John Embry: Die Was Cast Before Elections
Source: Karen Roche and Brian Sylvester of The Gold Report 11/10/2010
Regardless of who's controlling the U.S. Congress, Sprott Asset Management Chief Investment Strategist John Embry holds out little hope for economic happiness in the short run. As he tells The Gold Report in this exclusive interview, "It's consequence time" and "any opportunity to have a pleasant outcome. . .in the relatively near term is long gone." John's view of equity markets is equally dim as he foresees the U.S. plowing deeper into quantitative easing to postpone—and maybe even exacerbate—the inevitable. An exception, at least for the time being, may be in senior gold stocks, which he says, "have seldom been cheaper in relation to the price of gold."
The Gold Report: The last time we spoke, you said you'd gone long on precious metals and short on housing, banking etc., as you'd become more certain of your viewpoint. You said, "Everybody is being told things are fine and that the economy will return to normal and growth will continue"—an underlying assumption you called "dead wrong." If that assumption is dead wrong, why are equities markets generally increasing and what should we expect from equities and gold markets going forward?
John Embry: I think the equity markets are reflecting the enormous amount of liquidity being injected into the market, particularly in the U.S. There's no question that POMO (permanent open market operations) are going on continuously—to the extent that Goldman Sachs has identified the days they're happening and recommending people buy equities those days—and they're having an outsized impact on the market. This does not reflect the underlying economics whatsoever.
We're very concerned about what might happen to equities because we continue to believe our view on the economy is playing out and that the U.S. economy has no real forward thrust. I don't think equities are all that interesting now, particularly at the level to which they've been elevated due to these various market interventions.
The authorities wanted to make things look better going into the November elections. Maybe now, there will be less pressure to inflate things to such an extent and they will focus more on reality than elections. Now that we're through the elections, it's almost like the roadrunner off the cliff. The feet are going fast, but look out below.
TGR: Do you anticipate poor economic data will be released after the elections?
JE: I think the spin will be less positive. I am a great believer in John Williams' ShadowStats. His numbers are much closer to reality, but those the public sees don't look as bad as they really are. I think that perception will change. More people will start paying attention, see that things aren't as good as they think and realize we could get into a reasonably unpleasant period.
TGR: How do you feel about gold?
JE: We continue to like gold very much. All this talk about bubbles and overbought is interesting in that sentiment is actually quite lousy. Interest in the market amongst the hoi polloi is very limited. I don't see a lot of enthusiasm toward gold at this point, which is a precursor to better markets. So, we like gold; we don't like equities so much.
TGR: Ultimately, will the U.S. economy be affected by either Republicans or Democrats controlling the Senate?
JE: In the long term, maybe; in the short-term, no. In the short run, I think the die is cast. They realize how serious the problem is, and that the Fed is in control and will likely continue down this path of quantitative easing (QE). That will be the defining thing in the short run.
In the long run, I think the conservatives on the Republican side—certainly the Tea Partiers—may have an impact along the lines of what's going down in England now. What the Conservatives are doing in the UK is quite remarkable; really Draconian. It will be an interesting test case to see how this works out.
TGR: Wouldn't you say they did the same thing in Greece?
JE: Yes; but so far, the English are putting up with it; the Greek, French, etc., are already starting to rebel. It will be fascinating to see how Americans will respond to that sort of activity.
TGR: Given the power of the American consumer, could something that drastic happen in the U.S. without tanking the economy?
JE: No. I am absolutely positive on that point. If the U.S. took a really hard stance on dealing with the budget deficit, the implications would be horrific for the economy. I think it would set off a depression that would make the '30s look good.
TGR: When you say, "the die is cast," are you referring to QE as the proposed solution to counter that?
JE: Unquestionably. The government is going to take the path of least resistance in the short run. Do I believe this is a solution in the long run? No. It just postpones the inevitable and, conceivably, makes it worse. But that doesn't mean the Fed won't opt for QE in the short run; it's certainly indicated it will go that direction.
TGR: The Draconian cuts would push the U.S. into a greater depression; and, at the other extreme with QE, we don't know quite the magnitude. Is there no middle ground?
JE: No. This is where I differ from many analysts and pundits; I think the middle ground was lost years ago. Any opportunity for a pleasant near-term outcome is long gone. Americans can take the pain now or something verging on hyperinflation and greater pain later. So, pick your poison. If I were emperor, I'd take the pain now.
TGR: Is it a foregone conclusion that inflation or hyperinflation would lead back into a depression? Will we end up in the same place regardless?
