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July 31, 2019, Client Letter

In recent years, I’ve mentioned that the world is going through a gigantic monetary experiment. At first, I was referring to the “quantitative easing” that the U.S. Federal Reserve and other central banks began in 2008/2009, to offset the financial crisis. But the more I look at it, the more I see a process that’s been going on for a century.

A change in standards

Up till about a century ago, the world pretty much ran on the gold standard. Governments defined their currencies by how much gold each unit of the currency was equal to. (The U.S. dollar, for one, was defined as equal to a little less than 0.05 ounces of gold.) Countries stood ready to defend their currency, up to a point, by exchanging it for gold, and vice-versa, at the official rate.

National treasuries minted gold coins for use in trade. Commercial banks issued “banknotes”— paper money—that represented fixed amounts of gold.

Then a series of national governments set up central banks for themselves, such as the U.S. Federal Reserve (founded in 1913), and the Bank of Canada (1935). These ostensibly independent entities pushed commercial banks out of the business of printing paper money. You might say they nationalized the paper-money printing business, on behalf of the central governments that created them.

Not surprising—after all, a “license to print money” is a valuable asset!

In the 1930s Depression, one country after another gave up on the gold standard. Some were trying to devalue their currencies, to gain a trade advantage. Others did so to avoid having to redeem their currency, which could drain their national gold holdings. Some, no doubt, were preparing for the war that was brewing in Europe and Asia.

Although the classic gold standard went out of monetary fashion in the 1930s Depression and never made a comeback, a ghost of it did materialize to take its place.

In 1944, 44 countries met at Bretton Woods, New Hampshire, and agreed to launch a new so-called Gold Exchange Standard. The member countries of this “Bretton Woods system,” as it came to be known, agreed to peg their currencies at fixed rates to the U.S. dollar, which was in turn pegged to the price of gold at a fixed rate of one ounce for $35 U.S. (up from $20.67 per ounce when the dollar was still convertible into gold).

One key difference between the gold- and gold-exchange standards was that under the latter, only central banks could exchange their dollars for gold at the official price. This gold-exchange option was not available to other entities such as firms or individuals.

Considering the circumstances, all this worked well. After World War II, Bretton Woods member countries and their trading partners set off on an extraordinary period of economic growth—even West Germany and Japan prospered, and they were on the losing side.

However, President Charles de Gaulle of France resented the central role of the U.S. dollar in the system. So, he made a practice of gradually exchanging France’s U.S. dollar holdings for U.S. gold. He knew the $35 U.S.-an-ounce price was a bargain.

In 1971, French demand for U.S. gold helped spur U.S. President Richard Nixon to “close the gold window”—stop redeeming U.S. dollars in gold. From then on, trading in foreign-exchange markets determined the value of currencies. They rose, or fell, mostly on their own, but sometimes with intervention by one or more governments.

Today, the gold standard is not in use by any government. Now the entire world runs on a fiat-money standard, which is exactly what it sounds like. Unlike gold, which has value because people want it, fiat money has value because a government has issued a “fiat”—an edict or decree—that says it has value and is “legal tender.”

When I was in high school in the U.S., my history textbook said that fiat money was something you’d find in foreign dictatorships. It was vastly inferior to the U.S. dollar, which was “good as gold.” I don’t know if that scrap of text was just outdated, or if the author failed to see a difference between the gold standard and the gold exchange standard.

Gold’s exit made central banks more ambitious

The aim of the gold standard was to use gold as a stabilizer for currency values, as a fixed measure (like the inch or ounce) to facilitate commerce and to provide a safe “store of value” for wealth.

Today’s monetary authorities feel the fiat-money standard lets them aim for loftier goals. They try to promote full employment in the economy, calm foreign exchange markets, avert economic crises, avoid deflation, and maintain stable prices, modest interest rates and inflation of 2% yearly or less. In recent years, they have avoided deflation and mostly held inflation below the 2% limit. They haven’t eliminated crises by any means.

After 1971, the next big monetary shock came during the financial crisis in 2008/2009, when central bankers added “Quantitative easing” to their toolkit. That’s the central-bank tactic of buying government bonds, or private-sector financial assets, such of stocks and bonds, to inject new money into the economy.

This differs from the earlier tool, “Open-market operations,” under which central banks buy and sell short-term government obligations such as T-bills. This has an impact only on short-term interest rates. Quantitative easing has lowered long-term rates.

Central banks pay for their purchases by “writing a cheque” (electronically, of course) on their own credit, which is virtually guaranteed and unlimited, due to its link to the federal government. This is the modern equivalent of “printing the money,” which was a key tool for governments long before fiat-money went worldwide.

