John Embry - Investor's Digest

Gold has been experiencing a lengthy consolidation following its record high of slightly over $1900 per ounce in late August last year. The fact that this has occurred in the face of developments that can only be described as extremely gold friendly attests to both the desperation of the powers-that-be and their ability to dominate price action in the paper gold marker for a considerable period of time.

Gold was subjected to a sharp takedown post Labour Day in 2011 in the wake of a historic S&P downgrade of U.S. government debt in early August. It is absolutely essential to realize that the U.S. authorities are paranoid about gold being seen as a preferred alternative to the U.S. dollar and, by extension, U.S. Treasuries. The Treasury Department and the Federal Reserve have been prepared to move heaven and earth to make gold, the true historical currency, look unattractive.

Then, on so-called Leap Day (February 29th) this year, gold, after having steadied and started to rally strongly, was once again taken to the woodshed, counterintuitively collapsing as the woes in Europe proliferated. This has had the desired impact in the western world where sentiment towards gold is about as negative as it has been anytime in the twelve year bull market.

However, this hasn’t deterred the Chinese in the least and they continue to purchase increasing quantities of physical gold. Based on their current import rates, they are on course to pass India as the world’s largest consuming nation in 2012. Considering how small the actual physical gold market is, the voracious demand in the world’s two most populous countries is leaving less and less physical gold available for the rest of the world. Now, with the world’s central banks having swung dramatically from being large suppliers of gold to the market as recently as two years ago to being significant buyers (400-500 tonnes this year), the reality of significant shortages in the physical gold market is now upon us.

When one superimposes on this reality, the staggering amount of paper gold (ETF’s, gold certificates, pooled accounts, futures, etc.) much of which is backed by negligible quantities of physical, the true magnitude of the emerging shortage problem can be appreciated. The situation is further exacerbated by the shocking discovery recently that in many allocated gold accounts in the banking system, the clients are discovering that their gold isn’t readily available when they request it because it has been hypothecated and, in many cases, re-hypothecated.

This is an extremely explosive situation, and given the aforementioned very negative sentiment, gold is now set up for a powerful move that may surprise even the yellow metal’s most ardent supporters. I believe that the bottom is now in and that the all-time highs of last August could be easily surpassed quite quickly.

The fundamental backdrop to the move will be the growing necessity for a massive increase in quantitative easing throughout the developed world as the economy continues to decelerate and the grossly excessive debt in the system becomes an ever greater burden. Despite constant denials from officialdom that any significant QE moves are on the horizon (there is clandestine activity going on all the time) the truth is about to emerge and refute the misinformation coming from those in charge.

There are times in history when events just overwhelm those who think they can control the system and I firmly believe that we are in the early stages of just such a period. To wit, the events in Europe just continue to confound rational thought.

A leading German parliamentarian recently stated unequivocally that “Greece cannot be saved. That is simple mathematics.” At roughly the same time, the Greek Prime Minister acknowledged, correctly in my opinion, that Greece is in a great depression, similar to the U.S. in the 1930’s. Yet the so-called Troika (the European Commission, the European Central Bank and the IMF) continue to insist that Greece must adhere to the prescribed austerity program in order to qualify for future funding. In the absence of that funding, they will default for the second time in six months. This ongoing process seems surreal and, if it weren’t so tragic in many ways, it would be viewed as a comedy in many circles.

However, Greece is a small country and I suspect that the Eurozone could survive its exit although the banking system would undoubtedly be shaken. Spain, on the other hand, is the big enchilada and, to put it mildly, is in dreadful shape despite the constant denials by a number of its senior politicians. Leading up to the recent 100 billion euro Spanish bank bailout, and even in its aftermath, Prime Minister Mariano Rajoy and Economics Minister Luis de Guindos repeatedly insisted that Spain could cope without much outside assistance. What rubbish! It must be understood that this is a country whose economy is in a state of collapse and this became readily apparent when it was subsequently acknowledged that the country needed a minimum of 300 billion euros in assistance to avoid default.

