Paul Brodsky at QB Asset Management Co. warns:

There are more American net-debtors than net-savers and US federal and state governments are deeply indebted. Thus, it is politically expedient for policy makers to inflate away the burden of existing and future US debt repayment (which will grow as the burden shifts from private and state debtors to the government).

Link: Is Gold a Crowded Trade? by Paul Brodsky

Investing in gold is tough because it challenges the investor to come to terms with the faults of his or her government, and then to act upon them. It requires the admission that there is risk in holding cash. This is counter-intuitive to this generation’s vintage of financial asset investor accustomed to thirty years of a credit build-up alongside declining interest rates.

There is certainly much more chatter in the press than in years past surrounding gold, and there certainly is more US retail investment (through ETFs) than there has been. That has been reflected to some degree in its rising price, no doubt. An ounce of gold has risen from about $250 in 1999 to current levels, having moved higher in each year and making it one of the best performing assets over the last ten years. So then, is a person that pays $1,100 an ounce today top-ticking the market by entering a crowded trade that has little upside and great downside?

We don’t think so.

Do your own research. Call your investment advisers and ask them what percentage, if any, they recommend investors allocate towards precious metals. Ring up prominent friends with substantial portfolios and ask them how much gold they have as a percentage of their portfolios. What about your fund managers overseeing, say $50 billion? Are they actually long $2.5 billion to $5 billion in precious metal plays? Our guess is that the figures in both cases will be very small, say 5% to 10% (if any at all).

Let’s extend this thinking. If people you know have only dipped their toes in the water and are doing more watching than investing in gold, then the past ten years of price appreciation must have come from elsewhere. Did it come from institutional investors? No, not in any great way. Most mutual and pension funds that report their holdings don’t own any gold – zip – other than very minor positions in precious metal mining stocks (and these stocks usually comprise less than 1% of their holdings). Hedge funds? Yes, it seems hedge funds have been buying gold but of those that have, most have less than 10% of their holdings in precious metals.

What about foreign central banks, Middle-East sheiks, Russians, ultra-wealthy families around the world? Yes, we would argue they “get the joke” and have been diversifying their wealth out of their home currencies and fiat currency-denominated assets into this scarcer currency.

Currently there is about $55 billion in global gold and silver ETFs – that’s it. (Does that qualify to be in the top ten of the any single issue in the DJIA?) It is estimated that all the gold mined in the last 5000 years is about 130,000 metric tons (each tonne converts into about 35,274 ounces). It’s a cube that would be roughly the size of a tennis court.

So let’s say there are 4.6 billion ounces of gold above ground, which means that at about $1,100/oz, the total global market value of all mined gold is currently worth a little over $2 trillion. By comparison, US Treasury debt was approaching $13 trillion, last we looked and we believe total US equity market capitalization is about $11 trillion. And then there are other bond markets (at least $8 trillion) money market funds, etc. There is also real estate.

In the US alone there is estimated to be about $65 trillion in present value private sector credit outstanding and trillions more in unfunded government obligations. And then there are the financial assets (stocks and bonds), real estate and public sector obligations for the rest of the world.

Global central banks are trying to keep it all afloat by printing even more money (by making more debt). The response by central banks to declining velocity has been and will continue to be the same as their responses to credit deflation – they will continue to print money. They may give it to their fractionally reserved banks that may then use the money multiplier to distribute more credit and in turn raise systemic velocity, or they may give it directly to debtors in the hope they will spend like drunken sailors again.

There is enormous embedded inflation already and more to come. The high-powered money has already been created; it is leveragable and it is there to increase velocity. Higher prices must follow.

Will the Fed and other central banks withdraw liquidity? No, never. They never have and they never will regardless of how many tools they proclaim are in their toolbox to do so. If money velocity picks up leading to rising consumer prices, it will also lead to rising market-priced interest rates. They may decide to cut back their monetization, but they will not drain money.

We can look at price inflation contemporaneously or we can throw the ball ahead of the receiver. The result will be the same. The defense is blitzing; Jerry Rice is standing all alone in the end zone; Joe Montana is going to get sacked….but the ball is already in the air.

