April 9th, 2015 Gold Chronicles topics:
*Middle East overview and impact on markets
*Gulf of Aden strategic picture
*US – Iran Nuclear talks framework
*Why Isreal lacks strategic depth
*Price of oil is being determined by Saudi Arabia
*Expecting low oil prices through 2016
*Global above ground oil stocks hitting record levels
*Oil prices are a reflection of Saudi long term strategy to control oil market share
*Structure and influence of the new China led Asia Infrastructure Investment Bank (AIIB) 亚投行
*Argument for AIIB to keep books in SDR’s
*SDR’s have already been in use since 1969
*America’s Summit and shifting US foreign policy in relation to Latin America
*Very little allocation to gold in institutional portfolios
*The world as a whole has insufficient growth, currency wars alive and well
*Optimal portfolio allocations cash or gold during Deflation
*Inflation can happen almost overnight
Listen to the original audio of the podcast here
The Gold Chronicles: 4-9-2015
Jon Ward: Hello, I’m Jon Ward on behalf of Physical Gold Fund. We’re delighted to welcome you to our latest webinar with Jim Rickards in this series we’re calling The Gold Chronicles. Jim Rickards is a New York Times bestselling author and the Chief Global Strategist for West Shore Funds. He’s a former general counselor of Long-term Capital Management and is a consultant to the U.S. intelligence community and the Department of Defense. He’s also an advisory board member of the Physical Gold Fund. Hello, Jim, and welcome.
Jim Rickards: Hi, Jon, great to be with you.
JW: We also have with us Alex Stanczyk of the Physical Gold Fund. Hello, Alex.
Alex Stanczyk: Hi, Jon, great to be here.
JW: Alex will be looking out for questions that come from you, our listeners. Let me just say that your questions for Jim Rickards today are more than welcome and you may post them at any point during the interview. As time allows, we’ll do our best to respond to you.
Jim, in the past we focused quite a lot of attention in our conversations on Russia and the Ukraine conflict because it’s an issue with obviously huge economic and financial ramifications. But of course, you could say the same of the Middle East, which today remains in a state of constant turmoil. Since we last spoke we’ve had the approaching nuclear deal with Iran, a near meltdown in U.S.-Israel relations, Saudi military intervention in the Yemen, and ISIS setting up shop within a few miles of Damascus. My question to you at this point is a broad one. How does the crisis in the Middle East impact the global financial and economic picture?
JR: It’s a great question, Jon, and a great way to frame the issue. It would be nice if these various crises were sequential so that we could have a crisis in Ukraine and resolve it, and then have a crisis in Middle East etc. But they’re not sequential; they’re cumulative. We keep piling one on top of the other. To address your question, let’s talk about the Middle East but bear in mind that nothing in Ukraine has really gone away. It’s in a quiet period right now. There is a ceasefire, but there have been multiple ceasefires before that have broken down so it wouldn’t surprise anyone to see Ukraine spin out of control again. In fact, it probably will, but it’s a little quieter now so let’s go over to the current hotspot which is the Middle East.
I want to talk about the geopolitics first and then bring it around to markets, because I know our purpose here is to interpret geopolitical events in terms of the impact they have on markets and investor portfolios. That’s impossible to do without setting the right geopolitical frames, so let’s begin with the geopolitics. Yemen is certainly the crisis du jour. I think listeners know what’s going on there. There was never a lot of stability there to begin with, but the government that had operated out of Yemen was more Western-backed, Western-friendly and had been a base for a lot of counter-terrorist operations for years, certainly putting Al Qaeda on the run and performing joint missile operations and other aspects of the war on terror (even though the White House doesn’t call it the war on terror.)
There is a tribe who has been around for a long time, the Houthis. Backed by Iranians and Shiite co-religionists, they recently led an uprising and effectively deposed the government. They refer to the president of Yemen as “the Western-recognized president.” Whenever you hear the phrase ‘Western-recognized,’ it’s a pretty good sign that the guy is no longer recognized and is probably on the run somewhere. So our favorite has left the building as they used to say about Elvis. Although we have an Iranian-backed government that by the way wants to take control, in the Middle East nothing is ever easy or simple. There’s a third faction which is Al Qaeda. You have an Al Qaeda group in the eastern part of Yemen, the Iranian-backed Shi’a group taking over most of the western and northern part of Yemen, and then you have little pockets of Western resistance now led by an Arab coalition of Saudi Arabia and Egypt trying to hang on to some strategic locations in Aden and the western tip of Yemen. It’s very much of a mess and it remains to be seen how this is going to play out.
Let’s just signal the importance of it. Yemen is probably the poorest country in a poor region. Why do we care and why is this so important? I think listeners are familiar with the Straits of Hormuz. This is the fairly narrow chokepoint where oil leaving the Persian Gulf heading for Western or Asian markets has to pass through this stretch. Iran controls one side of it and the other tip of it is Oman. Iran certainly has the ability to at least try to interdict that traffic. Remember that the oil coming out of the Gulf is not just from Saudi Arabia but form Saudi Arabia, Qatar, Bahrain, UAE, Kuwait, Iraq and Iran. Almost all of that oil, except for some that travels overland through Turkey, comes out through the Straits of Hormuz. So you could really choke off the world’s oxygen supply, if you will, if you interdicted that. The United States Fifth Fleet is based in Bahrain fairly nearby and could probably reopen it if Iran did try to choke that off although it would be quite tumultuous in the meantime.
