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Sprott Precious metals watch
January 2017
During 2016, gold markets shook off three consecutive years of price weakness. Spot gold posted an 8.56% annual increase,
rising from $1,061.42 to $1,152.27. Gold equities were among the best performing global assets, with the Sprott Gold Miners
ETF (SGDM) rising 48.19% and the Sprott Junior Gold Miners ETF (SGDJ) surging 68.25%. By way of context, the S&P 500 Index
posted 2016 total return of 11.95%, with roughly 40% of the gain occurring in the seven weeks following the U.S. presidential
election. Despite strong relative performance during 2016, various gold sentiment measures registered year-end readings among
the lowest in three decades. In mid-December, the Bernstein Daily Sentiment Index actually tolled its lowest 21-day moving
average for bullish gold sentiment since inception of the index in 1987.
What accounts for the dispersion between gold’s 2016 market-leading performance and year-end bearish sentiment? As is
frequently the case in the gold sector, short-term sentiment is generally more reflective of recent price action than underlying
fundamentals. After consolidating sharp first-half gains during the third quarter (in constructive sideways fashion), gold and gold
equities suffered meaningful corrections in Q4. We attribute gold’s fourth quarter weakness to a combination of three factors,
each of which we view as temporary. First, the Fed’s second rate hike in the current tightening “cycle” has unleashed a new
round of forecasts for multiple rate increases in each of the next several years. Of course, this will be the eighth straight year of
consensus confidence in Fed tightening, a record so far unblemished by success. Second, the Trump victory has unleashed powerful
expression of latent longing for normalcy in business and economic conditions. While we are sympathetic to the frustrations of
consumers and business leaders from the distortions of eight years of QE and ZIRP, we suspect recent sentiment highs will soon
be tested by harsh realities of excessive debt levels and legacy malinvestment. And third, gold’s inability to sustain sharp first-half
gains has reignited debate as to whether 2016 strength was merely a bear-market rally. In our view, fourth quarter weakness
amounted to fairly textbook retesting of gold’s January 2016 breakout from a three-year downtrend.
If our analysis is correct, the investment opportunities afforded by gold’s fourth quarter correction are compelling,
and, in our view, likely to prove short-lived. We recognize that bullion’s inherent volatility makes an investment in gold
notoriously difficult to “time.” When gold is appreciating rapidly, it is natural for investors to feel an entry point may have been
missed. Conversely, because gold corrections can be sharp and swift, investors can find buying dips a bit daunting. Finally, during
occasional instances when gold trades flat for an extended period, investment urgency can be lost. In our experience, the most
logical juncture for a significant commitment to gold is immediately following a bull-market correction. As long as underlying
fundamentals remain intact, such corrections can help harness gold’s volatility within favorable risk/reward parameters, especially
over the short run.
At Sprott, we do not view ourselves as gold bugs. To us, a gold bug is a congenital pessimist who sees risk behind every corner and
who has become closed-minded to the possibility that good things can occur in the world, even in uncertain times. We recognize
that gold’s relative investment merits can shift over time. Still, we believe strongly that careful and honest appraisal of economic,
financial and monetary variables can identify certain periods during which gold serves an invaluable role as portfolio-diversifying
asset. In this report, we hope to establish beyond reasonable doubt that the current investment landscape is among the most
supportive of the gold investment thesis we have ever witnessed. We have organized our report in three sections. In the first two
sections, we present brief reviews of our investment case for gold and 2016 developments in gold markets (frequent readers may
skip). In the body of our report, we present our outlook for gold’s prospects in 2017 and beyond.
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January 2017
Gold Investment Thesis
In our fifteen years following gold markets, we have learned gold is an asset without peer in terms of the sheer number of
investment cues governing its day-to-day trading. Some perceive gold as an inflation hedge, others as a deflation hedge. Many
view gold as the ultimate “risk off” asset, and just as many view gold as a suitable “risk on” trade. During times of financialmarket stress, some view gold as an appropriate resting place for accumulated wealth, but others still favor the U.S. dollar’s safeharbor profile (which can pressure gold prices through the dollar’s traditionally inverse relationship).
We find it puzzling that, in an environment of compressed returns in traditional asset classes, institutional investors continue
to eschew gold’s market-leading returns. As shown in Figure 1, gold has generated annual returns, denominated in the world’s
prominent fiat currencies, which are more consistently positive than any major global asset of which we are aware. After twelve
consecutive years of advance and a 515.38% gain through 2012, gold corrected 36.65% through 2015. Gold appears to have
resumed its upward bias during 2016, rising 29.59% to an intraday high of $1,375.45 on 7/6/16, before closing the year with an
8.56% gain. Gold’s compound annual return during the past 16 years now stands at 9.44%, roughly 75% higher than the 5.37%
compounded total-return of the S&P 500 Index. There have been decades such as the 1980’s and 1990’s during which relevant
market fundamentals did not logically support a portfolio allocation to gold. And then there have been periods such as the past
16 years during which gold has provided unparalleled protection of portfolio purchasing power parity.
Figure 1: Annual Performance of Spot Gold in Nine Global Currencies (2001-2016)
US Dollar
Euro
Yuan
Rupee
Yen
Pound
CAD
AUD
CHF
Average
2001
2.46%
8.13%
2.45%
5.90%
17.62%
5.25%
8.65%
11.80%
5.32%
7.51%
2002
24.78%
5.76%
24.78%
24.08%
12.64%
12.67%
23.48%
13.85%
3.87%
16.21%
2003
19.37%
-0.21%
19.36%
13.52%
8.04%
7.80%
-1.81%
-11.22%
7.32%
6.91%
2004
5.54%
-2.19%
5.54%
0.54%
0.66%
-1.76%
-2.19%
1.40%
-3.10%
0.49%
2005
17.92%
35.09%
14.98%
22.23%
35.70%
31.44%
14.06%
25.84%
35.97%
25.91%
2006
23.16%
10.51%
19.11%
21.00%
24.32%
8.17%
23.46%
14.61%
14.24%
17.62%
2007
30.98%
18.46%
22.46%
16.64%
22.96%
29.28%
11.40%
17.77%
21.96%
21.32%
2008
5.78%
10.55%
-1.07%
30.62%
-14.10%
43.89%
29.91%
31.59%
-4.90%
14.70%
2009
24.37%
21.09%
24.40%
18.88%
27.38%
12.25%
7.90%
-2.39%
20.40%
17.14%
2010
29.52%
38.88%
25.02%
24.45%
12.75%
34.15%
21.95%
13.66%
16.91%
24.14%
2011
10.06%
13.51%
5.22%
30.74%
4.35%
10.65%
12.53%
9.81%
10.63%
11.94%
2012
7.14%
5.22%
6.04%
10.54%
20.84%
2.31%
4.86%
5.82%
4.39%
7.46%
2013
-28.04%
-31.13%
-30.15%
-18.76%
-12.42%
-29.45%
-23.13%
-16.30%
-30.09%
-24.39%
2014
-1.72%
11.99%
0.79%
0.45%
11.81%
4.48%
7.40%
7.44%
9.92%
5.84%
2015
-10.42%
-0.25%
-6.38%
-6.16%
-10.15%
-5.27%
6.65%
0.33%
-9.90%
-4.62%
2016
8.56%
11.85%
16.13%
11.42%
5.35%
29.57%
5.60%
9.66%
10.46%
12.07%
Source: Bloomberg.
