Numeraire to Saucissons?
Back
in the days when Greenpeace cast but a faint shadow across the affairs of the
global extractive industry, Newmont and its partner,
On
a daily basis, giant machines and 5,000 workers move 600,000 tonnes (metric) of
waste rock and ore. Noteworthy is the
fact that each tonne of ore contains .028 ounces of gold per tonne. This ratio
means that by volume, each tonne contains .000088% of gold. Gold mining of this type is essentially a
giant earth moving operation. Each year,
approximately 200 million tonnes of ore and waste are displaced.
Yanacocha
is the very model of a modern gold mining operation. It is above ground (open pit), capital
intensive, and highly efficient. However, much of the world’s gold is still
produced from accident-prone, labor-intensive underground mines. On a comparative basis, underground mining is
generally riskier, especially for those who labor in high temperature stopes with unpredictable rock conditions. Wages in underground operations represent a
comparatively high component of production costs. Labor disruptions, including strikes, are not
unknown. In the decades to come, even
Yanacocha could move to underground mining potential copper-gold deposits now
being explored.
The
vast operations of the Yanacocha mine produce 2.7 million ounces of gold per
year, or roughly 3% of the world total.
That works out to revenues of around $1 billon. While the typical gold
mine is far smaller, it is safe to say that the lead-time between discovery and
date of initial production is comparable.
Given the proliferation of environmental concerns and the growing
presence of Greenpeace-like interest groups, it is unlikely that these lead
times have contracted. In this context,
the sharp decline in gold exploration by the mining industry since its peak
year of 1997 at the very least suggests a hiatus of several years before the
curve of global mining production resumes any semblance of growth. Each year, global mine production removes 90
million ounces of gold from the surface or near surface of the earth. If the industry kept track of its reserve to
production ratio, as does the natural gas industry, it would cause one to think
that the maintenance of the current rate of world production is in jeopardy.
The
dore bars, hard-won treasure from the earth’s crust,
have only a notional market value at the end of the mining process based on
their gold and silver content. They are
unsightly, crudely shaped bars of bullion, which bear only slight resemblance
to the final products contained within.
Therefore, the operators of Yanacocha periodically load the dore bars onto jet freighters at the
The
Argor-Heraeus refinery is not a particularly
welcoming sight to unannounced visitors.
Ringed by a high wall topped with barbed wire, the only entrance is a
steel gate devoid of a company logo or much else in the way of identification.
In our case, we had requested a visit in order to view the gold bullion
purchased for our clients in the past year.
Dr. Wilfried Hoerner,
a shareholder-manager of the refinery, was our cordial and informative tour
guide.
In
the ordinary course of business, drivers communicate with internal security to
gain access in order to unload their cargo.
Trucks bearing dore bars from Yanacocha and
other world gold mines are joined by those loaded with the sweepings from the
factory floors of Swiss and other European watch and jewelry manufacturers, and
scraps of jewelry discarded from the souks in the
Inside,
the source materials are ground, chopped, melted, purified, extruded and
reconstituted in a series of low and high tech stages. State of the art security is impressive. The combined material flow is recast into
new shapes of “four 9’s” gold, the highest purity, or alloyed with silver,
copper and other metals depending on customer specifications. Final output includes coin blanks, 1 kilo
bars favored on the Indian Subcontinent, rods and bars for jewelry
manufacturers, and even semi-fabricated watch cases. In this way, central bank
gold, once the numeraire for all paper currencies, is
decommissioned from its official monetary status so that it may satisfy the
growing world appetite for luxury goods.
Twenty-five
years ago, the elite mainland Chinese wore mechanical steel wristwatches. Today, the affluent wear Rolexes, Patek Philippe or similar
brands. Twenty-five years ago, local
moonshine was the adult beverage of choice in many reaches of
The
managers of the Argor Heraeus
refinery purchased the facility in 1999 along with a consortium that included
the Heraeus Group, Commerzbank,
and the Austrian Mint (at a later stage.)