JE: I think we do end up in the same place. There's no example in history that unbridled money creation works to solve any problems; in fact, it usually exacerbates them. I'm not sure it's going to be any different this time because I believe today's financial structure is probably more vulnerable than it's ever been in history. I don't want to get into derivatives and all these various collateralized debt vehicles, but the fact is we've never seen anything like this before. If you try to deflate, that would come to the fore immediately; if you inflate, that just creates a bigger problem later.
So, I'm kind of stuck; I can't see a more positive outcome. I am a great believer in the Austrian School of Economics, and with a hugely excessive debt buildup in the economic system, there's no escaping the consequences. We've had the biggest debt buildup in history, and here we are in consequence time.
TGR: I think everybody agrees about consequence time; it's a matter of the degree of pain.
JE: If you went the tough route initially, you'd go through a lot of pain but you'd probably come out the other end sooner and save your currency. Now, if you go the unlimited QE route—or, as my friend Jim Sinclair puts it, "quantitative easing to infinity"—the currency will be destroyed. When that happens, you unleash an immense amount of inflation in your system; and, in that situation, people lose all their rudders. There's nothing to hang onto when your money's value is destroyed. I worry about social unrest; but in the end, you've got to clean the system out anyway.
TGR: That's why you're bullish on gold.
JE: That's why I am extraordinarily bullish on gold. Either way, gold will be all right because it's a tangible asset—a hard asset that's existed through centuries. The hardest point to get across is that gold isn't what's changing. Gold is gold. It's been around for thousands of years, recognized as money by most societies. What's changing is the current paper-money experiment.
Without exception, paper money is always devalued in the end and always ends up worthless. We've got a long way to go, but we're definitely en route to that ultimate conclusion. So, it's not gold that's changing; it's the value of the paper money in which gold is valued; that's why the price of gold is going up.
TGR: When you say, "we have a long way to go," what kind of timeframe are you thinking about?
JE: It's hard to put an exact timeframe on it, but I think the direction will become more evident in the next year and a lot more people will become acutely aware of the extent of the problem. Only a small minority of people realize the risk at this point. But once it starts, I use Weimar Germany after WWI as a guidepost. That experience lasted about three to three and a half years from beginning to end. We're now at the beginning, so I think it will take at least that long.
TGR: But that was one country. If the world's reserve currency loses all value, it will impact many more countries.
JE: Yes, that's why the G20 finance ministers and central bank governors got together in South Korea on October 23 in advance of the G20 Summit there, which I think will solve absolutely nothing. Many other countries are extremely unhappy with the route the U.S. is taking and they'd probably share my opinion and say, "Get your house in order now rather than taking the rest of us down with you."
TGR: But you say the die is cast and that this currency, the U.S. dollar will go down.
JE: It appears inevitable to me and that feeling is reinforced by the Fed's statements that it will indulge in some form of QE. Goldman Sachs Chief Economist Jan Hatzius said it needs $4 trillion worth of asset purchases to get this thing turned. That number is astounding—and he knows more about it than I do.
QE to infinity is a flawed concept because the more the Fed does it, the less interest other countries will have in buying U.S. paper. As a result, it'll need more QE. Once you get on the slippery slope, it moves quickly. That's why I think it's a horrible policy; but every indication tells us this is the route the Fed has chosen.
TGR: Countries that hold large amounts of U.S. currency are putting on the pressure against QE. Will they have any influence on this policy? If so, what will happen?
JE: There are only two outcomes possible: 1.) Debase the money to the extent that it lessens the impact of existing debt so it can be maintained; or 2.) Default on some portion of it (i.e., the Argentine route).
TGR: Your hedge fund focuses on a fair amount of precious metals assets as one way of protecting yourself regardless of which scenario plays out.
JE: Yes, we have a considerable amount in both gold and silver bullion, plus shares in both commodities.
TGR: Everyone agrees that gold is money but opinions on silver vary, including the idea that it's an industrial metal and monetary asset. What makes you want to invest in silver?
JE: Quite frankly, silver is a better story than gold—and I love gold. We'll see evidence of the expression, "silver is poor man's gold," come into effect shortly. More people are looking at silver as a store of value, and not buying it just to convert into jewelry or for medical and industrial uses. More people are starting to hoard silver bars and coins.
The silver market differs from the gold market in two ways: 1.) Central banks still have a fair amount of gold in their vaults, though not as much as they'd have you believe (and there isn't a lot of silver inventory because the central banks have accumulated none to speak of); and 2.) Silver differs from gold in that the vast majority of newly mined silver is being consumed for medical and industrial uses, jewelry, etc., and not much is left over for investment demand. There's been a deficit for many years. As far as we can determine, aboveground inventories are being reduced down to almost nothing. So if people want to invest in both gold and silver, it's going to have an outsized impact on the silver price.
TGR: Are you saying the price of silver will outpace that of gold?
