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The Hera Research Newsletter (HRN) is pleased to present the following exclusive interview with
Eric Sprott, Chairman, Chief Executive Officer and Chief Investment Officer
of Sprott
Asset Management LP and Chairman and
CEO of Sprott Money, Ltd. With over 35 years of experience in
the investment industry, Mr. Sprott is the Senior Portfolio Manager for
numerous funds comprising several billion dollars in assets.
After earning his designation as a chartered accountant, Eric entered
the investment industry as a research analyst at Merrill Lynch. In 1981, he founded Sprott Securities
(now called Cormark Securities Inc.), which today is one of Canada’s
largest independently owned securities firms. After establishing Sprott Asset
Management Inc. in December 2001 as a separate entity, Eric divested his
entire ownership of Sprott Securities to its employees.
Eric’s investment abilities are well represented by his track
record in managing the Sprott Hedge Fund L.P., Sprott Hedge Fund L.P. II,
Sprott Bull/Bear RSP Fund, Sprott Offshore Funds, Sprott Canadian Equity
Fund, Sprott Energy Fund and Sprott Managed Accounts. In December 2004, the Sprott Hedge
Fund L.P. was awarded the Opportunistic Strategy Hedge Fund Award at the
Canadian Investment Awards. In
addition, the Sprott Offshore Fund Ltd. won the 2006 MarHedge Annual
Performance Award under the Canada-Based Manager category. Furthermore, in October 2006, Eric was
the recipient of the 2006 Ernst & Young Entrepreneur of the Year Award
(Financial Services) and the 2006 Ernst & Young Entrepreneur of the Year
for Ontario. In December 2007, Eric was named Fund
Manager of the Year by Investment Executive, a widely circulated publication for Canadian
financial advisers. In October
2008, the Sprott Offshore Fund Ltd. won the award for the Best Long/Short
Hedge Fund globally by HFM Week, a leading
publication for the global hedge fund industry.
Eric’s predictions on the state of the North American financial
markets have been captured throughout the last several years in a series of
investment strategy articles entitled “Markets At A Glance”
Hera Research Newsletter (HRN): Thank you for taking the time to talk to us
today. You’ve commented in
your articles and elsewhere that the financial problems of the United
States are much more serious than one might imagine
based on the official statements of the US
government.
Eric Sprott: The situation goes back at least to 2000 when we saw the Nasdaq
rolling over. Before it rolled
over, we’d written about it, in fact, we almost to the day published an
article entitled “Speculation is Rampant, Don’t be a Part of
It”. From that point on,
I’ve believed we’re in a secular bear market. The Nasdaq certainly has been in a
secular bear market since then.
Somehow they resurrected the S&P and the Dow but in order to do it
they had to start a housing mania and a lending mania and now, a government
spending mania. We still think
that the situation peaked in 2000 and continues today in a secular bear
market, but it’s morphing into a bigger problem.
HRN: What is
the bigger problem?
Eric Sprott: The bigger problem that we have today is where the sovereign risk
stands and the size of the US
deficit and I think that the question today is “Does Keynesianism
work?” In other words, if
you spend money it’s supposed to stimulate your economy, but there have
been a number of reports suggesting that the opposite happens, that you get a
negative return for government spending.
One study was done in Canada
by the Fraser Institute and
another was done by three Harvard professors and their conclusions were that
government spending was not good for private enterprises, period. You can see this if you look at a
chart showing the marginal value of each dollar spent by the US
government from 1960 to today.
HRN: Do you
mean the marginal return on a dollar of debt?
Eric Sprott: The marginal value of government expenditures, yes, debt, essentially
the deficit spending. The
economic effect of running deficits is now something like negative 40 cents
on the dollar. I think
Keynesianism is sort of being stood on its ear and it seems quite likely that
there is a negative return on deficit spending. For example, if the US
government extended unemployment insurance benefits yet again, what do we all
think the people receiving unemployment benefits would do? Would they be rushing out to get a job or not
rushing out to get a job? You see, deficit spending almost
always works against the system.
When I look at US GDP, which I think last year probably went up by
$400 billion, but, at the end of the day, there was an extra debt of $1.5
trillion and this year it will probably go up by the same amount, any
thinking person would realize that if you tack on $3 trillion of debt and
you’ve got less than $1 trillion of GDP growth, that’s a formula
for bankruptcy.