But there’s another chokepoint. Once you come out of the Straits of Hormuz and get into the Arabian Sea, where do you go from there? Some of the traffic goes east to China. There are other chokepoints over there, but a lot of it heads west through the entrance to the Red Sea, the Suez Canal, to the Mediterranean and to Europe. There’s another chokepoint at the mouth of the Red Sea, and that’s where Yemen is. Now we have the prospect of Iran not only controlling half of one chokepoint, the Straits of Hormuz, but if Yemen falls to pro-Iranian factions, Iran would effectively control the other chokepoint at the entrance to the Red Sea. Now if they want to cut off the Western world’s oil supply and they also controlled Yemen at the entrance to the Red Sea, they could interdict it at two places. That means the Fifth Fleet would have to divide its forces and fight two battles in two different places. Anyone with any military background knows it’s always more difficult to fight two actions than one because of the inability to concentrate forces.
The U.S. Sixth Fleet could just come down from the Med through the Suez Gulf and help out there. That’s a nice thought, but we don’t have a Sixth Fleet. We have a Sixth Fleet in name only which is based in the Mediterranean and consists of one flagship and whoever is in the neighborhood. If any aircraft carriers or traffic happens to be traversing in the Med, they’re temporarily assigned to the Sixth Fleet, but there’s not much besides that. The Sixth Fleet is the fleet of the phantom. The Fifth Fleet is real, but if they had to divide their forces, they’d have their hands full. So that’s the strategic play; Iran is basically trying to prove its ability to choke off the oil supply.
I want to step back from the situation in Yemen and not spend too much time on what I call the crisis du jour but instead help our listeners look at the bigger picture. At the same time this is going on, Iran is building what’s called the Shiite Crescent starting in Iran, traversing now Iraq — Iraq used to be more Sunni and/or secular Ba’athist but today it’s pretty much fallen to Iran and the Shia — on into Syria, which is propped up by Iran, then through Hezbollah, to Lebanon, and to the Mediterranean. Hezbollah is basically an Iranian proxy army, so you have this prospect of Shia influence stretching from the Arabian Sea to the Mediterranean via Iran, Iraq, Syria and Lebanon and, by the way, completely encircling Israel. All that remains to be done is to peel off Jordan. Of course, there are plenty of Shia co-religionists of Iran agents in place in eastern Saudi Arabia and Bahrain.
Israel is feeling encircled, and Saudi Arabia is feeling encircled with what’s going on in Yemen because Yemen is on the southern flank of Saudi Arabia. They’re already confronting Iran across the Persian Gulf and, as I mentioned, there are plenty of Iranian agents in eastern Saudi Arabia where the oil is, and in Bahrain. (I’ve been to Bahrain and will be heading back there soon.)
So Iran is encircling Saudi Arabia and Israel and making huge strategic gains. What’s the United States doing? The United States is making friends with Iran. We are their new BFFs, best friends forever. The President started the process of détente with Iran in December 2013 when he relieved some, not all, of the economic sanctions on Iran. Since then we’ve been in these negotiations over the nuclear dossier, basically Iran’s enrichment capability.
There was some kind of breakthrough announced about a week ago. I wouldn’t even call it an agreement to agree. It’s sort of a memorandum of a framework of an agreement to agree. Whatever that is, that’s what the President announced. The Iranians were already disputing the White House version of it, so take your pick. Not much of this is in writing. It remains to be seen and all hinges on the ability to conduct inspections. We’re letting Iran keep the centrifuges and the enriched uranium, relying on their promise to not enrich or create enough uranium to build very many nuclear weapons. Since they’re not giving up their material or the equipment, it depends on inspections. Inspections are carried out under United Nations supervision which is subject to Security Council sanctions. Russia has a veto on the Security Council, so we’re kind of depending on our good friend Putin to make sure Iran plays straight. I don’t know how comfortable people feel with that.
A good friend of mine, Charlie Duelfer, wrote a column on this in Politico recently and pointed it out. No one knows more about weapons of mass destruction and inspections than Charlie Charlie Duelfer. He was the U.S. representative on UNSCOM in the 1990s the last time we tried this routine with sanctions on Iraq which broke down pretty quickly. Charlie was one of the few people who actually interrogated Saddam Hussain. After they dug him out of a spider hole in Iraq, Saddam Hussain was held in captivity before he was executed. Charlie got to interrogate Saddam face to face across the table and knows more about this than anyone. He’s very, very skeptical of our ability to enforce these sanctions on Iran, so it’s no wonder Israel feels uncomfortable.
The President gave an interview with Tom Friedman of The New York Times recently in which he outlined the Obama doctrine which is pretty fuzzy. You really have to parse words with the President. President Obama said, “I promise that Iran will not get a nuclear weapon on my watch.” That phrase, ‘on my watch,’ set off alarm bells around the world because his watch ends January 21, 2017. While it’s nice to know that Iran won’t get a nuclear weapon before then, there’s the rest of history beyond that.
It has been the strategy all along to basically make sure that Obama’s legacy or administration goes down without Iran getting a nuclear weapon, but he’s selling out the future of the United States and the future of Israel. He’s sort of dumping it in the lap of his successor, whether it’s Hillary Clinton or Jeb Bush or Rand Paul or Elizabeth Warren. I don’t know who the next president is going to be, but whoever it is, they’re going to get this dumped into his or her lap courtesy of Obama’s unwillingness to really wrestle with the future of this. When he said, ‘my watch,’ I didn’t take a lot of comfort from that. He also said, “If anyone messes with Israel, the U.S. will be there for them.” Again, these are his exact words. You can read Tom Friedman’s column in The New York Times. This is not me putting words in the President’s mouth; these are the President’s words. He said, “If anyone messes with Israel, America will be there for them.” Well, what the heck does that mean? The thing is, in ‘messing with Israel,’ if you dropped one nuclear device in Tel Aviv, it’s over. You’ve killed a million Jews just like that. A million Jews could be incinerated. It’s a second Holocaust.
