Global Market Commentary

October 23, 2015

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The Case for Gold

Recently we have been hearing from some of our old friends from the gold world. Except for the occasional trading position, we have not been positive on gold for about four years. Our attitude has recently changed. A few weeks ago, and last week as well, we mentioned that gold was becoming more attractive. In this note we hope to explain our renewed optimism about gold in the intermediate term.

First, a little history.

We view a core holding of gold as an “insurance policy,” and like many Europeans of the 20th century, who lived through two world wars, the Weimar Republic, and all sorts of political irrationality, we believe some gold bullion or coins should be kept in one’s home or in an appropriate facility for safekeeping. We continue to recommend an “insurance policy” in gold to everyone.

We began investing in gold and gold shares in the 1970s. When Richard Nixon closed the gold window in 1971, we began to buy aggressively for clients. We were out of gold for clients above $850/ounce, and received a lot of criticism for abandoning gold, which (some believed) was surely going much higher. We stuck to our view, and did not buy gold back for all clients until 2003, at $325/oz. Since late 2011, we have argued for investors to be patient and wait for an entry level for an intermediate-term up move. Traders have been advised to trade occasionally.

Since we believe that a new entry level has been found for a longer-term move upward, we are using weakness in price to gradually increase positions in gold. We may go further into gold if conditions warrant in the coming weeks and months.

Gold has gradually been moving up for several weeks now, and we see the outline of a bullish case for gold taking shape:

1. A weaker U.S. Dollar. As we have been saying in these pages for a few weeks, a weaker or sideways Dollar is necessary for stocks, foreign currencies, oil, and gold to do well. We have been seeing the Dollar move sideways for several months.

2. Inflation heating up a little in some countries (India is one of them).

3. The U.S. labor market is tight, and although no data has yet been disseminated about higher wages, we see many individual companies raising wages. Walmart (NYSE: WMT), with about 1.4 million U.S. employees, is raising its minimum wage by 25 percent to $10/hour by February, 2016, in addition to raises for other workers and managers. Wages are also rising in restaurants and other service industries where qualified employees are in short supply; the same is true in construction. Unemployment is at a multi-year low, and new claims for unemployment for the week ending October 10 came in at 255,000 — the lowest in over a decade. Low unemployment means higher wages, and we are already seeing that in several sectors of the US economy.

4. The probability that El Niño this winter will be one of the most powerful on record; that could upset the price for grains in the U.S. by affecting the production of feed grains in the U.S., South America, and Canada. This year’s El Niño has already brought an underperforming monsoon in India, leading to expectations of lower agricultural production in the current growing season. Less crop production creates higher prices for crops, feed grains, and food. The data to defend these views have not yet become completely clear, but if we wait for the data, gold will already be higher by the time the mass of investors realize that inflation is coming.

5. Middle Eastern instability and the return of Russia as a serious regional player for the first time in decades. Henry Kissinger recently wrote an about this in The Wall Street Journal. Mr. Kissinger has been a shrewd, realistic, and prescient advisor on global political events for decades. His recent comments in the Journal are a key to understanding the region, as well as past and present U.S. involvement in it. (Interested readers can find it here: A Path Out of the Middle East Collapse.)  We could summarize his main points simply by saying that the current situation in the Middle East — including the collision of rigid Shi’ite and Sunni blocs, the retreat of the U.S. as a competent power-broker, the rise of non-state actors, the arrival of Russian power, and the threat of nuclear proliferation — presents an exceptionally difficult picture for U.S. policymakers. Our takeaway is that there are many obvious and hidden triggers and flashpoints which could powerfully affect gold and oil prices. Given the rising prospects for disruptive events in the region, it seems naïve not to hold substantial positons in gold and oil.

6. The Chinese Yuan (renmenbi) is growing in clout as a world trade currency, not a reserve currency. Because the Chinese banking system is not open, the Yuan has a long way to go to become a world reserve currency. However, it is increasing in stature as a currency of world trade. We see the formation of a new trade bloc in Asia, with China at the head, as well as the potential for China to be a backup currency for the International Monetary Fund’s SDR basket (along with the Euro, Japanese Yen, British Pound, and U.S. Dollar). This inclusion is a technical matter, but will increase the status of the Yuan. A rising Yuan will mitigate upward pressure on the U.S. Dollar, and thus be bullish for gold.

7. Gold is acting better technically. Gold hit its recent low in the middle of the night on July 17, 2015 at $1,072/oz. After most participants have gone to bed, the markets are thin and easier to manipulate. We have often noticed such manipulations in gold and other commodities over the last four decades. Often when such manipulations fail to create another downward panic, they lead to market bottoms.

8. The efficiency of gold mining operations is increasing due to cost-cutting and technological advancements. Inefficient gold producers are losing money and being forced to sell assets or liquidate. Well-managed gold mining companies are becoming increasingly efficient (which is bullish for efficient operators).

9. Last but not least, fear. Fear of the Fed and its interest rate policy, first, but that’s only a part of something greater: the fear that those entrusted with the reins of the global economy will fail in their charge, whether that’s the Fed, central banks in general, or national politicians. Investors doubt that these groups have the wisdom or courage to implement a solution to the slowing economic growth that is gripping the world economy. When investors are generally unsettled or modestly frightened, they walk slowly in the direction of gold. When investors fear inflation or imminent war, they run to gold.

The rise will gradually continue as the public and government buyers of gold come to the realization that some or all of the following may come to pass.

  • Major disruptions take place in the production of oil.
  • Greater instability begins to be seen in the Middle East, and for the first time in decades the U.S. has little of no control over the outcome, endangering western interests and allies in the region.
  • Global economic growth continues to stagnate in spite of QE, because of unwise actions by politicians as they pander to special interests and neglect their countries’ economic growth.
  • Governments come to the realization that more fiscal and monetary action will be required to maintain growth.
  • Currencies of most countries need to be depreciated to handle debt repayments.
  • Inflation turns out not to be as quiescent as some expect.
  • World gold production falls due to high cost of mining.
  • Short sellers begin to take profits and seek other avenues for investment.
  • Central banks increase the percentage of gold in the foreign exchange reserves in order to protect themselves from economic disruptions.

    Until a few months ago we were in the “lower-for-a-few-years” inflation camp. We changed our view based upon many of the variables mentioned above.

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