasionally. We can applaud the ETF as much as it deserves it, but we also need to be cognizant of the risk it could pose.
I would also point out in this same vein is that with these "green shoots" of recovery as far back as February came a lot of overly optimistic expectations on what the commodity sector overall would be doing. It led people to believe that "Oh, gee, it's wonderful that we recovered because look at commodities go through the roof."
No doubt, this is—and will continue to be—a slow recovery defined by slow growth. Under such conditions and with examples, such as U.S. capacity utilization at a dismal—no, make that record low—of 68.5% there remain an output gap out there that does not make one hyper-bullish on commodities. Neither does the utter collapse of global trade in recent months (and to a degree worse than in 1929) give us much reason to cheer just yet, even if various and sundry corners have been apparently turned. No matter what one keeps reading in the published opinions of the usual suspects in the perma-bullish commodities camp.
If we want to even partially classify gold with the "commodity" label, I think we've got a problem. We certainly don't want to see the same demand destruction in gold that oil has already witnessed—although recent numbers clearly speak of total global gold consumption falling nearly 9% in the second quarter. I don't know what people are being fed fact-wise, but gold demand fell to a six-year low in Q2.
TGR: Clearly demand in jewelry is down, but hasn't investor interest in gold more than compensated for that decrease?
JN: Absolutely not. Tonnage wise, 719 metric tons was the global consumption. Jewelry was down 22%, electronics down 26%. Investors bought 222 tons in Q2. That may be 46% more than they did a year ago in the same period but it's only about one-third of the overall demand, so it doesn't "more than make up." If investment demand accounted for 60% of the pie, as fabrication jewelry demand normally does, I would agree that investment is the main driver. But it isn't. It's providing a cushion to prices that even the experts do not expect to continue indefinitely.
We must not willfully ignore essential drops in areas such as jewelry fabrication or industrial applications or to ignore, for instance, that there was a 6% increase in mine production in Q2 or—even more stupendous—a 21% jump in the supply of scrap metal flooding into the market.
TGR: That is stupendous.
JN: We'd already reached 500 tons in scrap supply in Q1 of '09; that's as much as a normal full year of scrap supply to the market. One year's worth in one quarter. Evidently, at a price (and we've had near record, or record ones) plenty of people are willing to sell their old gold into the market. Witness the proliferation of all the "cash-for-gold" enterprises. People decide they will sell into that strength and there you go. The furnaces at refiners are burning 24/7.
TGR: All things considered, what's your outlook for gold prices?
JN: In early July we put a range of $750 and $1,050 on our projections for gold for the next six months out. We said you can easily add or subtract $100 at either end of the range if unforeseen circumstances, political problems or one-off headlines come into play on the negative side. It could be just a total deflationary tornado or some unexpected unloading in an ETF all at once.
TGR: Is it safe to assume that you aren't looking for gold to rocket up within the next couple of years?
JN: I don't think it will.
DISCLOSURE: Jon Nadler
I personally and/or my family own the following companies mentioned in this interview: No ownership of any firms mentioned.
I personally and/or my family am paid by the following companies mentioned in this interview: No compensation from any firms mentioned.
Jon Nadler, Senior Metals Market Analyst and Investment Products Manager for Montreal-based Kitco Bullion Dealers, brings to his role a 30-year professional career centered exclusively on the precious metals market and its related investment products. After graduating from the University of California, Los Angeles and the UCLA Business School's Management Program, Jon established and managed several precious metals operations at such major financial institutions as Bank of America and HSBC's predecessor. He has consulted with mints (U.S. Mint, Royal Canadian Mint, Perth Mint), precious metals retailers (Kitco, GoldMoney, ASI), as well as to trade and membership organizations (World Gold Council, Industry Council on Tangible Assets, International Precious Metals Institute). His insights and observations on the market's fundamentals are quoted regularly in mainstream U.S., Canadian, and global financial media (MarketWatch, ROBTV, CBC Radio, BBC UK Radio, CNBC, TheStreet.com, The Wall Street Journal Online, Investor's Business Daily, Forbes.com, AFX News.com, Bloomberg, Resource Investor, Investor Ideas, Korelin Economics Report, Smartstox, Reuters—and of course The Gold Report). Jon also speaks and hosts workshop at specialized global investment conferences (International Investment Conference, Money Show, Cambridge House, New Orleans Investment Conference, New Shore Conferences, Academie & Finance Switzerland).
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