Since 2000, gold has logged strong positive performance in individual years marked by a wide array of financial market conditions.
Along the way, every popular variable to which some portion of consensus attributes strong gold correlation has oscillated
repeatedly, yet gold has advanced in the vast majority of years. We believe gold’s dogged performance belies an investment theme
more overarching in scope than kneejerk motivations commonly attributed to gold investors in the financial press. Our unifying
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January 2017
theme for gold’s advance since 2000 rests on our perceptions of an ongoing migration, at the margin, of a modest portion of
accumulated global wealth from traditional asset classes to a resting place safely outside the vagaries of an increasingly stretched
financial system. In most years since 2000, capital migration from the financial asset pile (roughly $290 trillion today) to the
available gold stock (roughly $2.5 trillion) may have averaged, say, one-tenth-of-one-percent. In years such as 2007 and 2010, the
rate of capital migration may have accelerated somewhat, and in years such as 2013 and 2015, the rate of migration may have
reversed in favor of financial assets.
Our investment thesis for gold does not involve financial Armageddon, Weimar Republic inflation or a collapse of the U.S. dollar.
Our thesis is that inevitable resolution of epic monetary and financial imbalances will accelerate the rate of capital migration
from global financial assets towards gold and other precious assets in precipitous fashion. Given the comparatively tiny stock of
investable gold, we expect gold’s price to stabilize at significantly higher prices.
The motivating fundamental which powers our gold investment thesis is the decoupling of financial assets (claims on future
output) from underlying output itself (GDP). In essence, the United States economy suffers a debilitating structural debt problem.
We present in Figure 2, the single most representative chart in understanding rationale for a portfolio allocation to gold: the
ratio of total U.S. credit market debt (Fed’s Z.1 Report) to GDP. Despite popular perceptions of deleveraging in recent years, the
ratio today rests at what we regard as an absurd level of 352%, roughly double the high-end of historical experience outside the
Great Depression and the Greenspan/Bernanke/Yellen era. In our view, to balance the U.S. financial system and return to healthy
economic growth, some $20 trillion of outstanding U.S. credit will need to be rationalized through default or debasement. We
believe economic events of the past fifteen years strongly support our contention that an $18.7 trillion dollar economy cannot
support total outstanding credit of $65.7 trillion without annual nonfinancial credit growth on the order of $2-$3 trillion. At least
since 2009, whenever the U.S. economy has been unable to generate nonfinancial credit growth on this order of magnitude, the
Fed has felt compelled to “bridge the gap” with equivalent rates of liquidity-creation through the auspices of QE asset purchases.
Figure 2: Total U.S. Credit Market Debt as % of GDP (1916-Q3 2016)
Source: Fed Z.1 Report BEA.
To us, variables such as individual U.S. economic statistics no longer hold much relevance to the gold investment thesis. By way
of illustration, with $65.7 trillion in outstanding U.S. credit atop U.S. GDP of $18.7 trillion, no rate of GDP growth can possibly
rebalance the U.S. economy in organic fashion. Even eight straight quarters of 10% GDP growth would increase GDP only to
$22.6 trillion, an amount of output no more capable of supporting $65.7 trillion in debt than GDP of $18.7 trillion. And, of course,
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if ratios of the past 15 years were to hold form, such GDP growth would require creation of at least $15 trillion in additional
credit. In an economy this out of balance, is there really much importance to parsing the difference between 2.5% GDP and 3.5%
GDP? Because the ratios of debt (and equity) claims on U.S. GDP only continue to deteriorate, the rationale for gold ownership
only continues to strengthen.
2016 In Review
With respect to gold markets, 2016 was clearly a year of two halves. Through the summer months, the gold complex achieved
scorching returns. During Q1, spot gold logged its strongest quarterly advance in 30 years, climbing 16.13%. After consolidating
these gains through May, bullion then carved out another five-week rally to its 7/6/16 intra-day high of $1,375.45, up 29.59%
year-to-date. Gold equities responded to bullion strength with trademark verve, posting through mid-August by far the strongest
year-to-date performance of any global asset. Through 8/11/16, the Sprott Gold Miners ETF (SGDM) had erupted to a 128.52%
gain, and the Sprott Junior Gold Miners ETF (SGDJ) had advanced 148.83%. By way of context, through 8/11/16, the S&P 500
Index had achieved a total return of 8.40%, and the DXY Dollar Index had declined only 2.81% (from 98.631 to 95.857). Perhaps
the investment variable most telling about gold’s first-half gains were 10-year Treasury yields, which collapsed 31.29% year-todate through 8/11/16 (from 2.2694% to 1.5593%).
Gold’s first half strength was primarily driven by downward recalibration in investor expectations for global rate structures. We
have long maintained that global central banks will remain powerless to raise short rates until such time as elevated global debt
levels are permitted to rationalize (default). The Fed’s early 2016 performance lent credence to our views. After hiking rates in
December 2015 and telegraphing four additional hikes during 2016, Fed stewards were forced to backtrack within weeks. The
flare-up in financial-stress measures during January, coupled with the surprise adoption of negative deposit rates by the BOJ on
1/29/16, forced Fed vice-Chairmen Dudley and Fischer to public pronouncements in early February that global conditions might
not be supportive of further tightening. The 2016 poster boy for fickle Fed forecasts was St. Louis Fed President James Bullard, who
as late as 3/24/16 was still proclaiming, “You could probably make a case for moving in April [2016],” but by 6/17/16 had become
so chagrined with deteriorating economic visibility that he felt one additional rate hike might suffice through December 2017.
