Gold Prices and the US Economy

Why economic growth could be good for gold prices...

JOHN KAISER has proposed a graphic model that relates the value of all above-ground gold stock to global Gross Domestic Product (GDP), thereby explaining why higher real Gold Prices — even with a recovering American economy — will be the new reality. 

Kaiser, a mining analyst with over 25 years' experience, is editor of Kaiser Research Online. He specializes in high-risk speculative Canadian securities and the resource sector is the primary focus for an investment approach he developed that combines his "bottom-fishing strategy" with his "rational speculation model." 

He shares his projections about where both Gold Prices and the US economy could be going in the future in this interview with The Gold Report. 

The Gold Report: Intel Cofounder Andy Grove wrote an article in BusinessWeek bemoaning the fact that US entrepreneurs in both the hightech and cleantech realm have become inefficient in the return of jobs created per investment Dollar basis. He said companies hire fewer employees as more work is done by outside contractors, usually in Asia. He suggested this is a problem not only for low-grade production jobs but also robs the US of its innovation edge, hurting the country's overall economic prospects for the future. 

Your economic research illustrates this manufacturing decline and shows the value of gold stock values over the last four decades mirroring the US GDP. Why is consolidating manufacturing and research important for US and global growth and how is it linked to the Gold Price?

John Kaiser: A lack of physical manufacturing stifles innovation because without access to support facilities, machine shops, test labs and other resources normally associated with a full-scale manufacturing operation, creative people don't see problems, quickly test solutions and have the ability to bring products to scale in a controlled environment. Cut off from manufacturing operations, development stalls. 

The American economy is still the largest in the world with a $14.7 trillion Dollar GDP followed now by China at nearly $6 trillion. The problem is that the employment structure of the US economy has, in the last 30 years, shifted very much to service jobs in the healthcare, retail, financial and professional sectors, away from making physical goods, that are increasingly imported. 

We also have a serious oil addiction, which contributes significantly to the trade deficit as we import oil to keep our cars moving. So what are we actually shipping abroad that allows us to offset all the stuff that we import? The jobs we see in the United States today produce less exportable output. That has not hurt economic growth, but it has been achieved through a drawdown of the wealth accumulated during the last century, a drawdown that accelerated during the last decade when a huge debt expansion party bubbled through the economy. 

That party ended in 2008. We have now had two rounds of quantitative easing designed to keep the economy from collapsing. In order for the United States to deal with its long-term structural debts and deficits, it needs to demonstrate that there is something American workers can do that is of value to the rest of the world. The core has to be manufacturing. 

TGR: Is your argument that we should ignore the lower cost structure we can achieve overseas, bring assembly jobs back to the US and start manufacturing here? Wouldn't the cost of goods go up and spur on inflation at a more rapid pace than we're expecting just because of quantitative easing?

John Kaiser: There could be some interim higher costs from bringing manufacturing back to the United States. However, inflation with regard to imported goods due to increasing transportation costs, higher Chinese workspace and emission standards, generally higher wages and the rising value of the Chinese Renminbi is coming anyway. 

We can't wait to react until we are stuck paying their higher prices with no domestic alternative because we have lost the manufacturing and R&D infrastructure at home. We need to anticipate this higher overseas cost structure and act now.

TGR: Won't those jobs just go to another lower-cost Asian country like Vietnam or Thailand?

John Kaiser: Those countries have considerably smaller populations and without super-automation they don't have the capacity to absorb a large-scale influx of manufacturing capacity. If the solution is super-automation, then you are reducing labor costs anyway so why not do it in the US and avoid the political upheaval that could disrupt the production? 

Two outcomes of the 30-year decline in US manufacturing are that the power of labor unions has diminished, and much of the legacy manufacturing infrastructure has disappeared. To a large degree American legacy production methods were simply shifted overseas where there was an abundance of cheap and willing labor. 

If manufacturing is to make a comeback in the US it will be in a highly automated form with newly trained employees drawn from the younger generation, not the current boomer generation or their near-retirement parents. If boomers hope to receive their entitlements when they retire, it cannot be paid for by taxing young workers doing little more than fulfilling those entitlement expectations through service jobs.