Their growth plan for the business is to integrate further downstream
into “value added” fabrications for their customer base. The refinery is
strategically located for “just in time” deliveries to Swiss watchmakers and
the Italian jewelry industry in centers such as
The
Argor Heraeus facility is
not your typical sausage factory. It is
as technologically advanced and environmentally compliant as any precious
metals refinery in the world. In their own words, “The Swiss environmental
regulations are among the most severe in the world and Argor
Heraeus for its part is dedicated to constant
research and development in order to guarantee state of the art technology in
this field”. The entrepreneurial
management group focuses on increasing throughput and adding value for their
customer base. They are motivated by the
desire for profits and growth and therefore pay close attention to matters of
cost cutting, efficiency, environmental compliance and process
improvement. The monetary and
macroeconomic aspects of gold appear nowhere on their agenda. The refinery’s exact capacity is classified
but it represents between 10% and 20% of world gold output. At periods of peak demand, customer
requirements are met
thanks only to a supply of 400 ounce bars from central banks.
There
was a time when the prevailing opinion of policy makers and individuals alike
that gold and money were synonymous. However, times change and opinions with them. Central bankers are not immune to these
forces. Today, most have little use for
gold and view it as an antiquity. Their
collective opinion matters since central bank gold reserves amount to 33,000
tonnes, about 20% of the above ground supply.
They are steady sellers of the metal and for that, jewelry consumers,
coin collectors, and value investors have much to be thankful. If it were not for central bank distaste for
gold, its rarity as a natural element and difficulty of procurement would
result in a much higher price. While
supply and demand analysis suggest that gold is scarce and would trade at a
higher price if not for central bank sales, it is equally important to view
gold as just one asset among many in the universe of equities, bonds, real
estate, and other commodities. As such,
it is in constant competition for capital flows against anything else that can
promise to deliver an investment return.
Viewed
as a portfolio asset, the supply of gold is not the 2,500 tonnes produced by the
mining industry each year plus scrap and other recycled metal. Instead, one must consider the entire above
ground supply, marked to market, and theorize that at any given moment this
quantity could be bought or sold in its entirety. The “market cap” of gold, like the market cap
of Microsoft, is subject to daily reappraisal on its investment merits.
As
sellers of gold, central bankers came to the realization in 1999 that episodic
but relentless attempts to liquidate were depressing the price of the
metal. In an attempt to create a more
transparent market, but stopping well short of the sort of the promotion and
inflated claims often utilized in the investment world to unload a large
position, the banks agreed to sell at a measured pace of 400 tonnes per year
for an initial five year term. That
initial term expires September ’04, but seems likely to be renewed as new
sellers want to join the action. Most
vocal of among these has been the Bundesbank, whose
15,000 employees might regard an ongoing gold sales program as a path to job
security against a background of declining relevance for European central
banks.
In
any investment situation, it is essential to determine whether the seller is
right or wrong. To be charitable, it is
quite likely that the motivation and mandate for central bank selling
transcends the narrow investment exercise of whether a sale at current prices
is well advised. As government (and
mostly anachronistic) institutions manned by bureaucrats, central banks do not
rank particularly high in the realm of investment acumen. It therefore does not require a major ration
of courage to suggest that it is better to be a buyer than a seller of gold at
this particular juncture in history. The
inevitable investment inference is that gold is too cheap and that money, as
the modern world has come to understand the term, is over-valued. The same observation would apply to the
handmaidens of paper money, i.e. equities and bonds.
It
is a truism that all the gold ever mined exists above ground. It is never consumed but forever recycled
into different shapes--- artistic, monetary and otherwise. During a recent restaurant experience, I was
served an entrégarnished with 24k gold leaf.
However, let’s assume that the truism is essentially correct. That works out to 140,000 tonnes, which in
turn equates to a market cap of $1.5 trillion.