***

At current valuations the gold market is a tiny speck in relation to where perceived global wealth is being housed. The fundamental issue is one of ratios and relative future value. Our bet is that the gold-to-everything-else spread will narrow substantially. We are indifferent to whether gold rises to $10,000/oz. while the DJIA stays at 10,000 or gold stays at $1,100 while stocks and bonds crater. (In fact, we would love it if gold stayed at current levels while financial assets fell because then we would greatly increase our purchasing power vis-à-vis the rest of humanity and wouldn’t owe any capital gains tax!)

Further, we think that fundamentally gold is worth many multiples of its current price. Remember, it rose from $35/oz to $880/oz in a matter of nine years from 1971 to 1980, and the piece de resistance came in the last few months when everyone had to own it and its price went parabolic (it became a bubble).

There is chatter and there are fundamentals. (Consider that 250,000 people watch CNBC on a good day and 10 million people regularly watch Good Morning America. And remember CNBC and most business media focus on financial assets, not commercial business.) We think the gold chatter is a bunch of financial asset predators talking up their businesses. Needless to say, we don’t think gold is a crowded trade.

Conclusion: Future global US dollar-based claims are now estimated to be above $100 trillion versus a current US dollar monetary base of about $2 trillion. Global markets, policy makers and politicians are beginning to recognize that existing US dollar-denominated public and private credit (claims) cannot be settled with current USDs outstanding. Either far more USDs must be manufactured or credit must deflate far more.

2. Expectations: Three “Flations”

- Price Inflation/Deflation: Price deflation is a natural economic function (through competition, economies of scale and innovation); price inflation (though monetary/credit inflation) is a political construct meant to offset the natural tendency of prices to decline

- Credit Inflation/Deflation: Credit inflation temporarily warps pricing structure of goods, services and wages, which leads to broad economic and asset mal-investment

- Monetary Inflation/Deflation: The only true inflation/deflation metric (“inflation is always and everywhere a monetary phenomenon…”), the growth or decline in a currency’s monetary base best defines the increase or decrease in that currency’s purchasing power over time.

Conclusion: In the current lexicon, “deflation” is commonly and mistakenly confused with economic contraction. They are very different dynamics that may not correlate. Monetary growth/contraction may cause rising/falling nominal prices over time independent of changes in supply/demand fundamentals (see Zimbabwe). Thus, money and credit growth from an economy’s political dimension could synthesize nominal output growth while real (inflation-adjusted) output and real asset values may contract. Real output and assets are produce sustainable economic capital and employment over time.

3. US Monetary Base

- M0 = Money in circulation plus bank reserves held at the Fed
- High-powered money => May be leveraged further through fractionally-reserved banking system
- M0 just increased 135% in last 18 months

4. Reflexive Cause & Effect
- Output contraction => central bank generated monetary inflation
- Monetary Inflation in the form of M0 (new money given to the banking system) unaccompanied by a further bank system multiplier effect and/or by an increase in monetary velocity (thereby increasing M1, M2, M3) will effectuate a different form of monetary inflation
- Will checks be sent to homeowners (debtors, not creditor banks) made out to their servicers?

In a global paper currency monetary regime, where banking systems do not multiply their new high-powered money and where velocity does not rise (i.e. today’s environment), price inflation is a lagging consequence of monetary inflation. Demand-led output growth does not matter; indeed contracting demand is likely to push prices higher because it engenders more aggressive policy intervention.

Q: So what has been the true rate of inflation already experienced?

A: Something closer to 135% than popular price baskets. Of course, this may not be manifest through price inflation in any discrete year and it is likely the goal of policy makers to drag it out.

Q: Will policy makers withdraw the inflation they have already created?

A: Yes, if they don’t mind economic contraction. No, if they do not want to witness substantial credit deflation leading to output contraction and rising unemployment.

Q: What will be the ultimate outcome of global central bank monetary inflation?

A: It seems inevitable that there will be a new global monetary regime. That is not as radical as it sounds, given the current one is only 39 years old and no paper money system has ever lasted throughout millennia.

Q: Would Americans suffer from a new global regime?

A: American debtors would benefit from inflation because the burden of their debts would be inflated away vis-à-vis their higher nominal wages and asset prices. American dollar holders would suffer because they would lose future purchasing power, as would dollar-denominated bondholders because the purchasing power from their coupon interest and principal repayment would be inflated away.