TGR: Is supply chain and geopolitical security part of what's driving this consolidation of research and the manufacturing?

John Kaiser: Yes. Long term, as China becomes stronger, it will flex its muscles. It's just refurbished an old Soviet aircraft carrier so that it can park itself in the South China Sea and exert its military presence. If the United States ceases to produce anything, it will become irrelevant and lose influence anywhere in the world. 

TGR: Does that mean consolidation of design and manufacturing domestically will be driven by private enterprise operating in their best long-term interest rather than the government mandating it though trade tariffs?

John Kaiser: Yes. Protectionism in the old style is not going to fly. Instead, individuals and companies will have to voluntarily adopt total cost accounting. Instead of just looking for a cheap price, consumers will have to consider all the costs associated, including safety standards, environmental factors and sustainability. By adding in the costs that have literally been dumped on somebody else, we do the responsible thing. We have to stop being parasites, hurting others for our own cheap goods. This total cost view will create jobs and make the country stronger in the long run. 

From a corporate perspective, the opportunity cost posed by supply chain disruptions needs to be factored into the cost-benefit analysis before they happen, not just ignored and then suffered when natural disasters or political upheavals happen overseas such as recently happened in Japan. If we stop assuming eternally cheap transportation costs, building and operating factories close to destination markets starts to make sense. 

It's also time to ditch the narrow-minded self-interest of the libertarian school and borrow a page from Henry Ford's book of enlightened self-interest: if you want consumers to buy your product, they need to pay with money earned through productive jobs, not entitlement spending. 

TGR: Do you foresee a precious metals mergers and acquisitions trend? 

John Kaiser: Yes. As companies focus on advancing projects, it will take large capital investment. It will be difficult for a stand-alone project to raise $500M+ without being absorbed by a bigger company that already has production in place and is generating cashflow. 

This is an opportunity for large, liquid companies to acquire these assets without paying a big premium, particularly if it uses its paper as currency. It is a one plus one equals three situation because as the acquiring company diversifies its revenue base, its catastrophe risk declines. As the market gets more comfortable with gold at current levels, we will see mergers and acquisitions step up and more money coming into the market. 

TGR: Is economic growth a price driver for both gold and copper?

John Kaiser: In the case of gold, yes. In the case of copper, the question is whether $4 copper is the new reality on which we can base mine development decisions, given a low inflation scenario. The key thing that has happened in the last decade is that China has become a significant economic force. It has now displaced Japan as the second-largest economy with a billion-plus population base and relatively low per-capita GDP. It could grow substantially and eventually become larger than the US economy. 

But, China is still an unusual political entity; it is a hybrid communist-capitalist country. As they get stronger, we have no idea how they will behave on the global stage. Therefore, people are shifting capital into gold as part of their long-term security plans. As GDP grows, it will probably grow faster than the ability to bring new gold supply on stream. Therefore, gold will rise in price as it tracks the strength of the global economy. 

TGR: If you're expecting the price of gold to track nominal GDP, which is growing 2% to 4%, won't you see money coming out of gold and going into equities that would probably represent a higher potential return?

John Kaiser: All the gold in the world is about 5.3 billion ounces., worth about $8 trillion. That's really a fraction of the estimated net worth of all other assets, which is about $130 trillion. Most gold is held as a long-term asset. So even if the crazy gold bugs start selling to buy stocks, they are a small minority and won't make a huge difference. 

I believe the value of gold stock as 10% of GDP is a reasonable level. Make it a lot higher and gold owners will look to convert it into other assets such as land, buildings, resources and dividend, or interest-yielding instruments capable of generating a cash flow as opposed to a capital gain. 

What would the new owner's reason be for buying? The only return generated by gold is psychological stress relief. However, if Gold Prices surge to 20% of GDP as they did in 1980, it will be because of an unstable global situation. Under such conditions, gold ownership is not likely to offer much stress relief, especially if government confiscation or a breakdown of law and order become risks. 

