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Sprott Precious Metals Watch, September 2017

Trey Reik, Senior Portfolio Manager

It's the Debt Stupid!

The investment climate of 2017 has been characterized by thematic crosscurrents.  Communication from global central bankers has at times appeared more hawkish, yet global rates of QE have only accelerated.  Optimism for the Trump agenda initially levitated sentiment measures, but hard economic statistics failed to follow.   Despite almost continuous upheaval in global geopolitics, volatility measures and credit spreads have remained unfazed near historic lows.  Since economic fundamentals can never compete with the intoxication of fresh weekly highs for the S&P 500, investor consensus now routinely ignores troubling imbalances in the global financial system.  Indeed, investors and asset allocators with the temerity to have employed risk-mitigation and hedging strategies have only succeeded in impairing portfolio performance and career prospects.  In an investment world now dominated by monthly inflows into ETF’s and index funds, unconstrained by rational analysis of portfolio components, it has become somewhat passé to fret over underlying fundamentals.

Amid such fervor for U.S. financial assets, gold’s solid year-to-date gains have been somewhat counter-intuitive.  After trading in a tight $100-range for seven months, spot gold broke upwards through resistance at $1,300 in late August and touched an intraday high of $1,357.64 on 9/8/17 (up 17.8% year-to-date).  Most investors are unaware that gold’s performance during this span exceeded the total-return of the S&P 500 (+11.51%) by some 55%!  Conventional wisdom attributes gold’s recent strength to North Korean provocation and Mother Nature’s wrath, but this narrative ignores the fact that gold broke through $1,300 (on its third attempt in five months) before Chairman Kim’s 8/28 Hokkaido missile launch.  We believe gold’s unheralded price-performance in 2017 carries an important signal for investors.  Much to the Fed’s chagrin, economic and financial imbalances are bubbling to the surface (once again), placing consensus expectations for further FOMC tightening in jeopardy.

As precious-metal investors, we frequently encounter the refrain that global economic conditions, while somewhat lackluster, are a far cry from the negative extremes of the financial crisis.  The funny thing about this nearly ubiquitous view is how precisely misinformed it actually is—virtually every measure of domestic and global debt is significantly worse today than at its financial-crisis peak.  In this note, we seek to disabuse the popular notion of economic and balance sheet repair, through dispassionate review of relevant statistics.  We recognize rehashing structural debt issues is a tiresome exercise for equity bulls, but we believe gold’s recent breakout may be foreshadowing an imminent uptick in financial stress.  If we are correct in our analysis, reigning positioning in prominent asset classes is likely to be recalibrated to gold’s tangible benefit. 

Perhaps the greatest misconception among contemporary investors is the belief that the U.S. economy has been deleveraging since the financial crisis.  Nothing could be further from the truth.  The Fed’s quarterly Z.1 report discloses that domestic nonfinancial credit (including households, business, federal, state and local) has actually increased over 40% since Q1 2009, rising from $33.9 trillion to $47.5 trillion by Q1 2017.  Of course, this aggregate measure does not capture growth in the Fed’s own balance sheet, which has expanded from $930 billion in August 2008 to its current level around $4.5 trillion.  Because we have always viewed the Fed’s QE programs as tacit admission that the Fed feels compelled to provide a liquidity bridge whenever U.S. nonfinancial credit growth is insufficient to stabilize the U.S. debt pyramid (now $66.5 trillion including financial debt), we find it highly implausible that the Fed can now reduce the size of its balance sheet meaningfully without straining liquidity conditions in the U.S. commercial banking system.

Our gold investment thesis rests on the gross over-issuance of paper claims (debt) against comparatively modest levels of productive output (GDP).  Total U.S. credit market debt of $66.5 trillion cannot be functionally serviced by a $19 trillion economy without annual creation of copious amounts of fresh nonfinancial credit to help amortize existing debt obligations.  Gold serves as a productive portfolio asset amid such “forced” credit growth for two important reasons.  First, the only options for rebalancing unsustainable debt levels back towards underlying productive output are default or debasement, and gold is an asset immune to both.  Second, gold is an effective protector of portfolio purchasing power during inevitable episodes of official policy response.

In Figure 1, below, we plot a simplistic illustration of how burdensome U.S. debt levels have become.  During the past four quarters, net economy-wide interest payments approximated $641 billion, or over 90% of coincident GDP growth of $708 billion.  This certainly does not leave much economic fuel to power capital formation!

fig1.png

Figure 1:  U.S. Annual Aggregate Net Interest Payments (1985-2017) [MacroMavens; BEA; U.S. Treasury]

Drilling down in the consumer segment of total U.S. debt, historically high debt levels are frequently discounted by the observation that debt-service ratios remain manageable in the context of today’s near-ZIRP environment.  We view debt-service ratios as a classic tool of cognitive dissonance.  While these ratios calibrate aggregate disposable income to aggregate debt service, they ignore the reality that the disposable income and the debt obligations are largely concentrated in different sub-sectors of the U.S. population, so netting them out is a pyrrhic exercise.  Further, in the current environment of soaring healthcare and housing costs, traditional disposable income statistics have become far less instructive in gauging consumer financial health than discretionary income measures (after basic needs are paid for).  Reflecting growing consumer stress, delinquencies are beginning to spike (from low levels) on a wide range of revolving and installment credits, from JP Morgan’s credit card portfolio to subprime auto loans, to everything in between.  Rapidly declining fundamentals in important industries such as retail, automobiles and restaurants only serve to reinforce the message of tapped and retrenching consumers.

Corporate balance sheets have been deteriorating for many years.  ZIRP fostered an epic decline in capex in favor of borrowing to finance share repurchase.  In essence, corporate income statements have been consuming corporate balance sheets at an alarming clip.  State and local governments are struggling with a $4 trillion funding shortfall in public pensions, due largely to the corrosive effects of seven years of ZIRP on the complexities of pension accounting. 

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MARKET SUMMARY

INDICES

Name Last Change
DOW 23328.60 0.71%
S&P 500 2575.21 0.51%
NASDAQ 6629.05 0.36%
TSX 15857.22 0.25%
TSX-V 789.51 0.00%

Resource Commodities

Name Last Change
Gold 1280.70 0.71%
Silver 17.04 1.23%
Copper 3.15 0.33%
Platinum 923.75 0.35%
Oil 51.29 1.46%
Natural Gas 2.87 0.66%
Uranium 20.14 N/A
Zinc 1.44 0.00%

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