Quantitative easing took the fiat-money standard into a whole new dimension. It has led to the lowest interest rates in all of recorded history.

For that matter, the fiat-money standard has also led to a situation where around $13 trillion (that’s trillion with a “t”) dollars’ worth of fixed-return investments has a negative yield, though only by a small fraction of 1%. In other words, the lender pays interest to the borrower, rather than vice versa.

Maybe these lenders look on a government bond with a slight negative yield as safe, cheap money storage. Or negative-yield bonds may fulfill some regulatory or contractual needs. However, according to Bank of America Merrill Lynch, there are 14 companies with junk bonds worth more than 3 billion euros ($3.38 billion U.S.) that also trade with negative yields.

Today’s exceptionally low interest rates have had unpleasant side effects. They have undermined the security of the pensions of millions of employees, public and private. Pension funds rely on a series of bond maturities for a dependable stream of cash flow to pay monthly pensions far into the future.

Low rates have also devastated the retirement plans of people who choose to hold their life savings in bank accounts, or government-guaranteed fixed-return investments such as GICs.

Interest rates play a variety of roles in a modern economy. Above all, today’s low rates have also neutralized the traditional fiat-money, central-bank tool for economic stimulation, by cutting short-term interest rates.

James Grant, an interest-rates and monetary-system expert, says that the worldwide monetary system has gone from a fiat-money standard to a “Ph.D. Standard.” That’s because the main thing backing today’s money is the public’s faith in the wisdom of the Ph.D. holders who run the system. (The U.S. Federal Reserve employs 700 of them.) Their collective wisdom led to today’s low interest rates, which range from lowest-in-recorded-history to negative, and the accompanying side-effects.

You have to wonder what happens to inflation, if/when the public loses faith in the Ph.Ds. You may also wonder about the outlook for gold.

When economics and investing diverge

After the gold-exchange standard ended in 1971, the price of gold, interest rates and inflation all started moving up. So-called “goldbugs” predicted that the worldwide switch to fiat money would bring great bouts of inflation and currency collapses. These views helped set off a boom in gold stocks and gold-related investments and collectibles.

I understood and sympathized with the goldbug theory. But I felt that most gold-related investments, including the highest-quality Canadian gold stocks, were priced as if the great inflation was a sure thing. Investors were willing to pay extraordinarily high prices because golds seemed like a special situation that deserved a huge premium.

If you pay a huge premium for stocks and guess wrong, you can lose a lot of money. So, I made few gold recommendations. I focused on conventional Canadian stocks, most of which traded at extreme bargain prices in the 1970s.

Gold prices wound up making a huge gain between 1971 and 1980, thanks to the inflation of the 1970s, plus high interest rates. High inflation spurred interest in gold around the world, since gold has a reputation as a reliable inflation hedge.

Perhaps more important, a lot of latent gold demand built up between 1933 and 1974, a period when it was illegal for U.S citizens to own gold. When gold became legal in the mid-1970s, gold-starved Americans rushed to buy. In 1980, gold reached a peak of $850 U.S. per ounce, up around 20-fold from 1971.

The twin factors that helped push gold up from 1971 to 1980—high inflation and high interest rates—made investors wary of stocks and the economy. The Dow Jones Industrial Average rose from 890 at year-end 1971 to 963 at year-end 1980, a total nine-year gain of 8.2%, although dividends added substantially to yearly profit.

Over the next couple of decades, downplaying or avoiding golds worked out well for my readers. Inflation continued in the 1980s and 1990s, although at much lower rates than the 1970s. We continued to make few if any gold stock recommendations. This time, my preference for stocks instead of gold paid off.

From 1980 to 2000, the price of gold dropped by around 69.4%, from $850 to $260 an ounce. The Dow Jones Industrial Average rose from 963 at year-end 1980 to 10,786 year-end 2000, an 11-fold gain.

Since the year 2000, we’ve recommended some golds in print, mainly junior golds that had appeal for aggressive investors. We only bought high-quality gold stocks for portfolio-management accounts, and then only to fulfill client requests.

We now think gold stocks give you good odds

Recently, we’ve begun investing in high-quality golds for our clients.

These gold-mining companies now look better than in the past for several reasons. For one, they have taken steps to cut their mining costs and expand their gold output. In addition, their shares have been poor performers since around 1990, while the rest of the market shot up. The falling rates of inflation since that time have wrung the speculative excesses out of golds’ share prices.

Investors now price golds much more like ordinary stocks, rather than special situations that are worth a huge premium.

If inflation rises these next few years (a clear possibility—see below), gold and gold stocks will attract new interest that will push up their P/Es—that is, the ratio of their share prices to their per-share earnings.

