Special Market Update: Black Swans and Ancient Money

Dear Reader,

We continue our special coverage of financial markets in the age of pandemic. As margin calls roil stock markets and liquidity disappears from the system, we believe there’s a flight to what few ‘safe’ assets are in the system. But hardly anything seems safe.

The ASX 200 closed 4.4% higher on Friday after an intraday swing of 12%. It was down over 8% at one point before buyers stepped in to save the day. Frankly, I’ve never seen anything quite like it.

The Dow Jones followed suit and closed up 9.36%. It was the first week since 1929 that the S&P 500 had moved more than 4% every single day of the trading week (down more than 4% three times, up more than 4% twice).

The strangest price action of all was in gold stocks. The gold price itself sold off to around US$1,500. That’s an important technical level of support. When investors get margin calls in a bear market, they sell whatever CAN be sold, including gold.

But that doesn’t explain the price action in several gold stock indices and gold exchange traded funds (ETFs). They plunged by double digits on Friday. The early evidence points to leveraged ETFs (promising three times the return of the underlying index) having to sell shares in a panic or getting a margin call.

A full description of the mechanics of what happened is beyond the scope of today’s report. To me, it’s a reminder that the core of your gold position ought to be in bullion. But rarely do you get such an obvious buying signal in an asset class as you got last week with the one-day plunge in gold shares.

I’m going to sit down with Greg Canavan and Shae Russell to discuss it in person tomorrow. What’s happening in financial markets is unprecedented. We’ll record that conversation and share it with you as soon as we can. Stay tuned.

In the meantime, central banks are moving. The US Federal Reserve just cut rates by 100 basis points. QE is back on, with planned purchases of Treasuries and mortgage-backed securities of up to US$700 billion.

Late last week, the Fed increased its monthly repo facility to $5 trillion (that’s trillion with a ‘t’). And Bank of America analysts report the Fed may soon announce the opening of a ‘commercial paper facility’ to unfreeze suddenly terrified corporate borrowing markets.

This morning, New Zealand’s central bank cut interest rates by 75 basis points to just 0.25%.

In other words, the authorities are throwing everything they have at the virus and the economic fall out it’s going to cause. It’s a veritable wall of money — a combination of interest rates, stimulus, quantitative easing and even ‘helicopter money’ deposited directly into your account.

It still may not be enough to calm fears in the real world. And it wouldn’t surprise me at all if markets took a ‘breather’ this week with an enforced holiday. Yet despite all that, if you keep your wits about you, you may get an extraordinary opportunity as well…

Three ways to buy gold during a mania phase…plus what would slaughter the bull

Central banks and governments must declare an ‘all-out war’ to prevent the coronavirus from sending the world economy into a wealth-destroying recession, according to Kristalina Georgieva, the head of the International Monetary Fund (IMF). As I wrote to you yesterday, we believe this ‘all-out’ printing of money, negative interest rates, and more quantitative easing could trigger the third and final phase of the gold bull market: a mania that sees prices go much higher from here.

These will be introduced as temporary crisis measures. But if history is any guide, it will be very hard to ‘normalise’ monetary policy no matter what happens with the coronavirus in the next few months. Once inflation leaks into the real economy, prices for everything begin to rise dramatically. It is a difficult process to reverse.

In this scenario, you can think of the authorities as the firemen from Ray Bradbury’s Fahrenheit 451. They show up with fire trucks filled with petrol. They spray it on everything. And they have special lighters to set everything ablaze. The coronavirus could be the spark.

Black swans and ancient money

The coronavirus isn’t a textbook ‘black swan’. It’s not an event anyone ever thought possible and it is suddenly changing everything we know about the world and financial markets. We’ve had ‘near misses’ with infectious diseases before. What we’ve never had — at least not in our lifetime — is a global pandemic, which shows just how fragile the world’s global supply chain is and could do so much damage to highly indebted businesses all over the globe.

We simply don’t know how long or how severe the disruptions could be. What we DO know is that gold preserves wealth in times of crisis better than any asset in history. We know that around the world, interest rates seem to be headed lower and government spending higher, to deal with a global pandemic. We also know that gold has broken out to new highs in nearly every major currency, not including the Swiss franc, the Chinese remnimbi, or the US dollar.

Greek philosopher, Aristotle said the ideal form of money must contain four key attributes: durability, portability, divisibility, and intrinsic value. In his eyes, gold is the ideal form of money, as it fits all four criteria.

  • Durability: Aristotle was referring to money’s ability to endure time, specifically its resistance to corrosion or fading. Gold was, naturally, the best choice at the time — it still is. Some tribes used clay coins or shells as currency. But these became brittle and eroded over time, making them a bad store of wealth. Today, paper money is popular, but bills erode if not handled properly. In fact, the average US bill spends only six years in circulation.
  • Portability: A medium of exchange will not work if you can’t easily pass it to someone. Can you imagine trying to pay for a car with bushels of corn? You’d need about 3,000 bushels — or 210,000 pounds — of corn for a $15,000 car. Or you could pay with less than a pound of gold.
  • Divisibility: For anything to function as a currency, it must be easily divisible. What if you had a 100-ounce bar of gold and wanted to buy that $15,000 car? You could cut off the proper amount, weigh it to verify, and the transaction would be complete. If that seems like too much work, you can buy coins with one ounce of gold in them for this transaction.
  • Intrinsic Value: The ideal currency should have value in and of itself, or be hard to make. This makes precious metals good currencies. They have many industrial and decorative uses. Precious metals also have intrinsic value because you can’t make more of them — you have to mine them.