The magnitude of the problem is encapsulated in an unemployment rate approaching 24% with youth unemployment comfortably in excess of 50%. However, it is compounded by an insolvent banking system, numerous important regions requiring immediate financial relief, a large current account deficit fuelled by an uncompetitive economy within the Eurozone and all topped off by a rapidly deteriorating federal government financial picture.

It is difficult for me to see how Spain can ultimately avoid a sovereign debt default unless the outside financial support is open-ended. We will soon discover how the Germans, who saw their own currency destroyed twice in the 20th century, feel about that prospect. Irrespective of the outcome of this travesty, the confidence in pure fiat paper currency is going to be further eroded, dramatically strengthening the case for gold.

The European problem, however, extends well beyond Spain and many of the numerous weak entities are like dominoes. When one falls, the next country comes under pressure from the international financiers who are like sharks smelling blood. Italy is currently the next most obvious target but France isn’t far behind. With a committed socialist, Francois Hollande, now in charge, it is doubtful that any meaningful austerity moves will be undertaken in that country and, accordingly, their finances are headed in exactly the same direction as the other distressed peripheral European countries.

The fireworks in Europe have conveniently taken the focus off the U.S. where the myriad financial and economic problems have continued to worsen. The seriousness of the situation may have been best captured by the words of former Fed Chairman Paul Volcker, whose draconian monetary policy at the outset of the 80’s was thought by many to have saved the U.S. from falling into the abyss at that time. Volcker recently stated succinctly that “American policy makers have exhausted fiscal and monetary remedies in their bid to cure the U.S. economy’s growth blues. There is no magic bullet in the fiscal and monetary policy.”

The announced intention to continue a zero interest rate policy through 2014 effectively removes any conventional monetary tools and an intractable annual fiscal deficit well in excess of $1 trillion has created a serious debt trap. The idea that any substantial increase in taxes or decrease in spending could rectify the problem without triggering economic collapse is naive. As in Europe, there is only one course of action left to avert a deflationary collapse in the U.S. and that is, in the words of the renowned gold expert Jim Sinclair, “Quantitative easing to infinity.”

There are many observers who continue to believe that the risk of mounting inflation is minimal because Fed Chairman Ben Bernanke has repeatedly stated “Inflation expectations are contained.” In the short run, that has proven to be true despite massive monetary creation at the central bank level, because so many individuals and corporations are sufficiently frightened that they are just hoarding their cash, leading to a massive drop in the velocity of money.

However, as the authorities persist in jamming money and reserves into the system to avert deflation, this mindset will change and people will attempt to get rid of the money by spending it or investing it in real assets. This will lead to a rapid increase in velocity and then mounting inflation. Historical examples of this phenomenon have demonstrated how quickly the process can unfold. The result will be a massive transfer of real wealth from the paper holders to those who possess tangible real assets. It is also worth noting that this will be the first time in history that this promises to be a global experience rather than just confined to a single country or a narrow geographic region.

In closing, I would like to comment on what many deemed to be a shocking announcement recently by Barrick Gold concerning its future production profile. Due to a massive cost increase at its planned Pascua Lama development on the Chilean-Argentine border, there will be a production delay of more than a year. Perhaps, more importantly, because of cash constraints, they have indefinitely postponed the development of the Donlin Creek project in Alaska and the massive Cerro Casale operation in Chile and reduced their future annual production guidance from 9 million ounces to 8 million. This is significant in that a 1 million ounce shortfall represents comfortably more than 1% of expected world production going forward.

While there were many gold enthusiasts who viewed this reversal for Barrick as “Schadenfreude” for their abhorrent hedging policies in the 1990’s which severely depressed the gold price before ultimately leading to billions of dollars in losses for Barrick shareholders. I personally think it is just indicative of how difficult large scale gold mining is today. They will not be the only large mining entity to announce cost overruns, delays or cancellations and, as a result, I continue to remain dubious that there will be any significant increase in gold mine production in the foreseeable future, another important positive in an ever-tightening supply-demand situation for physical gold

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