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The
outcome of the race for the U.S. Senate in Massachusetts has made our 2010
outlook for gold turn from grey to Brown. Grey is simply a mix of black and
white, something between the two extreme “either-or” outcomes.
Brown, on the other hand, takes us out of the grey area and onto the color
wheel, seen by us non-artistic types, and is a more complex shadow of the
political primary colors of blue, green, and red. As the analysis of the
political color chart receives attention of politicos, its effect on the
economic canvas will be to slow the extreme deficit-expanding legislative
brush strokes that made higher gold prices in the mid to long-term more or
less certain.
In
our 2010 outlook we offered our opinion that a bubble in gold was unlikely
due to past and potential deleveraging of global financial markets, and
remained bullish on gold for the mid to long-term. Our optimism was from a
U.S. perspective based on the apparent unstoppable political momentum of
one-party rule accommodated by a liquidity driven central bank ideology.
While political climatologists have not as of yet confirmed hell has frozen
over, reversals of political fortunes in Massachusetts may have removed a
major element of support for our thesis of the certainty of increasing gold
prices through the end of the decade.
Review
and Reiteration of 2010 Gold Outlook
Investors
should exercise caution when an asset reaches a 52-week or record high.
In addition, except for 2009, gold prices would typically move up in the late
summer to early spring due to seasonal holiday purchases in Asia and the
Middle East, then flatten or retrace slightly through the end of the
following summer. 2009 seemed to break the mold as precious metals remained
strong through the seasonally weaker spring and summer months.
Investors
are now wondering if investment demand may again override a seasonal decline
in demand from gold fabricators as it did in 2009, or if gold would revert to
earlier seasonal patterns. In either case, we believe gold should remain at a
level above operating costs, which should make investing in gold exploration
and production companies attractive.
Our
gold forecast for 2010 did not include a bursting bubble, but rather a
moderate range between US$900 and US$1,200 per ounce. We did not
observe the telltale signs of a bubble including excess use of leverage or
optimism for gold infecting the broader market. On the other hand, the
current U.S. Administration and Congress appeared determined to commit to
massive spending programs, which could not easily be accommodated with
extreme levels of income taxation or expropriating wealth.
Even
without these legislative initiatives, we have been warned by the
Administration to expect an additional trillion dollars added annually to the
national debt through the end of the decade. Recognizing that government
programs left unchecked routinely end up costing more by a factor of Pi
(3.14x), the national debt could potentially double. Clearly, through either
monetization of debt and inflation, or bankruptcy and deleveraging, gold
emerges from the background as a time-tested store of value.
Gold
Bears Betting on Deleveraging and Fiscal Responsibility
We
identified that gold bears would be betting on further deleveraging of the
financial markets or a return to fiscal responsibility. The market has
identified a looming crisis in commercial real estate. This may indeed result
in the write down of assets, reducing capital on bank balance sheets and
removing liquidity from the fractional banking system. It would appear that
this issue may be resolved as loans are rolled over, but the issue is kept on
the front burner by regulators demanding that banks increase capital
positions. As long as the banking system receives mixed signals from the U.S.
Administration, Congress, and regulators, the economy is prepared for additional
deleveraging as banks build capital and small businesses and consumers hoard
cash.
The
upset in Massachusetts may have thwarted a golden age of fiscal
irresponsibility but it remains unclear how, or even when, the U.S. will
resume a trend of broad based economic growth. Even without expensive
legislative initiatives, the absence of business savvy of federal and state
government, and a “let them eat cake” attitude, has inserted
significant instability into critical investment decisions of both small and
large businesses. Certainly, the only stable employment is in government,
which has the ability to print money for its own preservation. This odd and
somewhat contradictory mixing of economic hues has produced a lighter shade
of Brown that certainly even Senate President Harry Reid can recognize.