Israel lacks what we call strategic depth. Strategic depth is why no one has ever really conquered Russia. Charles XII, the Swedish conqueror, attacked in the 17th century, Napoleon attacked in the 19th century, and Adolf Hitler attacked in the 20th century. All three of them failed to subdue Russia, because they could drive 1,000 or 1,500 miles into Russian territory but then the winter came and the Russians just retreated and waited them out. Supply lines got stretched, equipment froze, men got illnesses, the army was decimated, and the Russians pushed back. So Russia can absorb tens of millions of casualties and remain standing because they have strategic depth. Israel does not have strategic depth. Going back to the original United Nations borders established in 1947-48, at the narrow stretch it’s only 16 miles from Palestinian territory to the Mediterranean Sea. I’ve driven around Israel from top to bottom. You can do it in a day or day and a half. It’s not much bigger than New Jersey. The point is if Israel ever suffers a major attack, they have no fall back. There’s no plan B, there’s no day two. They’re done. When the President says, if you mess with them, we’re there for you, that’s a meaningless promise, because Israel can’t withstand a first strike. They’ve got to make sure the first strike never happens.
What can we say? Iran is encircling Saudi Arabia who, I guess, used to be our friend. They’re encircling Israel who, I guess, used to be our friend. The President is engaged in happy talk about trusting people you can’t trust, relying on Putin to do the enforcement at a time when he’s calling Putin all kinds of nasty things with regard to Ukraine, and he’s saying nothing bad is going to happen on my watch which is over in about 20 months. So there you are; a pretty unstable situation. Here’s the way the President reframes this: he says, well, if you don’t like my policy, you’re a warmonger. Do you want to be responsible for boots on the ground and casualties? In analysis, that’s what we call false dichotomy or straw man. He sets up his opponents to be these warmongers who want to drop the 82nd Airborne into Aleppo or drop the 101st Airborne into Aden and incur a lot of casualties. That’s a false choice. There’s a lot of daylight between what I’ll call appeasement on one hand and war on the other.
There’s no better example of that than the Cold War. Through the entire length of the Cold War, about 40 years from roughly 1949 to 1989, or 1947 to 1991, however you want to date it, 45 years let’s say, Russia and the United States never fired a shot at each other. There was no war between Russia and the United States, but there was a Cold War. We used an array of policies, containment, proxies, sanctions, intelligence, and a lot of assets, but we never went to war. There’s something in-between appeasement on the one hand and war on the other. It’s smart policy and strategy. People like George Kennan and the Long Telegram and the X Article in foreign affairs, it’s things like that. That’s what’s missing from this White House. It’s either my way or the highway, so a very, very unstable, uncertain state of affairs.
Now let’s take all that, which is bad enough, and bring it over to markets. There are two big plays going on, the first involving the price of oil. It may surprise some people, but what’s going on with the price of oil actually has relatively little to do with everything we just went through regarding all this geopolitical uncertainty, at least for the time being. That’s a different play having to do with pricing, fracking, market share, and Saudi Arabia’s efforts to put frackers out of business. I’ve said this before – and I think the listeners may be familiar with this analysis – but Saudi Arabia needed to pick a price that was low enough to put the frackers out of business but high enough to sustain their revenues and budget requirements, or at least not any lower than it needed to be to put the frackers out of business. It’s an optimization problem. That number is $60 a barrel; low enough to kill the frackers and high enough to keep Saudi Arabia’s budget in a slight surplus.
That doesn’t mean that the price of oil is exactly $60. Markets overshoot, they trade in a range, there’s day-to-day volatility, and there are a lot of other things going on. I look for oil to trade in the $50 to $60 range with $60 being the cap and $50 being not a hard floor but a place that the price would gravitate to for the rest of this year and most of next year, because it’s going to take that long to put the frackers out of business. Does Iran get hurt by that? Yes, a little. Does Russia get hurt by that? Sure. Saudi Arabia doesn’t mind either one of those two things, but that’s not primarily why they’re doing it. They’re primarily doing it to maintain market share.
It’s important to understand the unique role of Saudi Arabia. People always talk about OPEC, but OPEC is not that important. Saudi Arabia is vitally important because they have a unique combination. They have the largest reserves, the largest potential output, and the lowest cost of production. That’s a unique combination. Other people have a lot of oil at very high prices. Other people have oil at low prices but not that much in reserves so they have to worry about depletion. Other oil producers have one of the three or maybe two of the three factors to worry about. Saudi Arabia doesn’t. They’ve got all the reserves, all the capacity, and a very low production cost all at the same time.
They can set the price of oil wherever they want. If Saudi Arabia wants oil to be $15 a barrel, they can do it. They just have to pump like crazy and fill up storage capacity, completely fill it up with floods of oil coming on the market. If Saudi Arabia wants to add to that, they can drive the price down. On the other hand, if Saudi Arabia wants to shut off the taps, they can take the price to $150 dollars a barrel tomorrow. In a huge range from let’s say $10 or $15 to $150 or $200, Saudi Arabia can set the price, so the price is whatever they want it to be. Right now they want it to be in this $50 to $60 range but not forever. They like $100 oil as much as the next producer, but they have to sink the frackers.
The difficulty is that the frackers don’t fold up their tents overnight. Fracking has a couple of interesting properties. One is the wells have a much higher degree of finding oil. The old wild cat days when you drilled a bunch of wells, most of them came out dry, every now and then you hit a gusher, and that’s how you made all your money — those days are over. At least with fracking technology, you have a very high probability of finding oil, but the depletion rate is much faster. Those wells tend to get depleted or dried up faster. The solution is to keep drilling new wells. That’s kind of how you can understand the dynamic of the fracking industry. In order to drill new wells, you need money to buy pipes, rigs, labor, leases, and do all kinds of things. This causes a unique situation where most fracking is not profitable at $50 to $60 a barrel. It needs prices of $80 and upwards of $130 a barrel. I’m sure somebody can point to some fields somewhere where the price is lower, but most of it is in that $80 to $130 range I just described. Nobody’s going to go out and drill for oil when the cost is $80 a barrel if the price is $50 a barrel. That’s crazy, so they’re not going to do new wells.