Wise investor Warren Buffett has issued a warning in the New Y0rk Times about the creation of paper money (debt) to stimulate the economy. Excerpts below.

Op-Ed Contributor – The Greenback Effect – NYTimes.com. 

…Last fall, our financial system stood on the brink of a collapse that threatened a depression. The crisis required our government to display wisdom, courage and decisiveness. Fortunately, the Federal Reserve and key economic officials in both the Bush and Obama administrations responded more than ably to the need.

They made mistakes, of course. How could it have been otherwise when supposedly indestructible pillars of our economic structure were tumbling all around them? A meltdown, though, was avoided, with a gusher of federal money playing an essential role in the rescue.

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.

Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens…. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

I want to emphasize that there is nothing evil or destructive in an increase in debt that is proportional to an increase in income or assets. As the resources of individuals, corporations and countries grow, each can handle more debt. The United States remains by far the most prosperous country on earth, and its debt-carrying capacity will grow in the future just as it has in the past.

But it was a wise man who said, “All I want to know is where I’m going to die so I’ll never go there.” We don’t want our country to evolve into the banana-republic economy described by Keynes.

Our immediate problem is to get our country back on its feet and flourishing — “whatever it takes” still makes sense. Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

…The dollar’s destiny lies with Congress.

Tony and Rob Boeckh provide their insights into an unstable future in The Great Reflation Experiment: Implications for Investors. Excerpts below.

Link: The Boeckh Investment Letter

Prior to government bailouts and stimulus, the panic, crash, and precipitous economic decline of 2008/9 were clearly on track to be much worse than the post-1929 experience. The pervasiveness of leverage – from banks to consumers to supposedly blue-chip companies – and the illusion of stability in the system, were fostered through the 25 years that this credit bubble has grown, basically uninterrupted. The speed and magnitude of the bailouts and stimulus – the end of which we won’t see for a long time – aborted the meltdown. However, the story is far from over.

The Great Reflation experiment ultimately has two components. The first is a rise in federal government deficits, debt, and contingent liabilities. The second is an expansion of the Federal Reserve’s balance sheet. Both are unprecedented since World War II. U.S. federal government debt is likely to reach close to 100% of GDP over the next 8 to10 years according to the Congressional Budget Office (CBO) and supported by our own calculations (Chart 3). Anemic growth, falling tax revenue, increased government spending, and bailouts of indigent states, households, businesses, and an aging population will all undermine public finances to a degree never before seen in peacetime. According to CBO data, government debt could reach 300% of GDP by 2050 as contingent liabilities are converted into actual government expenditures. This massive peacetime deterioration in public finances will have grave consequences for living standards and asset markets, particularly in the longer run.

In the short run, huge deficits and growth in government debt are necessary. They will continue to play a crucial role in deleveraging the private sector and in helping to fill the black hole in the economy that has been caused by the sharp increase in household savings. Further out, government deficits will put upward pressure on interest rates. However much of the economy, particularly housing and commercial real estate, is far too weak to absorb an interest rate shock. Therefore, the Federal Reserve will have to monetize much of the rise in government debt, making it extremely difficult to unwind the explosion in the Fed’s balance sheet and consequent rise in bank reserves – the fuel that could be used to ignite another money and credit explosion.

The bottom line is that the Fed is in a very difficult position. Its room to maneuver is either small or non-existent and the markets understand this. That is why there is a sharp divergence between those worried about price inflation and those fearing a lengthy depression.

Implications for Investors

Investors are also in an extraordinarily difficult predicament. From the peak in 2007, household wealth declined by about $14 trillion, over 20% to the first quarter of 2009. Tens of millions of people had come to rely on rising house and stock prices to give them a standard of living which could not be attained out of regular income alone. They stopped saving and borrowed aggressively and imprudently against their assets and future income, some to live better, some to speculate, and many to do both. That game is over.

Pensions have been devastated and people’s appetite for risk has declined dramatically. The return on safe liquid assets ranges from 0.60% to 1.20% depending on term and withdrawal penalties. Reasonable quality bonds with a five-year maturity provide about 4%. Bonds with longer maturities have higher yields but are vulnerable to price erosion if inflationary expectations heat up. As for equities, people now understand that blue chip stocks carry huge risk. GE, once considered the ultimate “bullet proof” stock, dropped 83% in the panic, and Citigroup lost 98%. Revelations of massive fraud schemes have further damaged trust and confidence in markets.