Only a small part of that total is represented by monetary gold. Using highly conservative
assumptions, monetary gold including coins, bars, and quasi jewelry and central
bank reserves account for perhaps 50% of this total. The remainder, which exists in the form of
Rolexes, museum artifacts, gold leaf on frescoes, and tooth fillings, is not in
play for the sake of this discussion.
Neither is most of the central bank gold. However, for discussion purposes only, let’s
assume that it is. Based on this
reasoning, the market cap of financial gold, assuming a $400 price, is a paltry
$750 billion.
As
an investment, gold has only two things going for it. First, and the one we prefer, is the
possibility that it can rise in value, perhaps
substantially, against other things, in particular stocks, bonds, and its paper
money price. The second, and potentially
very appealing feature to a wider population of investment constituencies, is
uncorrelated performance. Pension fund
investment managers, for example, who oversee multi-billion dollar portfolios
of stocks and bonds have a mandate to defend the
purchasing power of plan beneficiaries not for tomorrow, or next year, but for
generations. Whether gold rises or falls in the short term is irrelevant to
such managers, as would be the case in contemplating the imminence of a fire
when purchasing insurance.
Unlike
most alternatives, however, gold generates no investment return of its
own. There is no coupon or internally
generated rate of return to explain investment appeal. That appeal rests exclusively on the premise
that no return is better than a negative return. Gold does well during prolonged bear markets
in financial assets.
The
market cap of gold today at $750 billion seems pitifully small when measured
against world financial assets of $60 to $70 trillion. If only a sliver of that total were
reallocated to physical gold, the price impact would be highly disproportionate
to the fraction of reallocation. There are numerous ways to illustrate the
imbalance. In the following discussion,
we use US equities plus government debt including agencies as a proxy for
global financial assets since historical data on global financial assets proved
hard to come by.
In 1982, gold traded
briefly above $800/oz. By subtracting
cumulative production since 1982 of roughly 38,000 tonnes, the above ground
supply in that year was 102,000 tonnes of which 35,820 tonnes was held in the
official sector. Since gold had been a
strongly appreciating asset for the previous decade and a half, it would not be
implausible that more than today’s 50% ratio of above ground gold was held as
an investment. We will assume 60%. If so, the 1982 market cap of investment gold
at $800 would have been $1.6 trillion.
In 1982, according to Morgan Stanley, the market cap of US equities was
$1.5 trillion while US dollar denominated debt of all descriptions was $4.7
trillion. At that particular swing of the pendulum, the market cap of gold
represented about 25.8% of US financial assets.
In
1934, the
During these two
noteworthy episodes when investors fretted most about the value of their paper
assets, they placed a hefty premium on gold’s safety. As nearly as we can measure the degree of
concern exhibited in those two instances, the safety premium for gold
translated into somewhere between 21% and 25% of US financial assets. Today, that fraction is 1.6% ($750 billion
over $46 trillion, based on an equity market cap of $15 trillion and total debt
outstanding of $31 trillion.)
With
stocks trading at 26x trailing earnings and a 1.6% yield (S&P 500),
investors in general do not seem to be fretting. However, certain investment world luminaries
are beginning to sound downright alarmist.
Warren Buffet, in the November 10th issue of Fortune, suggested radical
measures to deal with the trade deficit in the form of a complex scheme of
import credits to stimulate exports.