If you have existing wells, the math is different because you’ve got some costs. You might not have done it in hindsight, but you did it. You got that well — and all this debt you incurred on the assumption of high oil prices. So you’re going to pump like crazy in the existing wells to generate cash flow to pay your bills, but you’re not going to do new wells until the price goes up, which it won’t because Saudi Arabia is going to hold it down. In that world, you get a short-term flood of oil as you pump the wells like crazy, but you get a long-term drying up of the industry because those wells will deplete quickly and no one’s building new ones. That’s going to take a year-and-a-half to two years to play out, but eventually the fracking will dry up and then Saudi Arabia will start to raise the price again.
People say, oh, how does that work? If they raise the price, don’t the frackers just go back in business? The answer might be ‘no’ for two reasons. One, they’re going to have to borrow the money again and there might be a lot of bad debts in the meantime. There might be trillions of dollars of write-offs the fracking industry jumped at as a result of the new low price of oil, so maybe the lenders aren’t willing to make new loans. Or there are the junk bond buyers, some of whom are unbeknownst to themselves. If you look in your 401(k)s, you might find some of this fracking junk bond in your so-called high-yield funds. In other words, don’t be surprised if you own some yourself. Once those losses come in, people might not be so eager to make new loans. Secondly beyond that, even if you could find credit-worthy projects, do you really want to go there? Saudi Arabia could just wash, rinse, repeat, and lower the price again. This is Saudi Arabia’s long-term play to put the frackers out of business and then ultimately raise the price, regain market share, and regain revenue.
This is all going on independent of the chaos in the Middle East that we just described. One doesn’t help the other. Now, just to connect the dots a little bit, some people have said if the U.S. has détente with Iran, doesn’t that put a lot of Iranian oil back on stream and doesn’t that drive the price lower, maybe down to the $20 range, etc.? The answer to that is some Iranian oil might come back on stream, I think that’s correct, but it doesn’t happen overnight. A lot of these fields really need substantial upgrades. Look for a lot of Chinese capital coming in to do that. Yes, there might be some more Iranian supply and Iran is notorious for cheating as is the rest of OPEC, but Saudi Arabia can just dial it down again. Maybe the frackers are coming off stream as Iran’s coming on stream and Saudi Arabia’s just standing pat waiting for all this to play out.
That’s how that works. Again, I look for oil to trade in that range. Just to tie it back to U.S. monetary policy, this has very important applications for the Fed. The Fed discounts food and energy, inflation or deflation, and they look at core CPI and core PCE for their guidance on price stability, which is part of their dual mandate. A lot of people laugh at that and say it’s ridiculous. What’s more important than food and energy? Why would you factor it out? Well, there’s actually a good academic reason for doing it because the time series and pricing shows that those things are volatile. They do tend to be mean-reverting and come back to where the core is, so in the long run they’re the same or close to the same thereby making some sense to ignore them in the short run because you’re just filtering out the noise. In other words, core CPI is a good prophecy for overall CPI over a longer time period.
It might be different this time, however, because if the price of oil is going down not for normal industrial supply and demand reasons but because of a large market share play by Saudi Arabia, that means it goes down and doesn’t come back up. This means it’s not mean-reverting but is actually being manipulated by the Saudis. That might be sending out false signals to the Fed causing them to think that inflation’s going to tick up to their goal when in fact they’ve got to first absorb the deflation. Secondly, they may not see the bounce-back or mean-reverting behavior, which, as usual with the Fed models, they’re going to get it wrong and possibly overestimate the tendency towards future inflation, by changing inflationary expectations. That’s extremely dangerous, because that might actually prompt them to raise rates at exactly the wrong time. The Fed has a long history of doing the wrong thing at the wrong time, so that makes it dangerous. I know we have a couple more questions, but we’ve got a big picture, long-term geopolitical mess with instability. By the way, if oil does bounce out of that $50 to $60 range I spoke about, it would be because of a geopolitical wildcard or something going very badly wrong. Given the mess I described, we can’t rule it out.
One last footnote: I talked about the Shiite Crescent, the Persian Gulf, the Red Sea, and Yemen, but don’t forget Libya. Libya is in chaos. There’s active ISIS and active Al Qaeda. ISIS is getting pledges from as far away as Nigeria at this point, so they’re actually getting stronger. Even as they suffer tactical defeats in places like Tikrit, they’re making strategic gains around the world, so they’re not going away. You could see that wildcard as a possibility, but oil will stay in a range. I think the Fed is overestimating the mean-reverting behavior of oil prices. They’ll probably get interest rate policy wrong, and that could be very damaging for markets around the world. I’ll stop there and throw it back to you, Jon.
JW: Thank you, Jim. That’s really a huge, complex, and very informative picture. Obviously these are big areas of discussion that we’ll no doubt return to. Let me pick out a single, tiny thread from the Middle East story, one that leads to China. Some rather unlikely bedfellows have rushed to join a new Chinese institution, the Asian Infrastructure Investment Bank. They include Saudi Arabia, United Arab Emirates, and most recently Israel. Of course, the bulk of the founding member countries are Asian, but among some other 40 or 50 nations participating, we’re seeing Britain, France, Germany, and Norway. I guess it would be nice to think all these countries suddenly care about Asia’s need for roads and railways, but perhaps there’s something else going on here.
JR: As usual, this is something that can be thought about or analyzed at multiple levels, so why don’t we jump in and do exactly that? The Asian Infrastructure Investment Bank or AIIB is a real institution that’s new and just in its foundational stages. China formed it and offered subscriptions. As a country, you could sign up, put in your share of the capital, become a founding member of the bank, and get a seat on the board. It’s really not different than starting a company or sending out an offering document in the fund. You sign up, send in your money, and you own a piece of it. This is a stick in the eye for two of the key Bretton Woods institutions, the World Bank created in 1944 and the Asian Development Bank created in 1966.