Against this backdrop, we offer a few thoughts. First, an increase in price inflation as reflected in the CPI is a long way off. The degree of excess capacity in the world is probably the greatest since the 1930s, although excess capacity does get scrapped during recessions. Western economies will remain depressed for years and China will also be important in keeping inflation down. Its capital investment is larger than the U.S. in absolute terms. It is currently 40% of GDP and growing at 30% per annum. Profit margins in China will probably get squeezed, which, together with the huge amount of underemployed labor means that the Chinese will keep driving their export machine at full throttle, continuing to flood the world with high-quality, inexpensive goods. Therefore, investors who need income are probably safe holding reasonably high- quality bonds in the five-year maturity range. A bond ladder is a very useful tool for most people. Holdings are staggered over say, a five-year time frame and maturing bonds are invested back into five-year bonds, keeping the portfolio structure in the zero-to-five year range. In this way, some protection against a future rise in price inflation and falling bond prices can be achieved.

Second, massive monetary stimulus is good for asset prices in the near term (e.g. stocks, bonds, houses, commodities) in a world of very weak price inflation and a soft economy. That is true as long as the economy does not fall apart again, which is very unlikely given all the stimulus present and more to come if needed. Therefore, investors who can afford a little risk should own some assets that will ultimately be beneficiaries of the wall of new money being created and thrown at the economy.

There is a major risk to our relative near-term optimism, and that is the U.S. dollar. Foreign central banks hold $2.64 trillion, overwhelmingly the largest component of world reserves. The U.S. role as the main reserve currency country is compromised by its persistent inflationary policies and current account deficits, a subject high on the agenda at the recent G-8 meeting in Italy and referred to frequently by China, Russia, Brazil and others. Foreign central banks fear a large drop in the dollar, which would cause them potentially huge losses on their reserve holdings. They don’t want more dollars, and yet they don’t want to lose competitive advantage by seeing their currencies go up against the dollar. To preserve their competitive position, they have to buy more when the dollar is under pressure. On the other hand, since the 1930s, the U.S. has never subjugated domestic concerns to external discipline. Officials may talk of a strong dollar policy, but their actions always speak differently. Their attitude towards foreign central banks is, “we didn’t ask you to buy the dollars”. The U.S. has typically seen such buying as currency manipulation to gain an unfair trade advantage.

The most likely outcome is a nervous dollar stalemate or, as Lawrence Summers once described it, “a balance of financial terror.” The most important central banks will continue to hold their nose and buy dollars to keep it from falling too sharply. However, this is a fragile, unstable situation and the dollar must fall over time.

Jim Jubak as MSN Money looks at the financial crisis from the perspective of an investor. He’s not optimistic about getting easy gains from investing in the tough times coming up.

In the excerpts below he describes why we won’t see a recovery for several years.

Link: 5 rules for post-recovery investing – MSN Money – Jubak’s Journal

The Congressional Budget Office predicts the U.S. economy won’t return to full-trend growth until 2015. And full-trend growth — sustainable economic growth without rising inflation — even then isn’t going to be what it was before the global financial crisis.

…a lot of evidence argues in favor of a very slow and tepid recovery:

• In the boom, the economy got the benefit of the wealth effect as families spent part of the gains in the value of their houses and investment portfolios. Now the economy is facing a negative wealth effect as lower home values and smaller investment portfolios cut into household spending. Household net wealth was down 20% from mid-2007 to the end of 2008.
• Like U.S. businesses, American families are going to have to deleverage their balance sheets by paying down debt. That means having less to spend on consumption. Household debt had climbed to 130% of income by the end of 2008.
• Losses in the financial sector of an estimated $2 trillion (only $1 trillion realized to date) will cut the amount of capital available for lending and raise the price of that capital.
• Any recovery will send the price of oil and other raw materials higher, which will act as a drag on the economy. Taxes will climb as governments around the world try to repay some of the debt they had piled on to end the crisis. In the United States, interest rates will climb as overseas investors demand a better return on all the U.S. debt they hold.
• Finally, many companies used cheap money to offer incentives to keep their customers buying. Even in a recovery, sales won’t bounce back to boom-year levels.