In Friday’s report I wrote to you about gold’s ‘fair value’ price and why I believe it could be headed much higher in the coming months. It’s a combination of low real interest rates, higher inflation expectations, a premium attached to the gold price, and much higher real inflation. All those factors could lead to the third and final phase of a gold bull market: the manic phase. But first, here’s an important question: what if we’re wrong?

Debt, demography, and crashing oil prices

The big Achilles heel to our whole gold bull mania argument is that inflation never shows up. We get, at worst, DE-flation, where gold falls along with financial asset prices and global GDP craters. Or we get stagflation like we had in the 1970s, no real GDP growth but rising prices due to shortages and geopolitical tensions. There are three other forces that could keep inflation in check:

Debt: The world has $253 trillion in total debt, according to the Institute for International Finance (IIF). That combination of government, financial (banks), corporate, and personal debt is 322% of global GDP. If the coronavirus triggers a global recession, that debt acts as a huge drag on growth and inflation.

Crashing oil prices: The oil price is working against inflation too. The recent oil price crash — and pricing war between Saudi Arabia and Russia — is seriously deflationary (although the cheap energy should be a gift to the miners). Global GDP was growing anemically before the virus. If the world is in recession in the second quarter (or now), oil and energy prices will fall, which makes it hard for inflation to take hold.

Demography: Isn’t it interesting that the coronavirus seems to have had the biggest impact in countries that have larger elderly populations (China, Italy, Japan). It’s also affected countries that are demographically younger like Iran and South Korea. But demographics in general, ageing global populations reducing consumption or with a bias to saving and hoarding, could prevent the authorities from inducing a raging bonfire of inflation.

It’s a big ask for central bankers and governments to fight recession and pandemic at the same time. It’s going to take bigger deficits, lower (and negative) interest rates, and more quantitative easing. The government in Honk Kong even recently resorted to ‘helicopter money’, giving residents the equivalent of US$1,200 (a $15 billion stimulus package) to counteract the negative effects of the protests (and the virus) on tourism and the local economy (reminiscent of Kevin Rudd’s $900 handout to Aussies in February 2009).

One sneaky tactic to watch for is the recalling or complete cancellation of bank notes. Chinese and South Korean officials recalled quantities of cash form certain ‘hot’ infected zones to sterilise (launder) the money so cash is not a vector of contagion. If you followed the idea through to its logical conclusion, a complete ban on cash and the issuing of digital money from the government (via a pre-loaded debit or credit card) would be the fastest way to ‘stimulate’ consumption. You can’t hoard a credit card.

But let’s not get ahead of ourselves. There are many things the authorities can try to prevent a panic from leading to a recession. Some of them may even be prudent. And the important point here is that if they don’t spur inflation, then gold may have value as a safe-haven asset, but there will be limited upside to gold’s price appreciation.

And in a deflation, gold’s price could fall just like anything. We view gold as an asset you can save in. It’s a means of storing your savings, preserving at least some of their value in chaotic times. But there are some situations in history and financial markets where there is simply no way to avoid a loss. The key — in bear markets, war, and global pandemics — is to preserve as much of your wealth as possible. With that in mind, here are three ways to own or invest in gold:

Gold bullion and gold coins: You can buy bars of gold in sizes ranging from 1–10 ounces to much more. Gold bullion is the most pragmatic way to take a position in physical gold, especially a large one. Gold bullion coins are ‘legal tender’ and can be used as money, although the face value of the coin is far below the value of the medal used in minting it. Australia has several reputable bullion dealers you can buy from. Storing your gold is another matter. You can hold it in allocated or ‘unallocated’ vaults. Or you can store it off site.

Gold numismatics: Collectable gold coins are historic gold coins whose value depends on their rarity, condition, the quantity of gold in them, and their aesthetic value to collectors. A beautiful, rare coin in ‘mint’ condition may command a large premium over the value of the metal in the coin. I buy and collect coins like this, but not to save in. I buy them because I like them and want to collect them. If you’re ‘saving’ in gold, we recommend bars and bullion coins. If you have extra money with which to buy nice things you like to look at, numismatics may be the go.

Gold exchange traded funds (ETFs): ETFs are easy to buy investment securities, which track the price of gold. Australia had the first-ever gold ETF. ‘Paper gold’ is not the same as owning or possessing physical gold. It may, however, be a big driver of a rising gold price in the mania phase. Why? It’s the easiest way for fund managers and institutional investors to get ‘exposure’ to gold on financial markets. It creates a demand for physical gold, which could push up prices.

Given Friday’s price action in the gold ETFs — and the risk in general that leverage in the system could lead to serious price dislocations in underlying assets — the ETFs look like the least attractive way to ‘own’ gold. In fact, they may, at least in the short term, contribute to more gold price volatility and even price falls.

In the meantime, we’ll be keeping our eye on the price action in bullion itself. Our various sources at bullion dealers tell us that there’s surging demand for physical gold. You can still get it. But wait times have gone up in some places and demand is high.

I’ve left out an obvious way to buy gold: gold stocks. That’s because it may be the riskiest way of all to buy gold or try and profit from its rise in a mania phase. But it also may be, by far, the most lucrative way to profit if gold enters a mania phase. More on that tomorrow. Stay tuned…

Until then…

Dan Denning,
For The Rum Rebellion

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