Bonfire of the Currencies
Investment Outlook (November 2010)
by Eric Sprott, Sprott Asset Management
World governments just canât get enough conflict these days. Theyâve now resorted to battling each other with money printing.1 The devaluation race is in full gear, and itâs tough to keep track of whoâs winning. Itâs been just wonderful for investors, of course. In addition to contending with 0% interest rates, they now have to navigate through increased currency volatility and uncertainties associated with potential inflation. Gold and silver are benefitting greatly from this âcurrency warâ as investors seek safe harbor in hard money. We canât say weâre surprised to see gold and silver where they are, but it has been surprising to witness just how willing and open governments are to blasting their own currencies down in value. Although we have complete confidence that the economists at the worldâs various central banks know exactly what they are doing, weâre content to own precious metals investments in the meantime until such a day arises when the currency war winner is finally announced.
Just to make sure youâre up to date in currency war news, the most recent devaluation shot was fired by the Federal Reserve on August 17, 2010, when it initiated its permanent open market operations (POMO) to stimulate economic activity. The central bank announced its intention to reinvest the proceeds of its maturing mortgage-backed security holdings back into Treasury bonds. Combined with recent comments by the Federal Open Market Committee (FOMC) on increasing the US inflation rate (through money printing), world governments have been coerced into action. Theyâll be damned if they let the US devalue against their own respective currencies and slam their exports, so everyoneâs devaluing in tandem. Itâs literally a "race to the bottom", with all major currencies on the potential fiat currency chopping block.
By our count, no less than 23 separate countries have now intervened in the foreign exchange market in some way since September 21, 2010. The goal for all is to increase the supply of their respective paper currencies in order to drive them down in value. In the cases where countries canât print outright, they have intervened through capital controls or "open mouth" operations (ie. talking down your currency in policy meetings, etc.). Both approaches have significantly increased the currency marketâs volatility. Japanâs October 5th announcement of a "new fund" to purchase assets ranging from government to corporate bonds has forced other countries to pursue the same policy, and the world now awaits similar announcements from the United States and UK in the form of new Quantitative Easing programs.2
Investors arenât clueless, however, and many are shifting capital to protect themselves. A large number of commodities are now benefitting from the uncertainty created by the devaluation race. Gold, silver, oil, copper, wheat, sugar and platinum are all on the run, and yet we have no reported inflation! Kudos go to the Central Banks for orchestrating that economic miracle. Nonetheless, regardless of what the CPI says, itâs clear that investors are proactively preparing themselves for more printing, and gold and silver seem to be the most popular choices for investors seeking safe harbor.
If you havenât participated in goldâs recent rise, donât fret, because the fun has only just begun. While gold and silver bullion have increased by 20% and 32% since January 1, 2010, respectively, gold stocks as represented by the Market Vectors Gold Miners ETF (GDX), the Philadelphia Gold and Silver Index (XAU), the NYSE Arca Gold Bugs Index (HUI) and the S&P/TSX Global Gold Index have all trailed goldâs performance for the entire year. You wouldnât expect the senior gold producers to be trailing behind gold in this environment. After all, at $1,300 gold, these companies literally have a license to print money. What better business is there to be in right now? These are companies that can process an ounce of gold for $800 and sell it for $1,300, with virtually no sales risk. What other investment sector can boast that kind of margin in this environment?
Chart A
We believe the gold producers present an excellent investment opportunity right now. To explain why, consider the NYSE Arca Gold Bugs Index (HUI). The HUI is a modified equal-dollar weighted index of companies involved in major gold mining. The HUI was designed to give investors exposure to near-term movements in the gold price by focusing on companies that do not hedge their gold production beyond 1.5 years. The HUI was launched with a base value of 200 in March 1996 and includes some of the largest gold mining companies in the world. Despite a 35% increase in the price of gold since March 2008, the HUI has barely moved at all. As Chart A illustrates, this gold equity index is currently trading at the same approximate level it was when gold was barely over $1,000. The current HUI valuation doesnât reflect the operating leverage that the $350 increase in the spot gold price could potentially have on earnings â which brings us to an important point that investors often overlook in gold stocks.
