In Gold we trust

Due to its high liquidity and unique characteristics, gold is becoming ever more prominent as collateral in these volatile times. Following the recent release of his well-received report, ‘In Gold We Trust’, Mr Ronald-Peter Stoeferle of Erste Bank AG (Group Research) tells Euroasia Industry’s Sarah Pursey about the renaissance of gold in international finance, and how the foundations are now in place for an all-time-high in the precious metal’s pricing.

Euroasia Industry (EAI): The global fiat monetary system celebrated its 40th birthday last year – is there much cause for celebration?

Mr Ronald-Peter Stoeferle (RPS): First we should clarify what ‘fiat money’ actually means, for those that are unfamiliar with the term. The word ‘Fiat’ comes from the Latin for ‘Let it be done’ and fiat money is basically credit money without backing – so, it cannot be converted into gold or silver, for example – and it becomes money when the legislative bodies of a state declare it so.

In August 1971, we saw the end of the Bretton Woods system [Established in 1944, this system fixed exchange rates by tying currencies to the US dollar. In turn, the US dollar was linked to gold, with US$1 equal to 35 oz. of bullion. Nations agreed to buy and sell US dollars to keep their currencies within one per cent of the fixed rate]. This wasn’t the real gold standard, but there was at least some backing for currencies through this system.

Since then, a global fiat monetary system has been in place, and, from my point of view, it is now struggling with a severe midlife crisis. Yet systemic risk is rarely seen as the reason for the crisis that we are presently in. Many people see only the short-term symptoms – the recent troubles that have emerged in Greece, Spain and the euro zone in general – but I think that the crisis is largely due to the global fiat currency system, and the fact that there is no backing for currencies.

It worked for a while but the system itself has changed quite dramatically over the past 40 or so years. Back in 1971, the US was the world’s biggest creditor nation – today, it has the largest outstanding debt. In the West, we have seen the level of interest rates continue to drop until now we basically find ourselves at the point of no return, where it is impossible to have any significant rise in rates.

It was at the beginning of the ‘80s, when the last big gold bull market ended, that Paul Volcker, then Chairman of the US Federal Reserve, raised interest rates to 20 per cent – back then there was plenty of room to hike rates, but now, due to almost global over-indebtedness, there’s very little ‘wiggle room’. Furthermore, with every new stimulus measure, we are now seeing diminishing marginal returns, which must also lead to the conclusion that it is impossible to solve these kinds of problems with yet more debt.

EAI: You say that gold has shifted from a commodity to a currency in recent years – how so?

RPS: We generally don’t regard gold as a commodity; we see it as an alternative currency – one that has been around for thousands of years.

One of the very important chapters in my report deals with the ‘stock-to-flow ratio’ of gold – this is probably one of the few factors that really differentiate gold from other commodities. The total stock of gold is currently 170,000 tonnes, and the annual flow [production] is roughly 2,500 tonnes. This means that, every year, gold experiences a natural inflation rate of about 1.5 per cent [i.e. every year we get 1.5 per cent more gold in above-ground stock]. If you compare that to oil, to gas, or to copper, for example, the stock-to-flow ratio for gold is much larger, and this has a very strong impact on price formation or building.

Another way to look at it is if a large goldmine shuts down due to, say, environmental issues, the total production might decrease to about 2,400 or maybe 2,200 tonnes, but that has no impact on the 170,000 tonnes of gold that is already out there. However, if a major war breaks out in the Middle East, and let’s say 10-20 per cent of oil production is lost, this would have a major impact on oil price, as the total stock for oil is much lower [it being consumed]. And that is what many analysts in the gold sector miss, I think – it’s one of the big differentiators between gold and other commodities (even silver, which also has a high stock-to-flow ratio, although not as high as gold, given that silver has more industrial uses).

EAI: If gold is so attractive at the moment, why is it that some high profile hedge fund managers have been selling off their shares in it recently?