A central macroeconomic theme of first-half 2016 was the methodical march of global sovereign yields into negative territory. With
the Fed’s 2016 QE activities limited to maintaining its balance sheet at $4.5 trillion (requiring monthly purchases of $48 billion
worth of MBS and Treasuries), the stimulus baton had been passed largely to the BOE, BOJ and ECB (purchasing $185 billion
worth of securities each month during 2016). The Fed’s overseas counterparts added a new element to the monetary concoction
known as policy: negative deposit rates at the central bank for financial institutions (BOJ -0.1%, SNB -0.75% and ECB ultimately
-0.4%). Given the relatively limited supply of eligible bonds available for purchase by these CB’s, global sovereign yields began
an inexorable downward migration, reaching spasmodic climax following the 6/23/16 Brexit vote. By mid-July, even mainstream
media seemed troubled that the universe of negative-yielding sovereign bonds exceeded $13 trillion. By this point, the sovereign
curve of France was negative out nine years, of Germany and Japan out 15 years, and of Switzerland out 30 years. Even Fed
Chairman Janet Yellen was discussing the legality of negative fed-funds rates in Humphrey Hawkins testimony!
However, a new development appeared on the global financial stage during 2016. Investors took pause with the negative rate
argument, and central bankers seemed to lose their uncanny ability to channel the inflation they conjured directly into financial
assets. After a one-day weakening, the yen strengthened 15% versus the U.S. dollar in the five months following the adoption of
negative rates by the BOJ. Similarly, the ECB’s bag of stimulus tricks, unveiled on 3/10/16 (more negative ECB deposit rates and
expanded monthly QE), weakened the euro for only a matter of hours before it spurted to a 7.5% gain versus the U.S. dollar in a
two-month span.
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By the Fall, recovering financial markets indicated Brexit fears had been a bit trumped-up. The Fed began its annual telegraphing
of a December rate hike and sovereign rate structures appeared to be in the process of carving out lows. Upticks in global PMI’s,
combined with first returns for U.S. Q3 GDP in the 3% range, rekindled congenital optimism in equity markets. And then came
Trump! Between election night and year-end, broad equity indices roughly doubled their year-to-date gains. The DXY Dollar
Index rallied 8.1% from its election night low (95.885) to a 12/20/16 high of 103.65. Bond vigilantes became so enamored with
prospects for growth and inflation, 10-year Treasury yields exploded 53.9% from an election night low of 1.7145% to a 12/15
high of 2.6394%. Not surprisingly, gold markets were jolted by such spontaneous ebullience for global growth. From an election
night high of $1,337.51, spot gold retreated 13.84% to a year-end close of $1,152.27. The question at hand is whether
gold’s Q4 correction was the end of a strong 2016 run, or a healthy retest of early-2016 breakouts which will
empower gold to new highs in 2017.
Gold’s Prospects in 2017 and Beyond
Trumponomics
Over the long run, we believe the gold investment thesis rests squarely on monetary, economic and financial imbalances which
continue to be resolved to the measurable benefit of investors choosing to denominate a portion of their wealth in assets which
can neither default nor be debased. Over the short run (one-to-two years), gold’s performance can be impacted by consensus
views on a wide array of market variables. We would highlight five such variables as motivating the lion’s share of trading patterns
in gold markets: Fed policy, the U.S. dollar, 10-year Treasury yields, U.S. economic performance and U.S. equity risk premiums.
It is unusual for any single event to impart significant impact on all five of these variables simultaneously. The Trump election
has certainly proven to be such an event! Trump’s victory has unleashed one of the strongest expressions of business and
financial optimism in history, starkly affecting variables central to gold’s short-term trading patterns. While optimism is never
a bad thing, we suspect financial markets are reflecting classic emotional blow-off. Investors, admittedly parched for a more
normalized economic world unfettered by QE and ZIRP, have, in our view, temporarily lost sight of immutable realities such as
debt, valuation, debasement and mathematics. Should our suspicions bear out that reigning euphoria proves short-lived, recent
market dislocations will provide excellent entry points for a wide array of investment assets. Given our confidence in underlying
fundamentals relevant to precious-metals, we view the Q4 back-up in gold markets as a rare opportunity to achieve a significantly
discounted entry point in gold’s unfolding advance.
Figure 3: NFIB Small Business Optimism Index
(1975-2016)
Source: NFIB, Zero Hedge.
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While Trump’s ascendency has invigorated most sentiment-measures related to investment markets, no measure has experienced
such historic levitation as the NFIB Small Business Optimism Index. As shown in Figure 3, this NFIB measure has posted a twomonth surge exceeding any period since the election of President Reagan. Indeed, Reagan comparisons are all the rage on
Wall Street these days. The problem with these comparisons, however, is that the current investment landscape bears very little
resemblance to conditions in place when Reagan took office. In the Reagan experience, interest rates (20%) and inflation (13%)
were sky-high and had scope to fall; the U.S. economy had been in deep recession and had scope for cyclical recovery; the ratio of
federal-debt-to-GDP was 35% and had scope to expand; and savings rates were high, providing the seed-corn for future capital
formation. President-elect Trump, on the other hand, is inheriting eight years of ZIRP and deflation-minded CB asset purchases;
below-trend inflation; a U.S. economic expansion already in its seventh year; a federal-debt-to-GDP ratio of 100%; and a net
national savings rate near zero for over a decade. No matter what mix of growth initiatives Trump finally chooses to pursue, the
resources and flexibility at his disposal are vastly more constricted than those available to President Regan.
Our friends at Cornerstone Macro have conducted exhaustive research on presidential cycles since 1980, and their conclusions
are decidedly pessimistic for President-elect Trump’s first year in office. Their work demonstrates that, without exception, U.S.
economic performance during the first year of any Presidency has far more to do with economic cycles already in place than with
policy initiative undertaken by the incoming administration. By far, the single most telling variable is whether financial conditions
are tightening or easing when the new President takes office. The administrations of Presidents Obama, Bush Jr., and Clinton
enjoyed smooth sailing during the first years of their terms because financial easing was already “in the pipeline” when they were
elected. In contrast, because financial tightening was already in the pipeline when Presidents Bush Sr. and Reagan took office,
the first two years of those presidencies were marked by poor economic performance and declining stock markets. In the Reagan
experience especially, people seem to forget that the S&P 500 Index traced out a 23.94% decline from inauguration day (1/20/81)
through its 8/9/82 low.