As a reminder, the Bretton Woods architecture had three institutions: 1) The International Monetary Fund (IMF), which we think of as a world central bank; 2) The World Bank, which is not a world bank but really a development bank for poor countries and infrastructure projects; and 3) The General Agreement on Tariffs and Trade — now the World Trade Organization — designed to encourage free trade. So you had a central bank, a development lender, and a free-trade organization as the basic architecture of Bretton Woods, completely dominated by the United States with participation from Western Europe and Japan. When this was set up, Russia and China were communist and not in the game. Over time, that all changed. Russia and China both joined the IMF, and China recently joined the World Trade Organization.
They were joining the club and playing along with the great game, the big international global monetary system game, but a couple of things happened. China grew so fast that it was probably deservedly entitled to a larger voice at the IMF. ‘Voice’ is their jargon for votes at the IMF. It was clear that some of the old members, Belgium and others, had too many votes relative to the size of their economy and China didn’t have enough. There was some reformat underway to give China more votes, but the U.S. stood in the way of that because the U.S. had its own agenda. We wanted China to restructure their economy away from exports and investment towards consumption. We wanted to sell them some stuff, we wanted them to stop fighting the currency wars, stop cheapening the yuan, and we wanted them to anchor their currency on the dollar. The U.S. had stuff that we wanted from China, and China had stuff they wanted from us, namely more votes in the IMF. It was sort of a stare fest, the two sides staring each other down and mobilizing weapons. It’s like everyone playing a poker game and piling up chips. One of China’s chips is certainly the BRICS Development Bank and their coziness with the BRICS, but also more importantly, I think, this Asian Infrastructure Investment Bank.
China is saying you let us in your club; we’re already in the club, so give us more votes or more power at the club. Put us on the membership committee or however you want to describe it. If not, we’ll set up our own club and go our own way. That’s what’s going on here. As far as the eagerness of Western Europe and a lot of others as well as Asia to join this bank, it was over U.S. objections. The U.S. did not join but voiced objections and were visibly disappointed when the U.K. signed up, our good old friends in the U.K. Why did they all join anyway? Why did they all sign up despite U.S. objections? The answer is they want the deals. If China is going to start doing multibillion-dollar, multiyear infrastructure projects in Central and South Asia, what are they? They’re railroads, bridges, highways, airports, telecommunications hubs, and oil and natural gas pipelines. These are big-ticket items, and don’t think that the Germans, the French, and the U.K. don’t want to be first in line for all those contracts.
China is behind the scenes saying, if you want those contracts and want us to lend money to your projects so you can get these contracts, then you have to sign up, put some capital in, and improve our credit worthiness. That’s what’s going on. Meanwhile, the wallflower left without anyone to dance with at the seventh-grade dance is Japan, because Japan is the head of the Asian Development Bank, which was designed to do exactly what the AIIB is going to do except that it’s part of the Bretton Woods infrastructure that China is turning its back on at least in the short run. We’ll see how this plays out.
Christine Lagarde was in Beijing a couple weeks ago, and we have the IMF spring meeting next week. There could be a lot of significant announcements there probably relating to the commencement of a process to include the Chinese yuan in the special drawing rights (SDRs). They haven’t announced it yet, but it will be very interesting to see how the AIIB keeps its books. It’s a bank, so they’re going to have books, assets and liabilities, loans, and profit and loss statements just like any bank. They have to pick a currency, but it wouldn’t really make sense to do dollars if they’re trying to break away from U.S. dollar hegemony and U.S. dominance of Bretton Woods. Why would they do it in dollars? It’s probably not going to be in yuan because that makes it China-centric. Even though China’s the dominant voice, they’re trying to make this multilateral. It could be euros, but why would they have euros for an Asian bank?
I don’t know, but it seems likely they’ll keep their books in special drawing rights or SDRs. The IMF already does that, so have a look at IMF financial statements that are available online. They’re all in SDRs. When the IMF makes a loan such as they did to Ukraine recently, those were in SDRs. I talk about SDRs a lot and people laugh at me. They’re like, oh, what are you talking about? It’s just another fiat currency that will never work. My answer is it’s been working since 1969 so there’s nothing new. SDRs work fine; it’s just that no one really understands them. It will be interesting to see if they do keep their books in SDRs which they may very well. A possible scenario is that the AIIB keeps the books in SDRs and the IMF includes the yuan in the SDR, which they may do starting as early as next week (it won’t be official until January 1, 2016, but that process may start next week). It would get formally voted at the IMF annual meeting in Washington in early October (I think the annual meeting might be in Peru). This SDR train has left the station a long time ago.
It’s a very important development. The U.S. is out in the cold, but what remains to be seen is whether the U.S. will nevertheless make peace with China by inviting them to have a bigger voice at the IMF and maybe at some point the AIIB gets merged with the Asian Development Bank to create one happy family with China having a few more votes. I think that really is the bigger play here. China doesn’t want to start their own club because they want to be in the big boys club, so to speak. It’s just a question of having forcing strategies to get there.
Going back to the first topic about Iran, part of this U.S.-Iranian détente is the lifting of sanctions. A lot people are looking at that and saying, wow, that’s a big opportunity. A lot of infrastructure and imports are needed in Iran if you take away sanctions. That’s certainly true, and I don’t doubt that American businesspeople will be on the first plane to Tehran once the president eases up some more of the sanctions. But what the Americans are going to discover is the Germans are already there. They never left. When you relieve sanctions on Iran, the big winner is not going to be the United States; it’s going to be Germany. German large caps like Siemens, Volkswagen, Daimler-Benz, and others are going to be the big winners on Iranian infrastructure projects. Of course, this all converges if Germany’s in the AIIB, the AIIB decides to finance projects in Iran, and Iran gives the contracts to Germany. Everybody wins except the United States. So watch that space, but it is a very interesting, fast-moving world.