RPS: We’ve seen George Soros and John Paulson sell some stakes, although mostly in gold ETFs [exchange traded funds]. Gold ETFs are basically paper gold, whereas those investors have still been buying up gold equities or physical gold. We’ve seen a tremendous shift from paper gold, which people have simply lost trust in – due to counter-party risk and so on. But we have seen a greater allocation to physical gold and also gold mining equities. In terms of the big institutional investors, however, there is still only a small allocation for gold in investment portfolios – for a typical US pension fund, for example, allocation in gold and gold mining equities currently represents just 0.15 per cent of their portfolio. Almost nothing. But investment in gold makes sense as a form of risk diversification. We don’t see high volatility in gold – although it is often cited. The volatility of gold is much lower than that of other equities and commodities. There’s a very low correlation between gold and other asset classes, and there is no counter-party risk, so I definitely see some sort of renaissance of gold in traditional finance – and I think, in the next phase of this bull market, this will perhaps be the biggest sector.

EAI: How is this different from the last bull market (of the 1970s and early ‘80s)?

RPS: I think that the base for this bull market is much more solid; the fundamental case is much stronger and I think perhaps more diversified than the last bull market.

In the 70’s and early ’80s we saw a highly inflationary scenario, and we saw high political risk – people lost trust in the dollar. On the other hand, the whole debt situation was not that dramatic back then – as mentioned before, the US was the biggest creditor nation, and now it is the biggest debtor nation.

Another difference is that back in those days, the impact of emerging markets like China and India was not there, whereas now around 70 per cent of all physical gold demand comes from emerging markets, whereas Europe and the US are more or less irrelevant to the demand today.

For me though, the most important factor for gold has been that of real interest rates. In the ’70s, we mostly saw negative interest rates, until Paul Volcker became Chairman of the Fed in 1979 and raised interest rates up to 20 per cent, which caused a dramatic recession in the US, with very high levels of unemployment. But that was also the basis for a 20-year bull market in equities. Nowadays, it’s almost impossible to think of raising the interest rate up to 20 per cent because every 25 basis points [0.25 per cent] is now such a big thing. For this reason, I do not expect interest rates to rise very dramatically, and I therefore see a very positive environment for gold.

EAI: What indicators are there that the present gold bull market has now entered a new phase?

RPS: As I said in my first gold report five years ago, every trend ends in euphoria – we have seen it with internet stocks in 2000, with oil in 2008, and with gold’s last big bull market, where the price of gold doubled within six weeks. And I think that this bull market will also end in euphoria and a mania stage, and that is going to be the time when you will need to start thinking about getting out of gold. In this euphoria stage, I think that people will mostly start buying gold mining equities – the HUI (AMEX Gold BUGS Index) has a market cap of roughly US$170 billion at the moment – those are the 16 biggest gold and silver producers in the world. And that is a pretty low number, if you compare it to some single stocks such as Apple or ExxonMobil. So, I think that there is plenty of room for growth – traditional finance is clearly underweight in gold mining equities, and I am absolutely certain that this will end in a euphoria stage.

EAI: So, at the moment, given your projections for the gold market, gold mining shares currently present a good investment?

RPS: Absolutely – we are far away from any euphoria at present. The performance of gold mining shares has been pretty disappointing, and I think there have been two main reasons for this – on the one hand rising input costs (energy and also labour). On the other hand, we have seen some ‘risk-off’ in equities – and in this framework, gold mining equities are being sold off. In general, I think that the pessimism is at the highest level since 2007, so no-one is overweight in gold mining equities.

Yet, if you have a look at the valuations, I think that the whole sector is standing on a very solid base. For example, the world’s four largest gold producers – Barrick Gold, Newcrest Mining, Goldcorp, and Newmont Mining – have a total net income this year of more than US$10 billion. Their margins have grown significantly, with dividend deals of two to three per cent, and with almost zero debt on their balance sheets, so I think that this is a very healthy sector and one that is underweighted in most portfolios.