As Trump takes office, financial conditions are clearly tightening. The Fed has just hiked the fed funds rate for the second time,
10-year Treasury yields are at two-year highs, mortgage rates have exploded 75 basis points in three months, oil has just doubled
from February 2016 lows, the U.S. dollar is trading at the highest level in over 13 years, dollar funding costs are soaring (cross
currency basis swaps) and bank lending standards are tightening. At the risk of appearing downbeat, we would suggest that no
collection of pro-growth policies, from any incoming administration, would be able to power through such a phalanx of tightening
financial conditions.
Figure 4: 5-Year Annualized Forward-Looking GDP Growth (1985-2006)
Source: Cornerstone Macro.
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Having studied the campaign of President-elect Trump, we have been intrigued by the prospect for true change in U.S. business
conditions with respect to regulation, taxation and governmental accountability. However, the fact remains that President-elect
Trump’s two most central campaign platforms, tax-cuts and fiscal spending, have achieved checkered performance histories in
altering established economic cycles. As shown in Figure 4, neither tax increases of Presidents Bush Sr. and Clinton, nor tax-cuts
of President Bush Jr., redirected prevalent business-cycle trends for several years. Further, the Trump camp’s tax-cut paradigm does
not include such short-term growth boosters as stimulus checks to individuals or retroactive enactment.
On the corporate side of the ledger, history also demonstrates that tax-cuts rarely outweigh the more relevant variable of capacity
utilization in influencing corporate behavior. As shown in Figure 5, the recently reaccelerating decline in U.S. capacity-utilization
rates (byproduct of legacy malinvestment and ZIRP-nurtured zombie credit) suggests any excess corporate cash flows generated
by tax-cuts and foreign cash repatriation are more likely to be directed towards stock repurchase and dividends than to growthsupportive capex.
Figure 5: NFIB Capex Plans (3-mos. mov. avg.) Versus U.S. Capacity Utilization (advanced 2-years) (1976-Present)
Source: NFIB, Federal Reserve, Cornerstone Macro.
Our conclusion about the Trump phenomenon is that investor sentiment and expectations may be peaking just as growth
encounters the significant headwinds of tightening financial conditions. This dichotomy foreshadows prospects for significant
investor disappointment in the weeks and months ahead. Nowhere is this volatile set-up more evident than in U.S. equity markets.
Despite high historical readings versus long established valuation methodologies, it has been a fool’s errand to handicap where,
when or why the current run in the S&P 500 Index may finally peak. Along the way, the one variable which has been missing from
a traditional market-top scenario has been excessively bullish sentiment. Since 2009 lows, the market has truly climbed a never
ending wall of worry. The Trump bump, however, has vaulted sentiment of equity-market participants to an altitude generally
coincident with important market tops. To site but one example, the Investors Intelligence poll registered 60.2% bullish during the
week of January 2, its sixth consecutive week over the traditional danger zone of 55%.
Populism
No discussion of the Trump phenomenon would be complete without addressing the ascension of populist political movements.
While populist leaders such as Greece’s Alexis Tsipras (Syriza) and France’s Marine Le Pen (National Front) have garnered attention
in recent years, the subtle implication in western media has been that European populists are like spoiled teenagers who don’t
really understand how the world works – they are to be tolerated but not taken seriously. Then, in the space of five months,
the United Kingdom and the United States were rattled to their respective cores by completely unforeseen
national populist victories.
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Figure 6: Time Magazine Covers
(8/22/16; 10/24/16 & 12/7/16)
Source: Time Inc.
We believe investors should be circumspect about post-Brexit and post-Trump investment analysis emanating from institutions
completely blindsided by these developments. Populism is all about rejection of status quo. Wall Street investment banks and
mainstream media are at the epicenter of status quo, and they will never foreshadow change which dilutes their sphere of
influence. We find the three Time magazine covers pictured in Figure 6, to be poignant metaphor for how out of touch U.S.
mainstream media has become. Further, we find the ease with which Wall Street has flip-flopped on the implications of a Trump
Presidency to be highly self-impeaching. Our concern is that in the rush to extrapolate positive investment implications from an
administration only recently perceived as anathema, Wall Street solons are glossing over the inconvenient truths powering the
Trump movement. Trump is President-elect because of chronic structural unemployment, debilitating economic bifurcation and
stagnant real incomes in the United States. Yet, the entire investment world is consumed with handicapping what will be Trump’s
first tax-cut, executive order or fiscal stimulus project. Is that really what is important for investors to consider? Perhaps investors
focused on Fed policy response to potential Trump stimulus should be more concerned with whether Fed elitism enabled the
Trump Presidency in the first place. Perhaps capricious decisions on the price of money, which enrich bankers and penalize savers
are finally being rejected by the U.S. collective. We are not suggesting Steve Mnuchin is about to abolish the Fed. What we are
lampooning is the consensus conclusion that U.S. rates should rise because the animal spirits of a completely disenfranchised U.S.
electorate are about to power heady GDP increases in an economy which has morphed to 70% consumption.
In our view, Trump is far less relevant as a political figure than as a symptom of deep-seeded economic and social problems in
the United States. We believe it a grave mistake to assume Trump’s ascendency will serve as magical palliative to the simmering
malcontent powering his election. The bottom line is that contrary to prevalent headlines, the U.S. economy has been mired in a
deep funk for over a decade. The last year in which the U.S. achieved real GDP growth of 3% was 2005. Government statistics do
not accurately reflect the declining standard of living experienced by most Americans. While President Obama pats himself on the
back for creating 14 million jobs during his Presidency, the BLS reports that “persons not in the labor force” rose to 95.1 million
Americans in December, a new all-time high. Professors Lawrence Katz (Harvard) and Alan Krueger (Princeton) estimate in their
9/13/16 treatise, “The Rise and Nature of Alternative Work Arrangements in the United States 1995-2015” (NBER https://krueger.
princeton.edu/sites/default/files/akrueger/files/katz_krueger_cws_-_march_29_20165.pdf), that fully 94% of net job growth in
the United States between 2005 and 2015 accrued from “alternative work arrangements – defined as temporary health agency
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workers, on-call workers, contract workers, and independent contractors and freelancers.” Trulia estimates that 40% of Americans
aged between 18 and 24 live with their parents, the highest percentage since 1940. The BLS reports that the number of Americans
reporting two jobs hit an all-time high in November 2016 (8,107,000).