JW: Thank you, Jim. We’ve covered a huge amount of ground with just two questions. We also have questions from our listeners, so I’m going to turn this over to Alex Stanczyk now to give us those questions from the listeners.
AS: Thank you very much, Jon. I also want to quickly say thank you to all of our listeners who have been sending in questions. There are a huge number of questions in the queue, and we’re not going to be able to answer them all, but we will pick out a couple and go over them. First, I want to provide a little bit of background information for this next question. The Summit of the Americas is being hosted here in Panama over the next couple of days with over 30 presidents from the Americas arriving for the summit. What’s different about this is that we’ll have President Castro from Cuba, Maduro from Venezuela, and Obama all in the same room at the same time. As far as we know, this is the first time this has happened in the last 50 years. The streets are pretty much all shut down, there is a U.S. warship in the bay of Panama, there are U.S. military vehicles on the street corners, there are military attack helicopters flying overhead, and Air Force One is expected to fly in sometime today. The question coming from Philip asks: Do you feel that this Americas Summit has any bearing on Russia-Venezuela or the Russia-Cuba relations? And does this, in any way, signal a shift of U.S. foreign policy in regards to the Americas?
JR: I think it does. On my last visit to Panama, I was able to enjoy some fine club activity in Casco Viejo also called Casco Antiguo or the San Felipe district; the old city, the old part, where I enjoyed some nice contraband Cuban cigars. I’m glad I’m not there now because it’s probably difficult to move around even though it is a beautiful city. This is a very big deal. Go back to the U.S. midterm elections in 2014. The Republicans already had the House of Representatives. They increased their seats in the House of Representatives and took control of the Senate. A lot of analysts and Republicans, in particular, looked to this and said, a-ha, this is a turning point. Finally, Obama is painted into a corner, if you will. This is going to trim his sales a little bit in terms of his abilities and degrees of freedom to act.
In fact, what happened is quite the opposite. Obama is unleashed, if you will. He’s now saying he can do whatever he wants. It seems paradoxical but not really, because as long as the Democrats controlled the Senate, he had to work with the Senate Democrats and Harry Reid. He couldn’t just ignore his own party’s majority in the Senate, so it was a three-way conversation among House Republicans, Senate Democrats, and a Democratic White House. Once the Republicans took the Senate, the president doesn’t have to talk to them at all. He doesn’t, so he’s just doing whatever he wants.
The president is feeling very strong, whether it’s détente with Iran, poking a stick in Netanyahu’s eye or relaxing sanctions for Cuba. That actually seems to be moving on a faster track. These things don’t happen overnight, but that’s going very quickly, and now with Maduro in Venezuela, what better opportunity than the Summit of the Americas that you just described. Traditionally and legally the president does have more degrees of freedom in foreign policy, so I think we’re looking at normalization of relations with Cuba and warming of relations with Venezuela. This is a bigger picture thing, and I think you put your finger on it, Alex, with the question in terms of peeling away Russia’s influence in the Western hemisphere. But Russia’s not really the problem in the Western hemisphere. That was true in the ’60s and ’70s from Bolivia to the Bay of Pigs, but Russia’s focus now is on the Russian periphery, reestablishing the Old Russian Empire, Eastern Europe, and Central Asia. Russia doesn’t care that much about the Western hemisphere. Maybe they care but they don’t have the capacity to do very much and it’s not Putin’s interest at all. Peeling Venezuela away from Russia is probably a win for the United States but it doesn’t mean very much to Russia. The real player is China. China is, obviously, actively studying a new alternative.
First of all, China has a lot of influence in Panama and the Canal Zone. China is actively looking at building a new canal possibly in Nicaragua. That’s a multiyear, multi-10-billion-dollar project that’s been talked about for over a hundred years going back to before the Panama Canal was built. Let’s see how it plays out, but that’s something China’s interested in. China is interested in buying Venezuelan oil and swapping it for other oil that arrives in China and sending the Venezuelan oil to the Virgin Islands or the Gulf Coast. Venezuelan oil is very undesirable. It’s heavy and sulfurous so it’s kind of at the bottom of everyone’s list. But it is oil with a margin, and Venezuela certainly needs the money. This is probably just unfinished business from the Cold War. Why shouldn’t the U.S. have closer relations with Cuba and Venezuela? But Russia’s not really the issue any longer. It’s China. I think you can win the battle and lose the war. So we’ve got close relations with Cuba and Venezuela — fine, but we’ve lost Latin America.
Before I went to law school, I was actually an international economics and Latin American studies grad student at the School of International Studies in Washington. My thesis adviser was Riordan Roett. I studied with Riordan 40 years ago, but to this day he’s a legend in Latin American studies circles and very active as the leading scholar of Latin America as well as the number one U.S. expert on Brazil. He considers Latin America a Chinese sphere of influence. Go to Santiago, Lima, Ecuador, Brazil or Argentina and look at the swap lines, look at the trade lines. China has really taken over Latin America without firing a shot, so there’s not much left of the Monroe Doctrine. Chalk up a win of Venezuela but maybe more importantly we should chalk up a loss for the U.S. sphere of influence in Latin America because there’s now a Chinese sphere of influence.
AS: The next question we have is coming from Francis F. by e-mail. He says, “Jim has said the entire world’s got the same problem when it comes to debt, deflation, and inflation. I live in Ireland. Apart from low inflation, the country, according to the national media, is supposedly on an accelerating recovery, which to me sounds like every other country around the planet. In your view, are these false promises and hopeful thinking or real economic expansion?” Francis adds a P.S., “I was recently 33 percent in precious metals but cut back to 26 percent and regret it,” because now he’s in euros.