JE: Without question. I virtually guarantee the silver price, on a percentage basis, will outperform the gold price by a considerable amount. That's not to denigrate gold at all, because I think it will outperform virtually everything else.
TGR: In the October Investor's Digest, you said, "I firmly believe the primary reason Western central banks hold any gold today is for purposes of manipulation." If the government can manipulate the gold price, why are you so excited about gold?
JE: That's an excellent question. It's because they're running out of ammo. We'll know for sure when that time comes because the gold price will go up $100 in one day. I believe these banks don't have a fraction of what they purport to have because they have been lending, leasing and swapping it surreptitiously for years rather than selling it outright. Their gold has gotten into the markets through the back door, not through any overt policies that made it easy for the public to discern what they were doing. The vast majority of what has been leased or swapped will not be retrieved and, as a result, they're close to reaching the limit where they don't want to part with what's left.
The theory is that Western central banks own 30,000 tons of gold give or take. If they have a third of that, I'd be surprised. Many of them are starting to realize the error of their ways now. But their ability to influence the gold price is rapidly coming to an end. They're being pressured dramatically by the Eastern central banks that have made no bones about diversifying out of paper into gold. As far as I'm concerned, the Western banks already look extraordinarily stupid for what they've done; and they'll look even more stupid if they continue in this vein. I don't think they will. There's no better example than what's happened under the European Central Bank Agreement, where they were able to sell up to 500 tons of gold a year and after meeting their quota year after year, they slowed down dramatically in 2009 and stopped in 2010. They sold nothing, which indicates either they don't have it or have lost any appetite for selling it.
TGR: So, do the holders of that physical gold get all of the price appreciation or do the governments get some of it?
JE: No. When it gets loaned, particularly in a financial transaction, it goes to a bullion bank that sells it into the market; and the gold migrates to the Middle and Far East where the wealth is being created. It's gone, and the central banks counterparties can replace it only by going into the market and buying it from existing mining production or whatever inventory is available. But to do that would drive the price to the moon. I think a lot of these loans will be forgiven in the end.
TGR: In the Investor's Digest, you mentioned the IMF sale to Bangladesh. Obviously, the IMF is bearish on gold if it's selling that much, and people like Paul Walker with GFMS are also quite bearish on gold.
JE: To be fair, Walker's been wrong the whole way up.
TGR: But how do you respond to those who look at your argument and say, "No, the supply/demand fundamentals say this."
JE: Well, I think they hang that on two things. They say investment demand is transient, which means that paper money is going to regain its luster and people will want to hold it. That would require interest rates that give people a real return, though; and I can't see that happening in, say, the next two–three years. So the idea that investment demand is going to evaporate is preposterous. I would argue the other way. I think it will accelerate because, to this day, it's still the purview of only a limited number of investors. So, I think the demand side of their argument is dead wrong.
Conversely, on the supply side, I think two issues are debatable. For one thing, they seem to think there will be an unlimited mine supply of gold. Gold is a precious metal because it's hard to find, and most of the new stuff being found is around existing mines. Very few greenfields are being discovered. At the same time, existing mines—particularly the open pits—are being depleted at an alarming rate. So, I don't see any threat from higher mine supply over the next five years.
TGR: What's the other debatable issue?
JE: Scrap. This one is a little bit more controversial because if the gold price gets high enough, people might sell even more jewelry and anything else from which they can recover gold. But we see a lot of that today—all of these TV ads with jewelers screaming, "Sell us your gold, yak, yak, yak." Then they rip them off. I think people are wising up to that; so I don't see scrap—which is not that huge a factor to begin with—rising so dramatically it will have any significant impact on the overall supply/demand equation.
Over the last 15 years, central banks have pumped a lot of gold into the market and they've likely reached the end of their rope in that activity while Eastern central banks are becoming buyers. Rather than supply 1,000–2,000 tons a year into the market, the central banks will be taking gold out of the market. With everything else going on—namely more investment demand and no new mine supply—the supply/demand equation becomes enormously positive. The only way it can be balanced is dramatically higher prices. So, I don't see a negative aspect on supply and demand.
TGR: Point taken. But is there any way they could be right?
JE: They could be right if, suddenly, the world magically rights itself and the economy starts to grow with no inflation. I don't think that's going to happen.
John Embry is chief investment strategist at Sprott Asset Management and Sprott Gold and Precious Minerals Fund. He also co-chairs the Central GoldTrust Board of Trustees. An industry expert in precious metals, John's industry experience as a portfolio management specialist spans more than 45 years; he has simultaneously researched the gold sector for 30-plus of those years. He joined Sprott in 2003, after 15 years as vice-president of equities at RBC Global Investment.
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