Figure 7: Trailing 10-Year Percentage Change in Real U.S. GDP Per-Capita (1957-2015)
45
40
35
10-YR % Change
30
25
20
15
10
5
0
1957
1967
1977
1987
1997
2007
2015
Source: BEA.
Narayana Kocherlakota, ex-President of the Minneapolis Fed, summed things perfectly in a 10/04/16 Bloomberg editorial entitled,
“Why Americans Feel Poor, in One Chart.” The article’s featured graphic, reprinted as Figure 7, portrays 10-year trailing change in
U.S. GDP per-capita. President Kocherlakota interprets the importance of the graph in his own words:
In every year between 1966 and 1973, per-capita income was up between 30% and 40% from a decade earlier… In every
year from 1984 to 2007… per-person income was up between 20% and 30% from a decade earlier… Cumulative perperson growth from 2005 to 2015 was lower than in any prior decade in the sample. That certainly helps explain why
many Americans are unhappy with the nation’s recent economic performance.
We are optimistic that the U.S. economy’s inherent vibrancy will achieve great heights in future periods. Our sincere hope is that
a Trump administration will help reestablish conditions conducive to trademark American entrepreneurship and opportunities for
true capital formation. Given existing structural imbalances, however, we expect this process to be painstaking and marked by
significant disappointments. In our view, any reorganization to productive economic conditions will involve a great deal of pain in
many financial asset classes. Along the way, during this rationalization of financial asset valuations, gold will play an invaluable
role as portfolio-diversifying asset.
Can Long-Rates Rise?
We believe the greatest miscalculation in contemporary financial markets is the consensus view that interest rates can rise and the
U.S. dollar can strengthen without causing serious damage to the global financial system. We would argue that reigning global
debt levels now preclude even moderate rate-increases without catalyzing immediate upticks in relevant measures of financial
stress. With total U.S. non-financial credit now standing at $47 trillion, every 1% increase in market rates causes total interest
charges in the U.S. to soar $470 billion, or over 2.5% of GDP. Further, eight years of ZIRP have fostered duration dynamics in
institutional bond portfolios which leave them especially vulnerable to even modest upticks in rate structures. Goldman Sachs
(Charles Himmelberg) suggests each 100-basis-point interest-rate increase would translate to roughly a $1 trillion principal loss
to the Barclay’s U.S. Aggregate Bond Index ($19.1 trillion market cap). These potential losses highlight the tightrope now facing
corporate and government pensions grappling with trillions-of-dollars-worth of funding shortfalls – while an increase in interest
rates would help sponsors meet elevated return assumptions, it will also decimate the value of fixed-income portfolio assets.
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As shown in Figure 8, 10-year Treasury yields have marked ever-lower cyclical highs for the past 35 years. There is certainly more
than one way to interpret cause and correlation between the declining rate peaks in this graph and the ten highlighted crises
coincident with these peaks. Our synopsis would be that aggregate debt levels have become so burdensome that even modest
upticks in rates catalyze default episodes, in one economic sector or another, which in turn require even lower rates to ameliorate.
Importantly, each outbreak of credit stress exposes prior malinvestment. In our view, the financial system has hit the point at which
interest rates simply cannot rise until nonproductive debt is cleansed from the financial system.
Figure 8: U.S. 10-Year Treasury Yields (1971-Present)
Source: MacroMavens.
A significant distinction between our view and consensus is the considerable skepticism with which we view the creditworthiness
of outstanding credit in the United States. During the past eight years, Fed stewards have artificially depressed the entire U.S. rate
curve – on the short end through ZIRP and on the long end through $3.6 trillion in QE asset purchases. The stated intention of QE
programs was to lower long-term interest rates by inflating prices of the world’s two most important financial assets (Treasuries
and MBS). Because almost all financial assets are priced in some manner to these bulwarks, the Fed successfully suppressed
rate structures around the world and ignited the greatest global search for yield in financial history. Economic behavior, decision
making, tradeoffs and commitments have all been distorted by artificially suppressed interest rates. Especially given the extended
duration of Fed-imposed ZIRP, the global financial system has morphed into something totally different from that which existed
during “normal” rate structures. To assume the world can now readjust to normalized rates without years of painful rebalancing
is a remarkably naïve perspective. We expect significant amounts of U.S. credit to be exposed as uneconomic. Using our preferred
lens of historical U.S. debt-to-GDP relationships, at least $20 trillion of U.S. total-credit-market debt should succumb to the
inevitable rationalization process.
Interest rates, at their core, are the price of time preferences. In the production of any good, there is a cost for each input and a
cost for securing that input. In producing a car, inputs from all over the world must be secured, and it takes time to do so. In a
ZIRP world, chains of production can evolve which might not otherwise be profitable. In a ZIRP world, long-lead time and capital
intensive projects (i.e., an iron-ore mine) can be undertaken which might not otherwise be profitable. Global supply chains and
global trade have employed ever lengthening global value chains (GVC’s). After eight years of ZIRP, is it logical to assume the
global financial system can painlessly adapt to higher rates? We think not.
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Since 2007, global debt levels have only continued to expand. Total credit-market-debt in the United States has increased
$16.9 trillion since 2007 (and $2.9 trillion during the 12-months through Q3 2016). The balance sheets of the top five central
banks have expanded over $12 trillion since 2007. McKinsey & Company estimated in its infamous early 2015 report (“Debt
and not Much Deleveraging”) that global debt increased $57 trillion since 2007 to $199 trillion. On 1/4/17, the Institute for
International Finance estimated that global debt increased an additional $11 trillion during the first nine months of 2016 to
a new high of $217 trillion. We view accelerating rates of global credit-creation as proof positive that the world economy is in no
position to tolerate the tightening effects of rising rates.
Figure 9: Trailing 5-Month Percentage Change 10-Year Treasury Yields (1962-Present)
Source: MacroMavens.