If the world economy continues to expand, particularly in emerging economies, consumer gold purchases will rise as well. This too could help push up gold prices.

Top gold stocks now seem to offer a classic “good odds” opportunity over the next five or 10 years: heads you make an attractive return; tails you make a well-above average return.

Monetary changes could aid gold

Our current monetary system has on the whole served us well since 1971. Now, however, the system’s monetary tools for interest-rate manipulation seem to be losing their mojo.

The U.S. Federal Reserve kept its policy rate at zero for six and a half of the eight years following the 2008/2009 recession, in hopes of spurring economic growth. However, businesses were reluctant to invest, despite the low rates, due to the rising taxes and increasingly costly and complex regulatory environment of the Obama years. As a result, the U.S. economy averaged yearly growth of just 2.2% from 2010 to 2017.

That’s well below the 3% historical average growth rate. It’s particularly weak in view of the fact that it includes a period of recovery from a recession, which is often a time of well above-average growth.

Low interest rates do encourage government borrowing, however. The national debt in the Obama years rose from $10.626 trillion to $19.99 trillion—a high price to pay for weak growth. (It has since risen to $22 trillion.) Low rates continue today, and the economy has sped up in the past few years, raising tax revenues with it. So, the interest cost on that debt is bearable for now. The U.S. Federal Reserve recognizes that interest rates are extraordinarily low. It has talked of raising rates gradually to more normal levels, and reducing its bond holdings.

In contrast, the European Central Bank said it’s getting ready to cut interest rates soon, for the first time since 2016. It may also resume its quantitative easing/bond-buying program. It expects to keep its key interest rate at the current negative rate, minus 0.4% or lower, until mid-2020.

Many central banks face challenges like this. Fine-tuning their changes may prove disruptive.

If interest rates were to shoot up—as they have from time to time in years past—it would raise the cost of servicing today’s high government debt. Higher rates could also spark a recession. This would cut tax revenues and reduce funds available to service the debt.

The only course for keeping current on the debt might then be to force rates down and carry out additional quantitative easing—again, this is the modern version of “printing the money.” This practice has led to high bouts of inflation in dozens of countries that were on a fiat money standard, as we are today.

High inflation needs a trigger

When the Federal Reserve and other central banks turned to quantitative easing to fight the 2008/2009 financial crisis, many people saw it as a modern version of high-powered money-printing. They feared it would quickly cause a big rise in inflation.

I didn’t share that fear. I felt it rested on a glib-but-shallow rule-of-thumb that is really more of a myth-of-thumb. Excess money growth (either the printed or electronic variety) merely provides the potential for inflation.

(I wrote about this in my 1993 Canadian best-seller, Riding the Bull: How you can Profit in the Coming Stock Market Boom, in a 12-page chapter entitled, “Gold, Inflation and the Beer Tickets Theory.”)

It takes a trigger of some sort to turn inflationary potential into reality. Triggers have come from a variety of sources. Wars, failures of grain crops or anchovy harvests, the 1973 Arab oil embargo, COLA’s (Cost of Living Allowances in labour contracts), and demographic trends are some examples. Without a trigger, central banks can “print” vast amounts of money for years or decades, and get away with it.

If the right trigger comes along at the right time, however, inflation can shoot up almost overnight.

A foot-in-the-door for gold

In his book, The Magic Formula, monetary historian and gold expert Nathan Lewis shows how, down through the centuries, the combination of sound money and low taxes has been the common factor of prosperous nations and empires. But he stresses that you need both to prosper. He also shows how high taxes and/or fiat money have routinely led to high inflation.

The Trump tax cuts have moved the U.S. toward a low-tax regime—lower than in the past, at least. The Trump Administration’s move toward deregulation has enhanced the tax cuts, since regulation acts like a payment-in-kind tax. Regardless of good intentions, new regulations raise business costs, just like new taxes.

However, President Trump seems to have mixed feelings about sound money. For instance, he has harshly criticized his own choice to lead the Federal Reserve, Jerome Powell. When Mr. Powell failed to follow Mr. Trump’s advice about cutting interest rates, Mr. Trump muttered about firing him.

Monetary stability is a delicate matter in a fiat-money environment. This kind of political meddling has helped set off past bouts of inflation.

Turkish President Recep Tayyip Erdogan fired his central bank governor in July this year, for refusing his instructions to loosen monetary policy. Mr. Erdogan hired a new governor who started his term that same month by cutting the central bank’s benchmark rate from 24% to 19.75%.

Turkish inflation hit 25% in summer 2018, but is now down to 16%, mostly due to a weak economy. Critics doubt the cut in rates will do much for the economy, since Turkish companies already carry heavy debt, and Turkish banks hold a lot of bad loans.