Whatever its other faults, his proposal is no more than a clever
disguise for a substantial devaluation of the dollar vs. other key
currencies. Forgoing the social
engineering impulse, John Templeton recently advised investors to “get out of
US stocks, the US dollar, and ‘excess’ residential real estate.” His sell recommendation was based on the
belief that “the dollar will fall 40% against other major currencies….and that
this will lead the nation’s major creditors, notably
What
about those non-US creditors who already hold 46% of
Thoughtful
investors wonder what could ever replace the dollar. The
Some
small reasons for concern might include
Perhaps
investors and corporate managers should continue to contemplate business as
usual, as did Pravda, until one day before the regime change. In this respect, the managers of the Barrick
Gold hedge book can take solace in the company of large numbers. Their view, it may be inferred from their
posture regarding their most recent financial statements, would differ from our
view that gold is seriously mispriced and unlikely to
revisit levels that would vindicate indefinite extension of Barrick’s
16mm ounce short position. The company
reported a negative mark to market of its hedge position as of
Comex
option writers agree with Barrick. They
have written call premiums for near term expiration at 400 to 450 amounting to
nearly 5.6mm ounces, or more than 160 tonnes of gold, a very sizable bet by
historical standards, that these strike prices will go unbreached. Months ago, when these calls were written,
400 seemed distant and the premium income like easy
money. 2.6mm ounces are at nearby
strikes, 400 to 420 that expire in early December.
The
stance of Barrick and the option writers is consistent with the prevailing
financial market view that any foray by gold above $400/oz would likely be a
short-lived and anomalous event.
Implicit is the thought that the dollar will remain unchallenged as the
world’s reserve currency. Also implicit
is the thought that world financial policy makers, especially the Federal
Reserve, possess the wisdom, the skills, and the power to promote global
prosperity and stave off contractionary market forces
that from time to time threaten global financial stability.
In
this view, the Fed’s increasingly transparent attempts to manipulate financial
markets through barrages of liquidity would be seen as clever adaptation to the
realities of the 21st century economy. A contrasting take would be that of James
Grant, editor of Grant’s Interest Rate Observer, who wrote: “Our age in finance is an age of heresy. Budgets go unbalanced, currencies go
uncollateralized, current account deficits go uncorrected, securities go
unanalyzed and bubbles go unpopped (until too
late)”. (
The
impressive headline numbers on the economy’s recent performance cannot hide a
disproportionate dependence on consumer spending and service jobs. For example,
despite 7% GDP growth, corrugated box shipments, usually a good proxy for
coincident economic activity, were flat during the period. Manufacturing employment continued to decline
despite overall job growth. GDP, having
moved far afield from the manufacturing sector would
be better measured in terms of cell phone traffic, hamburgers flipped, casino
winnings, or box office receipts.
Traditional measures of economic health such as inventory to sales
ratios, the purchasing managers index and similar
ratios have become less relevant. To
understand the economy, one must comprehend the engine that drives consumer
spending. That engine is the wealth
effect. Its principal moving parts are financial asset prices, employment
levels, consumer sentiment and personal income.
Of these parts, financial asset prices are the core, and the others mere
derivatives.
In
its November 14th Economic Newsletter, the San Francisco Fed asked
whether the Fed should “react to the stock market.” Fed senior economist Kevin Lansing concluded
that “although central banks control only short-term interest rates, their
ability to influence longer-term rates and other asset prices is part of the
transmission mechanism of monetary policy.
Movements in asset prices can have important consequences for real
output and inflation.”
Over
the past several years, the Fed’s excursion into extreme liquidity has
disembodied financial asset prices from their fundamentals. The Fed wants investors to forget that the
invariable precursor to positive equity returns has been bear markets, complete
with high dividend yields, low p/e multiples and pervasive skepticism. With bond yields at multi decade lows despite
record fiscal and trade deficits, what positive outcome to these historically
troublesome issues is necessary to prevent the bloodshed that normally results
from overvaluation? If generous bond
market valuations cannot be sustained, how can the equity markets continue to
flourish? Lack of inflation is essential
to low interest rates. The basis for low
inflation is high productivity, or outsourcing of manufacturing to
Factory
orders, unemployment claims, capacity utilization and housing starts do not
hold the key to the future, celebrated though they may be by the wise men of
CNBC. What we need to know in order to
peer into 2004 and thereafter is where stock and bond prices are headed, for it
is these and these alone that will affect consumer psychology and
behavior. Consumer spending held up
despite a cyclical downturn thanks to the Fed’s aggressive cycle of interest
rate cuts, justified by fears of deflation.