Past instances in which 10-year Treasury yields have risen 50% against the backdrop of ebullient equity markets, such as 1999
and 1987, have ended in tears for equity investors who failed to take notice. Of course, in each of these prior episodes, the 50%
increase in Treasury yields took roughly six-months to unfold. In the current experience, yields backed-up 54% in just seven weeks!
As demonstrated in Figure 9, this yield surge already qualifies as the most dramatic tightening in over 50 years. Some will shrug
off this percentage jump because yields still remain at historically low levels. We think this is a critical miscalculation. We view
the backup in Treasury yields during the second half of 2016 as highly problematic for the U.S. economy, and we
do not expect these higher rates to stand. Indeed, the investment surprise of 2017 is likely to be a retreat of
Treasury yields back towards the lows of 2016.
Figure 10: Yr./Yr. Basis Point Change U.S. 10-Year Treasury Yields (1990-Present)
Source: Cornerstone Macro.
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One supporting aspect of our argument that Treasury yields will fail to maintain second-half 2016 increases is that our logic requires
no new information or speculative conclusions. To us, the body of economic evidence during the past 15 years is consistent with
our contention that debt levels in the U.S. are simply too elevated to tolerate rising interest rates. Cornerstone Macro suggests
that the tipping point to U.S. financial stress in the past quarter-century has been a year-over-year increase of 75 basis points in
10-year Treasury yields. In Figure 10, a simple plot of the trailing 12-month basis-point change in the 10-year Treasury reveals that
without exception, any year-over-year increase in excess of 75 basis points has led to significant financial stress. Should 10-year
Treasury yields remain at 2.5% through early April 2017, the 75 basis-point year-over-year barrier will be breeched, and by June,
the year-over-year increase will exceed 100 basis points. Quite simply, if rates do not recede from current levels, the long-overdue
process of U.S. debt rationalization will begin anew.
Figure 11: U.S. 10-Year Treasury Yield (Inverted, Advanced 6-mos.) versus NAHB Index (2009-Present)
Source: Cornerstone Macro.
Underlying our confidence that long-rates are headed lower from 2016 year-end highs, we site two critical transfer mechanisms
which are already flashing red for aggregate U.S. economic growth: housing and automobiles. With respect to housing, the linkage
between long-rates, homebuilder sentiment and economic growth is well-documented. As shown in Figure 11, the recent advance
in 10-year yields suggests slowdowns in both homebuilder sentiment and housing starts are “baked in the cake” for at least sixto-nine months.
The 3-month, 75 basis point leap in 30-year mortgage rates through 1/6/17 adds roughly 10% to the mortgage payment on
the average U.S. house. With affordability already stretched in recent years, housing turnover and price momentum look to have
peaked. As shown in Figure 12, mortgage applications have already started to recede.
Figure 12: MBA Mortgage Applications (2001-Present) and MBA Mortgage Refi Index (2005-Present)
Source: Mortgage Bankers Association, Zero Hedge.
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With respect to second-derivative impacts of rising mortgage rates, we highlight in Figure 12, that cash-out refi’s have collapsed
all the way to Lehman lows. Refi’s and HELOC’s seem like yesterday’s news – the days of home-equity withdrawal are long gone,
right? Truth be told, the importance of cash-out refi’s in subsidizing retail-sales growth has exploded during the past two years. As
shown in Figure 13, the percentage of annual retail-sales growth financed by cash-out refi’s and credit-card borrowing averaged
roughly one-third between 2012 and 2014. Then, during 2015, fully 100% of retail-sales growth was bankrolled, at the margin,
by refi’s and plastic. In 2016, this percentage is set to exceed 102%! Given the fact that the refi spigot may have just closed, we
would expect retail sales to remain lackluster throughout 2017. Along these lines, the Commerce Department reported on 1/13/17
that December U.S. retail sales (ex-autos and ex-gas) were statistically flat at 0.0% (versus consensus expectations for a 0.4%
increase), the second worst December reading since 2008.
Figure 13: Cash-out Refi’s, Credit-Card Borrowing and Retail Sales Growth (2012-2016E)
Cash out Refinancing Annual $
Credit Card Borrowing Annual $
Retail Sales Annual $
2012
64.6
5
224
2013
59.2
11
187
2014
42.3
30
193
2015
65.9
46
112
2016 est.
$70.6
$59b
$126b
Source: Freddie Mac, Federal Reserve. MacroMavens.
A striking example of the degree to which U.S. economic growth now relies on unfettered credit-creation is the domestic automobile
industry. Given the second and third derivative effects on employment and GDP of auto manufacturing, impacts on the U.S.
economy are huge. From the depths of 2009, the annual rate of U.S. auto sales has now roughly doubled, from nine million units
to just over 18 million units. This recovery appears impressive, until one examines the degree to which this growth has been fueled
by reckless credit-creation. Indeed, as MacroMavens illustrates in Figure 14, it has required a 34% increase in outstanding auto
credit just to return annual auto sales to their pre-crisis levels. In a Kabuki opera eerily reminiscent of 2007 Miami condos, autofinancing terms have trended towards borderline ludicrous. Experian reports that 30.7% of new-auto loans originated during Q3
2016 featured repayment periods of 73 to 84 months.
Figure 14: Annual U.S. Automobile Sales versus Aggregate U.S. Automobile Credit Outstanding (1994-Present)
Source: MacroMavens.
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Obviously, seven-year car loans raise the prospect of “upside-down” automobiles. We outlined in our November report that 25%
of all vehicles being traded in for used-car purchases in the U.S. in Q3 2016 involved rollover of negative equity from the trade-in
car averaging $3,635. Since then we learned that negative-equity baggage is even more prevalent in the new-car market. Edmunds
reports that fully 32% of trade-in vehicles in new-car loans (originated in the U.S. in Q3 2016) involved rollover of negative equity
from the trade-in car averaging $4,832! With the average new car priced at $33,000 during the quarter, this means that initial
principal balances for these new-car buyers amounted to 115% of the new car’s value. Only in America! Of course, with a 7-year
loan available at a 2% interest rate, what’s another 15% added to principal to amortize? Not only is it apparent the automobile
cycle is breathing its last tortured gasps, but it is also a pretty good bet that the recent backup in interest rates will play havoc
with the latest financing innovation of “hot potato” negative trade-in equity.