Chart courtesy of Nathan A. Martin
HRN: Are you
saying government stimulus doesn’t work because debt rises faster than
GDP?
Eric Sprott: Yes, it doesn’t work.
I’m not even including debt at the state and municipal
levels. I’m just using
federal debt. Debt at other
levels of government in the US is going up too, but not at the rate the
federal government debt is increasing.
HRN: What sort
of outcome or endgame do you foresee?
Eric Sprott: A few months ago, I wrote an article entitled “Surreality Check Part Two…
Dead Government Walking” where I specifically zeroed in on the US government. When I wrote Surreality Check … Dead Men
Walking back in
November of 2007, I predicted that some companies—I pointed out
Citigroup, GM, Fannie, Freddie—were all broke. They had pretty good market caps at
the time, but the reality was that they were broke and I think the reality is
that the US government is broke.
If you take all of the unfunded liabilities—the number is
something like $60 trillion or $100 trillion—there’s absolutely
no way that it can be repaid.
They’re going to have to repudiate some obligation, just as
other governments are doing now.
For example, the UK and France and maybe even Germany all extended the
number of years you have to work before you get a pension. There is a sense of repudiation of
what they promised and that will have to happen in the US as well.
HRN: Is debt
monetization a repudiation of debt?
Eric Sprott: All of history says we shouldn’t trust government, so why do we
trust the money that the government says is worth something when the history
of governments is one broken promise after another? The only thing they’ve done,
over the last 90 years or so, is to keep gouging the taxpayer, while at the
same time racking up increasing debt.
There’s very little responsibility at the government level for
the financial well being of a country in the long run. Fiat money will all go back to its
intrinsic value, which is zero.
You need real things to support the valuation of currencies. I find it absolutely shocking that we
trust government.
HRN: Since you
expect fiat currencies to fall in value, do you also expect real assets to
rise in price?
Eric Sprott: I think it depends on the class of the real asset and what determines
its value. For example, I always
question real estate because a lot of real estate is so indebted. If people have to pay their debts back
you can have real estate going down, even though you might be in QE2 or QE3
by the time, because there’s just not enough cash flow being
generated. I think of things like
agricultural products, oil and gas.
I think of things that can be used as a medium of exchange, such as
gold and probably silver, or maybe other precious metals but that’s the
category I think is the most survivable in terms of holding its value.
HRN: Is that
why you’ve invested in precious metals and gold in particular, to
survive the bear market?
Eric Sprott: My history with gold goes back to about 2000 when things were
bottoming out there and, in fact, coincided with our belief that we were
going into a bear market. When
you look at any bear market, you think “How do you survive
it?” We’ve thought
‘you’ve got to have gold and gold stocks’ and it’s
worked out so beautifully that it’s shocking. To think that the markets over the
last 10 years are down and gold is up something like 500% and gold stocks are
up something like 1200% from their lows.
That’s been the place to be.
HRN: It seems
a lot of money is flowing into the Sprott Physical Gold Trust (NYSE:PHYS).
Eric Sprott: As it applies to US residents, the tax rate on a capital gain in the
Sprott Physical Gold Trust is 15% today whereas if you own the ETF, because
gold is considered a collectible by the IRS, the tax rate is 28%. That’s a big reason for people
to choose this vehicle versus an ETF.
In addition to the tax benefits for US investors, the gold is held at
the Royal Canadian Mint in Ottawa and to some people in the US that’s a
good thing, because they’d like to see it out of the country. Also, the trustee is not a levered
financial institution. The
trustees for the gold and silver ETFs are levered financial institutions and
therefore, when you have leverage there’s always potential risk. Of course, the reason we started it
was that a lot of people realized there’s so much paper gold around
that when you go to claim your gold it’s not going to be there.
HRN: I
understand there’s a premium of between 5% and 10% for shares in PHYS
over the spot price of gold.
Eric Sprott: We wanted people to be able to literally get their physical gold, so
there’s a mechanism where, if you can buy a bar, which is 400 ounces,
we will deliver it. The physical
quality of it—the knowledge that the gold is there—in addition to
the tax advantages, creates the premium.
I think it’s justified.
There are certainly no other North American vehicles where you can get
physical gold. That’s why
we created this vehicle.