The desired boom in housing, mortgage refinance, and auto sales kept the
cyclical downturn from accelerating. The
unintended consequence was a bubble in yield instruments of all types as risk averse investors sought refuge from equities. Now that the refinancing boom has waned, will
housing and autos decline and choke off an incipient
upturn in business spending? Clearly,
the Fed is not waiting for an answer.
Their response to the sharp downturn in mortgage refinance has been
aggressive expansion of the monetary base.
The Fed has become a
prisoner of its policies. It cannot
tolerate an economic downturn. Flood
upon flood of liquidity has not put to rest long-term issues of solvency. The
price for relief from short-term stress has invariably been increased debt
issuance. The consequences of a possible
protracted bear market in equities and bonds have become intolerable. In attempting to avoid the experience of
The
willingness and/or ability of international trading partners to hold
A slowdown in the rate of
purchase or outright sales of foreign held treasury and agency debt could
easily lead the trade weighted dollar index to a level of, say, 65 or 75 versus
the current 92. An index at that lower
level would depict a far different world than the one we know. It would be a world of higher interest rates,
lower bond and equity prices, inflation, faltering economic activity and
permanently higher gold prices. In the
words of Roach, “it boils down to flows versus analytics.” In other words, it may be difficult to make
an abstract analytical investment case for the yen or the euro. However, it is not difficult to imagine, in
light of the existing imbalances, that safety-seeking investment capital might
flow to liquid alternatives based on convenience and expedience.
In his day, Otto von
Bismarck warned the squeamish to avert their eyes from the manufacturing of
sausages by sausage makers and laws by politicians. Today, that advice could be updated by
including the deconstruction of money by central bankers. Saucissons, in the
mining lingo of the early 20th century, referred to the flexible
casings used for explosives in mine operations.
Numeraire, of course, refers to gold’s
historical role as the reference point for all paper currencies once used by
the entire commercial world including central bankers. The numeraire
function, according to economist David Ricardo, was essential if “one wish(ed) to make intertemporal or interlocal comparisons (in the) problem of measuring
value.” Over the last three decades, it
has been the practice of central bankers to demonetize gold, thereby making intertemporal and interlocal
assessments of value much more difficult, if not impossible. In theory, a
dollar standard might have worked, but in practice it has not. Without a global
monetary compass, unrestricted issuance of government and corporate debt, trade
imbalances, misallocations of capital, periodic banking crises, and currency
turmoil should come as no surprise. It
seems more than likely than ever that the world’s central bankers will
eventually convene to reprice gold to a level
sufficient to persuade a world of paper skeptics that the metal must be
reinstated as the numeraire. That level will exceed whatever the market is at that
time by a substantial amount. Our guess
is the market at the time of an official sector bid will be well into 4-digit
territory.
The views
expressed by the portfolio manager in this article are current as of the date
of this article, and are subject to change at any time based on market and
other considerations.
The Gold Fund is subject to special risks associated with investing in gold and other precious metals, including: the price of gold/precious metals may be subject to wide fluctuation; the market for gold/precious metals is relatively limited; the sources of gold/precious metals are concentrated in countries that have the potential for instability; and the market for gold/precious metals is unregulated. In addition, there are special risks associated with investing in foreign securities, including: the value of foreign currencies may decline relative to the US dollar; a foreign government may expropriate the Fund’s assets; and political, social or economic instability in a foreign county in which the Fund invests may cause the value of the Fund’s investments to decline. You should consider the investment objectives, risks, charges and expenses of the Fund before investing. The prospectus contains this and other information about the Fund and you should read it carefully before investing.
This commentary is not an advertisement or solicitation to subscribe to The Tocqueville Gold Fund, which may only be made by prospectus. For more complete information on any fund including management fees and other expenses, please order a free prospectus by downloading a copy, by contacting one of the broker/dealers listed on the Funds website or by calling 1-800-697-3863The Fund is distributed by Lepercq, de Neuflize/Tocqueville Securities, L.P.
New York, NY 10019