JR: There’s not much I can say for the latter. As you know, I pretty consistently recommend 10 percent gold for the conservative investor and 20 percent for the aggressive investor. I have consulting clients who have 50 percent in gold and I say, fine, you didn’t get that from me. I think 50 percent is way too much, and 33 percent is way too much. The point is, institutional allocations around the world are at about one and a half percent. Even if you took my conservative recommendation of 10 percent or you cut that in half to 5 percent, that’s still more than three times what institutions actually have in gold. If institutions even tried to move from the one and a half percent to the 5 percent level, when we’re talking about trillions of dollars of wealth around the world, the impact on the gold price would be incalculable. That would get you way past $2,000, probably in the $3,000 to $5,000 per ounce range on its way higher, because at that point, it’ll be a disorderly route in favor of higher dollar gold prices. My recommendation is 10 percent but that’s five or six times what institutions actually have today, so there’s not a lot of headroom if there was a shift of gold. As far as the euro is concerned, if it’s any consolation, it’s probably at a low.
Let me come back to the listener’s question. There’s real growth in Ireland, no doubt about it. There’s real growth in Spain and Europe, but I think the bigger picture is that there’s insufficient growth around the world. The world as a whole does not have enough growth to go around. That’s clearly in the data, and we’re going to see confirmation of that next week at the International Monetary Fund spring meeting. They’re going to update the world economic outlook as they do twice a year.
They marked it down last September, and my guess is they’ll probably mark it down again next week. China is slowing down visibly, and the U.S. has fallen off a cliff. We have 5 percent growth in the third quarter of 2014 which was phony for some accounting reasons having to do with the election, but it dropped to 2.2 percent in the fourth quarter. It looks like it’s coming in way below 1 percent, maybe even zero in the first quarter of 2015. I don’t see that picking up. Again, U.S. growth has fallen off a cliff, Chinese growth is rapidly slowing down, and Europe’s picking up. Why is that? It’s the currency wars, the same old story. Go back to 2010. It’s true that the guy with the cheap currency gets temporary growth. Barry Eichengreen, Paul Krugman, Stiglitz, and others come out and say cut your currency, you’ll get some growth. It’s true in the short run, but all you’re doing is stealing the growth from somebody else. You’re not doing anything for global growth and you’re hurting your trading partners.
My analogy or metaphor is you have four or five thirsty soldiers on the battlefield. They’ve been fighting all day in hand-to-hand combat and 110-degree heat. They caught a break and they’ve got one canteen. What do you do in that situation? You pass the canteen. Everybody takes a drink, hands it to the next guy, and people try not to be too much of a pig and drink too much of the water. That’s the best you can do and it’s one way to understand global economic growth. In August 2011 the dollar was at a long-term low and gold was at its all-time high. (By the way, the dollar and gold are just inverse to each other). That was the U.S. holding the canteen drink, but the U.S. said to the world, hey, we need the growth. If the U.S. doesn’t grow, the rest of you are sunk. We’re all sunk, so give us a chance.
By 2012 – 2013, it looked like the U.S. was growing more strongly, but it wasn’t really. That was just based on a bad Fed forecast, but they thought it was. That’s when Bernanke did the taper talk in March 2013, started the taper in December 2013, and Janet Yellen finished the taper through November 2014. That was the U.S. handing the canteen to Japan and Europe. Japan got the first drink in December 2012 with Abe economics. They trashed the yen which went very quickly from 120 to 90 or so. Then they passed the canteen over to Europe, and they trashed the euro. The euro went from roughly 135 to 105, somewhere in that band, very quickly. These are huge swings. If you look at the history of foreign exchange trading, foreign exchange is a market that’s traded at the fifth decimal place. When you talk about 103 euros to the dollar you hear quotes like 103.12345 — this is stuff that trades at five decimal places. If you move it and bang it 30 percent in 6 months, that’s an earthquake. That’s what happened to the euro.
It was pass-the-canteen. Yes, Ireland and Spain are growing, and that’s good for them. Germany’s picking up all the pieces, but it’s coming at the expense of China and the United States. How long is that going to last? How much stronger can the dollar get before we go into a recession? The answer is not much. The question is, is there a bigger play here or are we converging on something that starts to look like what happened in the mid-1980s at the Plaza Accord and Louvre Accord. Let’s watch that space, but I would see the euro at a low here. If it goes down tomorrow, don’t call me up and tell me I’m an idiot. These things are volatile, they overshoot, it could go lower. I see the euro at the low end of the range, the dollar at the high end of the range, and I see the yuan as joined at the hip with the dollar. The Chinese trying to suck it up and deal with the strong currency, but that’s part of getting into the club that we talked about earlier. These are very big plays. The mavens of finance as I call them are working behind the scenes. This isn’t a conspiracy theory. This is how the system has always operated under what I call the rules of the game in my book The Death of Money. So watch the space.
Gold is showing a lot of strength. People ask why gold isn’t at $1,400 or $1,500 an ounce. The better question is why isn’t it at $900 an ounce? Commodities have fallen off a cliff, deflation’s got the upper hand, and growth is slowing down. All of these things say that gold should be lower, but the facts show that it’s hanging in separate from the commodities index – it’s hanging in at $1,200 an ounce. That looks like strength to me. If the dollar’s at a peak and is going to start to come down, and gold has weathered the storm vis-à-vis deflation, that’s a bullish signal for gold. We could still see some unpleasant surprises for gold investors between now and the end of the year. Some interesting things going on, needless to say.
AS: I really love the analogies you gave there. That’s probably one of the reasons why so many people find what you have to say appealing, because you are often able to take very complex issues and boil them down into very simple ways for people to understand. That’s really great. Our next question is coming from Harry B. who says, “Deflationists say that cash is the go-to asset first and that gold comes after a multiyear deflation. Do you see this playing out differently?”