Can the Fed Hike Rates?
We view Fed prognostication for three FOMC rate hikes in each of the next three years with the same bemusement we have
viewed similar projections in each of the past eight years. As shown in Figure 15, the Fed’s annual “dot plot” rate projections have
become utterly risible. We wonder why consensus continues to pay notice to Fed rate forecasts. They have been so wrong for so
long, isn’t it obvious the Fed feels they cannot raise rates? We attribute the cognitive dissonance in consensus acceptance of Fed
rate forecasts to the intoxicating power of successive weekly highs in the S&P 500 Index. As long as stocks hit new highs, who
cares if the Fed can’t raise rates. It’s all good!
Figure 15: Fed Estimates for Future Fed Funds Rates (Dot Plot Midpoints 2013-Present)
Source: Deutsche Bank.
We continue to search for any aspect of economic, monetary and financial conditions which may have changed substantively
enough to permit the Fed to raise rates when they have felt powerless to do so in recent years. As shown in Figure 16, relevant
economic measures in the U.S. remain today at levels below those at which the Fed felt compelled to launch QE2 and QE3. Even
the lone metric showing relative improvement, the unemployment rate, appears a bit pyrrhic in the context of a new high in
Americans not in the work force (95.1 million) and a near 38-year low in labor-force participation rate (62.70%).
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Figure 16: Comparative Economic Statistics at Launch of QE1, QE2, QE3 and Today
Labor Partic.
Rate
Unemployment
Rate
Core PCE Deflator
yy
Retail Sales
yy
Nom GDP
yy
QE1 Launch Nov ‘08
65.9%
6.8%
1.7%
-9.7%
-1.0%
QE2 Launch Nov ‘10
64.6%
9.8%
1.0%
6.5%
4.6%
QE3 Launch Sep ‘12
63.6%
7.8%
1.7%
5.4%
4.5%
Today
62.7%
4.6%
1.6%
3.8%
2.9%
Source: MacroMavens.
On 1/12/17, St. Louis Fed President James Bullard augmented his reputation as the Fed’s maverick jawboner by becoming the
first FOMC member (though non-voter until 2019) to suggest that, now that the FOMC has undertaken two rate hikes, the Fed
“may be in a better position” to suspend its $48 billion worth of monthly asset purchases designed to replace maturing securities
and maintain the Fed’s balance sheet at $4.5 trillion. Given that consensus projected outright asset-sales from the Fed as early
as 2010, a decision to permit asset roll-offs some six years later is hardly an earth-shaking development in U.S. monetary policy.
We would caution, however, that the Fed’s balance sheet has come to play a critical role in maintaining sufficient global dollarliquidity (Triffin dilemma). It is our strong contention that the current Fed policy stance is already creating serious strains in global
dollar-liquidity (the Fed is already too tight). Significant dollar-funding shortages are popping up around the globe. Andy Lees
(MacroStrategy) calculates that through year-end, the dollar-value of global money supply had fallen $3.2 trillion from its 9/30
peak ($77.938 trillion), a -15.70% three-month annualized rate of decline. We are fairly certain the Fed will need to address this
declining-global-liquidity trend in earnest before the first calendar quarter expires. Stay tuned.
Even domestically, we believe consensus fails to recognize the importance of the Fed’s balance sheet in supporting commercial
bank liquidity. As commercial banks have increased their lending since 2014, aggregate cash liquidity levels have fallen from their
2014 peak of roughly 20% to today’s level of 14.1%. As shown in Figure 17, while there is some room for the Fed to reduce
its balance sheet from current levels, completely removing the Fed’s balance sheet would be impossible, as it would reduce
commercial banks’ cash liquidity to negative 8.1% of total assets.
Figure 17: U.S. Commercial Bank Cash Liquidity (Measured as Percentage of Overall Assets) Excluding Fed Balance
Sheet (3/7/97-Present)
Source: MacroStrategy Partnership.
Can the U.S. dollar strengthen?
In our experience, no opinion clears out a room quicker than questioning the pedigree of the U.S. dollar. We find Western investors
remarkably closed-minded about the dollar’s reserve currency status. The dollar bug doctrine cites that no country can rival the
depth and liquidity of U.S. capital markets; that the dollar is the world’s least dirty shirt, and that no arrangement could possibly
replicate the dollar’s dominance of global affairs. While we are not suggesting the dollar’s role in global monetary affairs is about
to disappear anytime soon, we are quite certain that many of the world’s worst economic ills emanate directly from the dollarstandard system. We are sympathetic to the view that the U.S. dollar is facing late-stage, destabilizing, Triffin-dilemma quandaries.
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The Triffin dilemma was first posited by Belgian-American economist Robert Triffin in the early 1960’s. In impassioned testimony
to Congress, Mr. Triffin warned against the failure of Bretton Woods by arguing no single country can perpetually issue the reserve
currency for the world. Mr. Triffin’s elegantly simple logic was that fiat control of a global reserve currency by any one nation will
always lead to the currency’s over-issuance, overvaluation and eventual demise. In essence, external demand for the currency
necessitates that the host country run an ever expanding current account deficit to satisfy external currency demands. An inevitable
consequence of chronic capital account deficits will be overvaluation of the currency, leading in turn to eroding competitiveness
of the issuer’s domestic economy.
While Mr. Triffin’s analysis correctly foreshadowed the demise of Bretton Woods in 1971, his work is even more relevant to the
fate of the contemporary (floating exchange rate) dollar-standard system. While our views are decidedly non-consensus, our
confidence increases with each passing day that the Fed’s eight years of QE and ZIRP have only hastened the dollar’s demise as
hegemonic reserve currency. Global pressures linked to the issuance of $10 trillion in offshore dollar-denominated debt are now
so acute, the Fed will remain trapped in a near-zero rate environment until such time as this uneconomic obelisk of debt is allowed
to rationalize (default).
To those who might suggest that the U.S. economy is sufficiently strong, and the Fed’s mandate sufficiently narrow, for the Fed to
ignore overseas implications of FOMC rate hikes, we would cite in counterpoint the percolating monetary pressures now roiling
the Chinese economy. So much is written about China, we hesitate to labor a long narrative in this context. However, we wish
to highlight a critical change in focus by Chinese apparatchiks in recent months: it has become all about capital flows!