Fortunately, Mr. Trump never acted on his firing threat. But Mr. Powell started talking about a cut in rates soon after anyway, presumably because the economic situation had changed.

Interestingly, President Trump has also nominated a new Federal Reserve Board member, Judy Shelton, who was a Trump campaign advisor. She is also an advocate of re-establishing an official link between gold and the world monetary system. This nomination rattled/amused/enraged some orthodox advocates of today’s Ph.D. monetary system such as Alan. S. Blinder.

Mr. Blinder worked in the Clinton administration’s economic team, briefly as vice-chairman of the Federal Reserve, and in other roles. He’s a professor of economics and public affairs at Princeton. In a recent Wall Street Journal article, he sniped at Ms. Shelton on what I would call political grounds. Then he went on to say, “But it gets worse: Ms. Shelton advocates a return to the gold standard. Yes, I know she isn’t alone, but the Flat Earth Society has members, too.”

Rather than a fair assessment, I’d say this comment reflects political and personal conflicts of interest. Ms. Shelton works for a Republican president, and Mr. Blinder worked for a Democratic president. If Mr. Blinder were to admit that there might be some value in the gold standard, he and his Ph.D. system colleagues would see it as a repudiation of his entire professional career.

I doubt that the world will soon revert to the gold standard. But, if problems appear, gold may inch its way back into the world monetary system.

For example, in the gold-standard days, many loans and other contracts included a “gold clause.” It gave the lender the right to demand repayment in gold or gold equivalent, at the gold/money ratio in force at the time of the making of the loan. This protects the lender/creditor against currency devaluations, regime changes and so on. The gold clause could serve as a financial safety valve in a new financial crisis.

If interest rates went so high that debtors were going broke, lenders might offer secured loans at
2% to 3% interest rates, in exchange for including a gold clause. Instead of going broke right
away, this would let the borrower buy time, at a cost of taking a chance on how high gold would
go during the term of the loan. If used on a wide scale, the gold clause could introduce flexibility
into a brewing crisis. It could stave off a crisis without the need for taxpayer guarantees or
quantitative easing.

Similarly, gold miners sometimes finance new gold mines by borrowing ounces of gold instead of dollars, at 2% to 3% yearly interest. They sell the gold and use the proceeds to build the mine. When production begins, they pay off the loan with the same number of ounces of gold they borrowed, regardless of whether the price went up or down. This could serve as an income-producing alternative for people who want to invest in gold. Instead of paying storage and insurance costs, they would earn interest.

Both these gold-related financing methods could add to gold demand.

The big risk in the next financial crisis is that central banks just might decide that the Ph.D.- standard medicine will work once again, if they just double the dose. Instead of success, I think that could spark abrupt, random economic misfires, and wide swings in interest rates and/or inflation.

Summing up…

The only investment change we plan is to include gold stocks in our clients’ investment portfolios. These stocks have attractive prospects and are a good choice for the Resources & Commodities sector of your portfolio.

As I’ve said before, the world is going through a giant monetary experiment, and it could end badly. Or, the experiment could continue for decades, and today’s monetary system could perform as well as it has so far. Or, things could turn out as they did after World War II, if the world takes up the Nathan Lewis “Magic Formula” of sound money and low taxes.

My view is that today’s fiat money system lets the money supply keep growing, out of proportion to economic growth. Quantitative easing just lets it grow faster. This growth whittles away at the scarcity value of money. This builds the potential for inflation, but it takes a trigger to turn potential into reality. This potential needn’t turn into a crisis, however.

As I’ve said, countries do sometimes grow fast enough, long enough, to reduce a high debt load to livable proportions, as the U.S. did after World War II. This is the best foreseeable outcome of the global fiat-money experiment, but the least likely.

No one can say when the next inflationary period will start, or how severe it will be, due to the large random element. A great deal depends on consumer confidence, crowd behaviour, world events, weather and crop yields, and so on. Gold stocks help offset that randomness.

The worst thing you could do is to invest heavily in long-term government bonds, which now yield little more than the current rate of inflation. (After taxes and inflation, this leaves you with a loss.)

Your best defence against inflation in my opinion is to stick with our Successful Investor portfolio approach, which we apply to portfolios that our clients entrust to our care. It has three key rules:

Invest mainly in well-established stocks with a history of revenues, earnings and dividends.

Spread your money out among most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities).

Downplay or avoid stocks in the broker/media limelight.

Judging by results to date, our Successful Investor approach seems likely to pay off in the long run, whether we have deflation, inflation, or something in between.


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