HRN: So,
there’s a level of insurance that’s just not there with ETFs like
GLD. Do you view gold purely as
insurance or do you also view gold as currency?
Eric Sprott: When I first got involved in gold, I came to the conclusion, based on
Frank Veneroso’s book, The Gold Book Annual 1998 (Jefferson Financial,
1998), that the gold market was being suppressed by central banks and that
that logjam had to break.
Veneroso proved that there were sellers of about 400 tons a year. Given enough time, their willingness
to sell gold had to run out. Now
we are in a situation where central banks, which used to be sellers of gold,
have become buyers of gold. The
gold market is very small. The
mines produce, let’s say, 2,600 tons per year and the central banks
used to sell 400 tons.
That’s a lot of tons in a 2,600 ton a year market. Now, central banks are buyers of
probably 200 tons or more. I
think the World Gold Council estimated that central banks bought as much as
400 tons last year. Imagine a
shift of going from a seller of 400 to a buyer of 400 in a mine supplied
market of 2,600 tons. Where are
all of the normal users of gold going to get gold with this huge change at
the central bank level?
HRN:
It’s curious that central banks would have sold gold as the price was
declining and are now buying when the price is rising.
Eric Sprott: Now we have gold ETFs, that didn’t even exist 10 years ago, and
they are now among the largest owners of gold in the world. There are also funds like ours and
Paulson & Co. or David Einhorn’s fund, Greenlight Capital, as well as various pension funds that now own gold
but that never owned gold 10 years ago.
Where are these funds getting all of their gold when they
weren’t even part of the supply and demand equation 10 years ago? I wonder where all of this gold is
coming from. I’ve always
been suspicious that it’s surreptitiously coming out of the central
banks.
HRN: Central
banks manage the exchange rates of currencies, which is no secret. If gold is still treated as a
currency, the gold exchange rate might be managed, as it was under the London
Gold Pool.
Eric Sprott: Central banks can also influence bond markets, and not just
government bonds. Last year the
US Federal Reserve bought $1.2 trillion worth of mortgage backed securities.
HRN: That was
a huge injection of liquidity.
Eric Sprott: We’ve had a huge shot in the arm both in the financial markets
and in the fiscal markets, but we took on huge debts as well. The hand of government in everything
has been unbelievable and what do we have to show for it as we sit here
today? We’ve seen the
economic data fall off a cliff: retail sales, new home sales, consumer
confidence, the Baltic Dry Index, the Chinese stock market index. I mean, the things that have fallen
off the table have been so dramatic and over such a short time.
Chart courtesy of InvestmentTools.com
HRN:
We’re not seeing much of a recovery in the US.
Eric Sprott: In some of the data you’re seeing, no recovery. Housing, for example, is at a dead,
flat bottom. I expect that car
sales are going to start doing the same thing. In fact, we’re going negative
right now: the leading economic indicators, the ECRI Index, I mean
everything. You’ve got to
think we’re just going straight down, not even slowly.
HRN: You
mentioned the heavy hand of government in these massive interventions.
Eric Sprott: The conclusive evidence is that when governments get involved with
things, the impact is negative because you get a misuse of funds. It’s like the Fed goes in and
buys a bunch of mortgage-backed securities (MBS) so the housing market stays
together but if they stop, the housing market collapses because it was a
misallocation of resources. We
should not have been encouraging people to be buying houses. We should have been doing the
opposite: saving money. We have
to learn to save here both at the individual level, the corporate level and
at the government level. The
government is giving all the wrong signals, they’re getting the wrong
people to do exactly the wrong things and it makes the problem that much
bigger.
HRN: Would it
be fair to say that, in your view, central planning and the economy is just
sort of an ineffective strategy?
Eric Sprott: You know, I think we’d all agree when we hear that
statement. Central planning
doesn’t work, but then when it comes to our own government, all they
want to do is centrally plan even though they don’t think they’re
centrally planning, but, by god, they are. The US government is saying that to
make the economy go they’re going to run a trillion and a half dollar
deficit. If that’s not
central planning, I don’t know what it is.
HRN: I think
the US national debt is expected to reach $20 trillion. Do you think the US is going to be
able to borrow and roll over debt at those levels?
Eric Sprott: Where does the money come from?