JR: First of all, I wouldn’t say that cash is the go-to asset for deflation. I definitely recommend cash in the portfolio and a significant piece, maybe 30 percent or so. Mohamed El-Erian is by all accounts one of the savviest investors in the world. He ran Harvard Endowment and PIMCO, so he’s an inner circle member of the international monetary elites. Not too many people know more about this stuff than El-Erian. He gave an interview to Bloomberg recently and said he’s mostly in cash. Warren Buffett has $55 billion in cash, the most cash he’s ever had. So cash is definitely a place to be in deflation, and an allocation of 30 percent or so cash to me makes sense. In this environment, the value of cash does go up in deflation. It is a deflation hedge but has other features such as huge optionality. If you get some more visibility, you can pivot and use the cash to scoop up assets which no doubt is what Warren Buffett plans to do.
Also, think of it as the opposite of leverage. Leverage will increase the volatility of whatever else you have while cash will decrease the volatility of whatever else you have. In a volatile world cash will help you sleep at night, but it’s not my go-to inflation play. My go-to inflation play are U.S. Treasury 10-year notes. They’re still yielding with a maturity just under two. German yield to maturity is around zero. Well, something’s wrong there. Either Germany is too low or the U.S. is too high. Based on everything I see, I would say the U.S. is too high. We have to get to negative real rates to get the economy moving, but negative real rates are a world where inflation is higher than nominal rates. Nominal rate is the rate you actually get when you buy it, and the real rate is inflation minus the nominal rate. You have to get inflation above the nominal rate to get to a negative real rate.
What’s been happening is that inflation’s dropping, so the nominal rate has to chase inflation down to even try to get to a negative real rate. The way things are going it might just chase it below zero, but that’s already happened in Europe. It has not quite happened in the United States, but it is happening. This is a little geeky, but there’s something called the DV01 which is the dollar value one basis point change in the yield to maturity in terms of the impact on the price. The DV01 goes up at lower absolute levels of interest rates, so when you move from 2 percent to 1 percent, your capital gain is much greater than if you move from 10 percent to 9 percent. Moving from 10 percent to 9 percent is the same 100 basis point change in yield, but the capital gain at lower rates is much greater. Moving from 2 percent to 1 percent and 1 percent to 1.5 percent produces huge capital gains for the holder of 10-year notes. That’s what I see happening, so I like 10-year notes for a slice as my go-to trade for deflation.
Cash absolutely has a place, but let’s address the question about gold. Gold can do very well in deflation but only at the end game meaning when all else has failed. What do I mean by “all else”? You cut rates to zero, did QE1, QE2, QE3, Operation Twist, currency wars, forward guidance, and helicopter money. You tried everything, still didn’t get the inflation you want, and now you have persistent significant deflation of 3 or 4 percent, something on that order of magnitude. Well, you can always get inflation. I can get inflation in 15 minutes. All the Fed has to do is go into a room, take a vote, walk out 15 minutes later, and announce that the price of gold is $5,000 an ounce. They’ll use the gold in Fort Knox and the market maker banks to stand up to the market. They’re a buyer at 49.95, a seller at 50.50. Come and get it or sell us your gold, but either way, that’s the price.
That’s how you get instant inflation. It’s not hard to do. The United States did it in 1933. But you’re not going to get there until the end game. Now the problem is you can’t just put a stake in the ground around deflation. Inflation is an equal opportunity outcome with $4 trillion of money splashing around. We don’t have much inflation now but that could happen almost overnight. We’ve seen that before obviously in Weimar Germany. Something similar but not quite as extreme started to happen in the United States in the late ’70s until Paul Volcker snuffed it out.
To me, the optimal portfolio is ready for both outcomes. You’re going to have some gold for inflation, you’re going to have some gold for extreme deflation, you’re going to have some cash for lower volatility and deflation, and you’re going to have some 10-year notes for deflation. I might like some other trades, some venture capital or hedge fund selections, fine art, some other things for alpha. Just don’t be monocausal and put all your eggs in one basket. That’s obvious but it’s never been more important than today where the threats to the basket are coming from multiple directions. I do think this mix of gold, cash, 10-year notes, some alternatives, some fine art, and some equities is the right way to go. One of the surprise outcomes could be that the Fed is going to blink later this year, probably September, and not only not raise rates but maybe even drop a hint or two and show a little leg around QE4 early next year.
If that happens, the stock market’s going to scream and go way up really quickly. On the other hand, if the Fed actually raises rates, which they’ve threatened to do ad nauseam, that’s going to sink the stock market. I can give you two really completely plausible scenarios. Under one scenario, they raise rates and sink the stock market. Under the other scenario, they blink and the stock market goes to the moon.
So how do you invest in that environment? Both of those scenarios are plausible. That’s not me throwing up my hands and saying I don’t know what’s going to happen. That’s me telling you that those are equally plausible outcomes. Well, you better be ready for both.
AS: That’s very good. We still have a ton of questions, and some of these are really great. I wish we could respond to them, but we’re out of time. With that said, thank you very much, Jim, and thanks to all our listeners. I’m going to hand this back over to Jon.
JW: Thank you, Alex. Let me remind our listeners that you can follow Alex Stanczyk on Twitter by going to Twitter and typing in Alex Stanczyk. Great insights and valuable links to follow there. Thank you also, Jim Rickards. It’s always a pleasure and an education having you with us. And thank you most of all to our listeners.
You can also follow Jim on Twitter. His handle is @jamesgrickards. Let me remind you that you can find recordings of all of The Gold Chronicles webinars with Jim Rickards online. Just visit the website Physical Gold Fund Podcasts and register for updates. Goodbye for now everyone, and we look forward to joining you again soon.
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