Brown
and the Political and Economic Color Wheel
It
has been interesting to watch the Dow Jones slide following the upset in
Massachusetts. One would think that the vote would be interpreted as a move
toward free markets, which would be good for Wall Street and the
world’s largest corporations. One party rule can have a very cozy
and mutually beneficial monopolistic relationship with major special
interests. One only need look to the government support of large banks at the
expense of smaller banks to recognize the connection. This is, in effect,
what U.S. President Dwight Eisenhower termed as the
Military-Industrial-Congressional-Complex; just substitute any powerful
special interest group with one-party government and the relationship holds.
We regretfully note that the 2010 Index of Economic Freedom, published by the
Heritage Foundation, reduced the overall score for the U.S and its ranking
among nations to eighth place, just below Canada.
Politicians
stay in power favoring special interests and large corporations, and
suppressing the margin-destructive innovation of less lobby-heavy small
business and entrepreneurs. The upset in Massachusetts was not a defeat
for Democrats or a win for Republicans as much as increasing demand in a
political market for free and open competition, which may find its way into
other markets. The people have crossed party lines and have asserted their
voice, seeking to be heard over the über-rich, academic elites, and the
dependent classes.
Both
parties are claiming this as a victory, but it is apparent that there is
something unique happening in the body politic. It may be a win for
free markets and the democratic form of government with rule of law. (At
least this is our bias and hope.) While democracy and free markets are
often unstable and inefficient in appearance, they remain the most stable and
efficient system over the long term. While this may jeopardize extreme
prognostications of hyperinflation and accelerating gold prices for gold
bugs, the move toward moderation is exceptionally positive for economic
growth, wealth creation, and a balanced acceptance of developing natural
resources.
Growing
Concern of Global Systematic Risk
Not
to get carried away with a supposed new era of goodness and stability, we
continue to note increasing levels of systematic risk in the world’s
economic system. Systematic risk increased in the previous century as
nations have moved away from a gold standard and into hybrid systems of
exchange rates. Possibly one of the greatest economic faux pas exacerbating
systematic risk was the Smoot-Hawley Tariff Act of 1930 that deepened the
Great Depression. Systematic Risk is now clearly integrated into the
financial lexicon with “Too Big To Fail” policies in the U.S. The
global response to the U.S. subprime mortgage debacle was to flood the
markets with liquidity. Even with offsetting deleveraging, gold continued to
move higher.
The
U.S. Federal Reserve remains reticent to increase interest rates ahead of
bone-fide signs of inflation. Despite the Feds admitted inability to perceive
forming asset bubbles and adoration of liquidity to stimulate the economy,
they are most certain to wait until it is too late to raise interest rates.
Should a sluggish U.S. economy persist, we suspect that China will reduce its
exports to the U.S. and their purchase of newly minted U.S. Treasuries. This
suggests the potential for a dual negative of higher rates in the U.S.
resulting in a slower economy, and overseas payment of interest and a
correction in Chinese markets facing bubbles of its own.
The
upset in Massachusetts has somewhat reduced the likelihood of a mid to
long-term financial implosion from a U.S. perspective. It is interesting that
the answer in reducing systematic risk has been to require banks to hold more
capital while the Federal Reserve becomes the holder of the nation’s
government-guaranteed mortgages. This may have increased overall risk by
concentrating risk in a single area where the only recourse is to print
money. The increase in global systematic risk suggests that in the next
crisis, central banks will manage stable currency exchange rates at the
expense of holders of financial assets, which will be favorable for holders
of gold.
Mike Niehuser
Beacon Rock Research.com
Mike Niehuser is the founder of Beacon
Rock Research, LLC which produces research for an institutional audience and focuses
on precious, base and industrial metals, and substitutes, oil and gas,
alternative energy, as well as communications and human resources. Mr.
Niehuser was nominated to BrainstormNW magazine's list of the region's top
financial professionals in 2007.
Mr. Niehuser was
previously a senior equity analyst with the Robins Group where he was a
generalist and focused on special situations. Previously he was an equity
analyst with The RedChip Review where he initially followed bank stocks but
expanded to a diverse industry range from heavy industry to Internet and
technology companies.
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