And if you look at the DCF [Discounted Cash Flow] models of most gold analysts, in the long-term they project a US$1,200-1,300 gold price. So, there’s no euphoria priced in – that is like a ‘free option’ that you get when you buy into gold mining equities, making it a very attractive investment.

EAI: In the past, US congressman Ron Paul was viewed as outlandish in his belief that the US should return to the gold standard as an alternative to fiat money – yet now the idea seems to be gaining strength. What is your opinion on this?

RPS: I totally agree. A few years ago, when people were talking about the gold standard, it was considered very much ‘out of the box’ and pretty much unthinkable – now, however, we are seeing initiatives in Utah [in May 2012, Utah became the first state in the US to legalise gold and silver coins as currency] and also in Switzerland, where the government is discussing the wisdom of creating a new gold-backed national coin – the ‘gold franc’ – to float in parallel with the Swiss franc. Elsewhere, a report was recently issued by the German Bundesrechnungshof suggesting repatriation of German gold reserves. Sentiment has also emerged in the UK in the form of the ‘Buy Britain’s Gold Back’ campaign, after 395 tonnes of gold were sold under Gordon Brown as Chancellor of the Exchequer [1997-2007].

These initiatives demonstrate that political resistance to gold and precious metals is decreasing and that gold is again becoming the ultimate currency. This is what I call the remonetisation of gold – the return to sound money. There have been numerous advocates of a return to the gold standard – among them, Robert Mundell, Rob Celej, Newt Gingrich and Ron Paul. While this would have been unthinkable a few years ago, the fact that gold is gradually becoming ‘politically correct’ again is another sign that we are in a new stage of this bull market.

EAI: What would be the advantages of returning to a universal or gold standard, given the present economic environment?

RPS: It would definitely dampen the fluctuations, and would probably restore people’s faith in their currency. I also think that interest rates would rise back to a normal level. Everyone knows that the current interest rates are not where they would naturally be; they are way too low, and this causes further misallocations of capital. That is the basis of the problem that we are facing at the moment – and the longer they remain at this level, the greater the threat of an even bigger crisis in the future, as the misallocations continue to get bigger. And obviously, we are also getting these in the bond markets, with negative yields on German and Swiss bonds, for example – and this is not normal, given the risk.

EAI: To sum up, what are the main conclusions that your draw in your report? And what is your outlook for gold?

RPS: The long-term [two to three year] target is US$2,300 – but I think even that could be conservative. The remonetisation of gold indicates that the bull market has entered a new phase, and that gold has become politically correct again. At the moment, with negative real interest rates – not only in the US and euro zone, but also in China and India – this is the perfect environment for gold. As long as real interest rates do not rise to three or four per cent, it will remain very favorable for gold, which is able to provide very reasonable, low priced protection against a worse case scenario. I think that financial repression will continue to crop up in many shapes and sizes – negative interest rates is just one.

While many have regarded gold as an investment for doomsayers and pessimists, we should not forget that most demand now comes from China and India, so gold is also a beneficiary of rising incomes in emerging markets. Compared to the year 2000, gold demand in Greater China is up 170 per cent, while in India it has risen by 30 per cent. Meanwhile, in the UK and the US, gold demand has dropped by 69 and 47 per cent respectively. As we expect incomes in China and India to continue to rise, gold will therefore be recognised as the main beneficiary of this development.

Gold is now returning to the traditional finance sector – we have seen the recommendations by the FDIC [Federal Deposit Insurance Corporation] in the US with regards to regulatory capital requirements, and it intends to decrease the risk rating of gold to zero, which is a very important point. Overall, I think that gold is still very much under-owned – perhaps over-talked, but still very much under-owned – and therefore its current price level remains very attractive.

To download Mr Ronald-Peter Stoeferle’s 2012 gold report, ‘In Gold We Trust’, click here