Theoretically, the money has to come from companies or
individuals. If we just took one
country and said that they should fund themselves from the earnings of
companies and savings of individuals and if there were no way, between the
individuals and the companies, that they had the money every year to throw
into government, it wouldn’t work.
The US government funded itself with debt all of last year and
certainly into March of this year.
The thinking is that between the Fed buying financial assets in the
market and the banks buying government debt and not lending, that
they’ve been able to fund the government, but we’re going to find
that it’s not sustainable.
The process of asking people to be indebted to the tune of a trillion
and a half dollars per year just at the federal level is impossible; and to
do it several years in a row with the growing legacy of the debt is not
sustainable. What if interest
rates were where they really should be?
HRN: Do you
think that, with a weakening dollar, the real interest rate could be negative
right now?
Eric Sprott: This 0% interest rate policy, 20 years from now, will be looked at as
one of the biggest financial jokes of all time. Of course, the primary beneficiaries
are the banks and the government.
Banks can borrow for nothing and the government can borrow for next to
nothing, but the true interest rate should be much higher. I mean, what’s the point of
saving? You’re asking
somebody to save to fund the deficit and then you pay them nothing to
save. What’s the
point? You get nothing for your
savings. Why would people save?
HRN: With a
second round of quantitative easing, QE2, do you think there could be a loss
of confidence in US government debt or in the US dollar?
Eric Sprott: We have a dilemma staring us in the face and I don’t see an
easy way out of it. People will
start questioning sovereign risk.
It started with Ireland; it went to Iceland; it went to Greece;
it’s maybe now with Portugal or Spain and it might be washing up on the
shores of North America. As you
know, the dollar has been quite weak recently and I think, as more and more
people assess the problem, they’ll find that there aren’t many
safe sovereign places to go.
There just aren’t many.
They’re very, very rare.
Either there will be no QE2 and interest rates will go higher, or, if
there is a QE2, interest rates can stay low, but ultimately, if we then go on
to QE3 or QE4, the gig will be up because everyone will realize we’re
just printing money and we’re not getting out of this problem. If we’re just printing and
printing and printing, people will want to convert their bank deposits to
something real because they’ll realize that fiat money is not going to
hold its value.
HRN: What do
you see as a solution here?
What’s the path forward for the world?
Eric Sprott: I don’t think there’s a solution. People always say to me, “When
would you not be bearish?” I say, “Well, I won’t be bearish
when I see people in the central banking community and in the sovereign area
start to take responsibility.”
One might argue that maybe we’ve seen the first signs of that
over in Europe and the UK and Greece with austerity. What’s interesting is that most
of these programs start a year later.
They don’t start today.
It will be interesting to see when we get there, how powerful those
programs will be.
HRN: Are the
European austerity measures indirect bailouts, preserving sovereign debt?
Eric Sprott: That’s why they announce them. We saw QE with the ECB when they put a
trillion dollars in for the Greek bailout. If they hadn’t announced
austerity programs what would we all be thinking? You can’t get the bailout and
not at least say you’re going to try to stop spending money. It was almost mandatory for people to
say at the time. They all had to
chime in because the Euro and the European banking system were under immense
pressure. Deposits were leaving
those countries, so they had to do something.
HRN: How do
you foresee the sovereign debt situation unwinding?
Eric Sprott: I think we’re too far gone. There’s way too much debt. Just the federal debt is something like $40,000 for every American, so a family of four has got $160,000
in debt they’ve
got to lug around; and that’s forgetting the states. I don’t think we can work our
way out of it. We’ve gone
for 60 years by expanding debt and, all of a sudden, that era ends and you
have a contraction and the contraction will be rather elongated.
HRN: Thank you
for sharing your views with us.
Eric Sprott: Thanks a lot.
After Words
Eric Sprott’s track record as a Portfolio Manager and as an
entrepreneur in the natural resource sector speaks for itself. Whether one agrees with Eric
Sprott’s skepticism regarding the fiscal responsibility of governments,
the soundness of fiat currencies, or the stability of debt-laden companies
and sovereigns, his contrarian analysis has enabled him to capitalize on the
trade of the decade: gold.
Between the anemic US economy, the Federal Reserve’s low
interest rates and purchases of financial assets, as well as the US federal
government’s deficits, and a second round of quantitative easing (QE2),
the US dollar will certainly weaken further, fueling demand for gold.
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