At 20% of GDP, the value of the gold stock would imply a price of about $2,400 in real terms (as opposed to a price rise generated by excessive inflation or a major devaluation of the US Dollar against other currencies). In 1980, when gold was 20% of GDP, some thought the United States had reached the end of the line. But the United States survived that crisis and went on to win the Cold War, unleash globalization and accelerate time through the Internet communications revolution. 

Short of a calamitous collapse in China, I see the center of gravity for global economic and military power gradually shifting away from the United States during the coming decades. On the other hand, I do not see the value of the gold stock dropping back to 5% of GDP because this would require a major decrease in our uncertainty about the future global order.

TGR: What does this mean for silver? Both gold and silver had a setback recently.

John Kaiser: Silver has been the worst performing metal for decades. What it's doing now is a bit of a catch up. Although most of the above-ground silver stock of 46 billion ounces is fabricated into some useful form, unlike gold, silver is gaining popularity, especially in emerging economies. The above-ground silver stock value went from 1.5% of GDP in 1970 to a peak of 6% in 1980. But by 2002 the silver stock was worth only 0.5% of GDP. Right now it's between 2% and 3%. 

I believe silver can parallel gold's role as a hedge against the uncertainty associated with the long-term relative decline of the United States and the gradual disappearance of the US Dollar as the world's reserve currency. If we assume the silver stock will establish a value as 3% of global GDP, the price will base out in the $30–$40 range this year, which will grow to $47–$57 by 2016. If it goes to $100/oz., that would indicate a bubble reflecting the inflation-adjusted equivalent of the $50 peak in 1980. 

Because the recent price growth looks exponential, the markets have fought back and a bear attack is pushing silver back down. But I believe $30–$50/oz. will be the new long-term reality, which opens up some good buying opportunities among silver companies in the next couple of months. 

TGR: Since the pullback is happening right now and it has been pretty dramatic, wouldn't the buying opportunity be now? What will be different in two months?

John Kaiser: I'm not a big fan of catching falling knives and anvils. I like to see them bounce around first so I know they're not going to hurt me. Especially this time of year, it might be best to see where silver and gold stabilize. 

TGR: What do all these new economic drivers mean for gold, copper and silver mining companies? 

John Kaiser: Well, the pessimism embedded in the market right now about the US economy and, ultimately, the global economy that still very much depends on the US economy, has discouraged the market from taking current metal prices seriously. If you plug in $1,500/oz. gold and $4/oz. copper into the discounted cash-flow models for development projects, you get some very sexy numbers compared to what the stocks are trading at currently. 

We see this across the board, an unwillingness to plug current metal prices into the valuations because of an assumption that we're going to see copper back below $2/lb. or gold back to $1,000/oz. And, yes, if we end up in a global depression we will certainly see the metal prices go back down. But I see the global economy trending upward, causing gold and copper to stay strong, thereby leading to an inflection point when the market realizes this pessimistic attitude is all wrong. Then the market will take these prices seriously and put capital into mining projects to mobilize new metal supplies. 

The problem with mine development is it takes three to five years to realize. That is why we need to start going after these huge profit margins now instead of perpetually waiting for signs of an enduring recovery. The irony of the inflation we are seeing in raw material prices today, which threaten to destabilize emerging market economies, is that it is due to the reluctance of capital markets to take the IMF GDP growth projections seriously and deploy capital to mobilize new mine supply.

TGR: Are you saying that whether we are in a depression as some believe or a recovery as you have outlined, we've already seen the floor of $1,200/oz. for gold and these companies are a low-risk return investment?

John Kaiser: Not exactly. In the scenario where gold rises because the American economy is in a death spiral, the solution is to pursue a hyperinflation strategy that results in costs rising in conjunction with the price of gold. So, that is of no benefit to the companies. If the alternative is to just curl up in a fetal position and suck one's thumb and prepare for the end, that will result in Gold Prices going down. 

The best alternative for resource juniors is if the world avoids both a deflation-linked depression and hyperinflation scenarios, the American economy gets back on track with a revival of manufacturing on US soil and the global economy continues to grow. That will be good for raw material demand and gold and silver prices.

TGR: Thanks, John. Enlightening as always. 

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