Recognizing that no country can simultaneously control domestic monetary policy, currency exchange rates and capital flows,
Chinese stewards are notably shifting their focus to the capital-controls side of the equation. It is just our speculation, but this
clear shift suggests to us that a change in policy may be on the horizon for one of the other two points on the monetary triangle.
Assuming the PBOC will always view control of domestic monetary policy as sacrosanct, it is logical to assume probabilities for an
exchange-rate recalibration are rising.
Our colleague and resident China expert, Seth Daniels (JKD Capital), has cobbled together a list of recent Chinese edicts designed
to stem capital outflows. Because we believe the full scope of Chinese efforts remains somewhat under consensus radar, we
summarize Seth’s list for general consideration. In the past month, Chinese officials have announced:
•requirements for all banks and financial institutions to report to the PBOC all domestic and overseas transactions of more
than 50,000 yuan ($7,201) versus 200,000 yuan previously,
•restrictions on the annual $50,000 F/X quota for Chinese nationals, including outright bans on overseas purchase of property,
securities or life insurance,
•vetting by State Administration of Foreign Exchange (SAFE) of corporate outbound transfers of $5 million or more, down from
$50 million previously,
•new limitations on Bank of China (China’s largest commercial bank) customer purchases of foreign currency to $1 million
versus no prior limits,
•restrictions on Macau ATM withdrawals and currency “imports,”
•steps to curb the ease of gold imports,
•prohibitions against banks issuing dual currency credit cards,
•restrictions on outbound corporate M&A and dividend remittances,
•restrictions on issuance of debit cards,
•restrictions on Bitcoin trading, and
•increased taxes on luxury car imports.
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While western consensus assigns the Fed little responsibility for China’s unfolding monetary challenges, we see the two as
inextricably linked. The Fed’s eight years of QE and ZIRP unleashed an historic search for yield leading to massive accumulation
of global F/X reserves. Indeed, global F/X reserves doubled in six years to their August 2014 peak of $12 trillion. We see it
as no coincidence that the explosion in global F/X reserves coincided precisely with the launch of QE1 and has now reversed
sharply, coinciding precisely with QE3’s final taper (Figure 18). While it has become de rigueur to chastise the Chinese for their
management of capital markets, little credit is given to China for its valiant defense in recent years of the renminbi peg to the U.S.
dollar. From the launch of QE1 through June 2014, Chinese foreign exchange reserves doubled to $4 trillion. We would suggest
$2 trillion in F/X reserve-growth was the tangible cost of Chinese efforts to cool hot money inflows during the QE era. Now that
the Fed is attempting to reverse eight years of unprecedented largesse, the immediate and reflexive consequence is spirited EM
outflows which are destabilizing global currency markets.
Figure 18: Total Global Foreign Exchange Reserves (4/4/2008-1/13/2017)
Source: Bloomberg.
It is one thing for us to suggest FOMC rate hikes are contributing to monetary turmoil in China, but quite another for Fed stewards
to ascribe to the same reasoning. On 1/6/16, just three weeks after the FOMC’s 12/16/15 rate hike, Fed Vice-Chairman Stanley
Fischer remarked, “If all China’s neighbors and other large parts of the world are negatively affected to a considerable extent by
China, then that would be an impact [on Fed policy]. The rest of the world matters to us.” After the Shanghai composite collapsed
28% in the five weeks following the Fed’s 12/16/15 rate hike, Fed Vice-Chairmen Fischer and Dudley took to the airwaves in the
first week of February to quell expectations for further 2016 rate hikes. Given the urgency with which Chinese officials are raising
the dikes on capital outflows in recent weeks, we would expect any further FOMC rate hikes to be met with strenuous Chinese
objection and reaction. In the meantime, China continues to dump Treasuries at an accelerated monthly clip ($41.3 billion in
October and $66.4 billion in November) and reduce its reliance on the dollar peg. On 12/29/16, the China Foreign Exchange Trade
System reported it had reduced the dollar’s weighting from 26.4% to 22.4% in the foreign-currency basket to which the yuan
is managed.
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Figure 19: Trailing Twelve-Month Long-Term Foreign Official U.S. Treasury Purchases (1992-November 2016)
Source: TIC Report, Meridian Macro.
While overseas impacts of Fed policy are most vividly portrayed in China, they are felt just as urgently across the globe. The world
has made no secret in recent years of growing resentment toward imbalances linked to dollar hegemony. As demonstrated in
Figure 19, the rush by global central banks to exit Treasuries, despite their vaunted yield-premiums to competing sovereigns,
continues to accelerate. Having watched the entirety of President-elect Trump’s 1/11/17 news conference, we are guessing global
interest in U.S. Treasuries is not about to skyrocket any time soon. With all due respect to published estimates for the 2016
U.S. federal budget deficit (roughly $600 billion), we would observe that the U.S. public debt on the last day of 2016 totaled
$19.977 trillion, an increase of some $1.054 trillion versus year-end 2015. To those projecting multiple Fed rate increases and
a declining Fed balance sheet in 2017, we would pose the question, exactly which buyers are going to plug the gap between
reaccelerating U.S. Treasury needs and declining foreign interest therein? As shown in Figure 20, that trailing 12-month gap
already measures roughly $1 trillion. Given Trump (campaign) promises for increased fiscal spending, tax cuts, import tariffs
and border walls, we would rate 2017 probabilities for additional Fed Treasury purchases as significantly higher than those for
additional FOMC rate hikes.
Figure 20: Trailing Twelve Month U.S. Treasury Issuance Versus Net Foreign Purchases (1990-Present)
Source: U.S. Treasury, TIC Report, MacroMavens.
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2017 Outlook
A seminal characteristic of the 2017 investment landscape is limited visibility. Given the unprecedented scale of monetary stimulus
during the past decade, now clashing with the unpredictable nature of populist sentiment, it is fair to say no one has any idea
how financial markets will perform during the next twelve months. Stating that the future is uncertain is hardly a novel maxim, but
in this instance, we seek to emphasize that the range of potential investment outcomes has never been wider. Because so many
market variables are registering such elevated readings, and because market plumbing is now measured in milliseconds, it seems
inevitable that volatility will be a prominent market feature during the coming year.
During the past three months, market sentiment has shifted on fundamentals dominating short-term trading in gold markets.
Consensus views have gravitated towards further Fed tightening, rising Treasury yields and a strengthening U.S. dollar. In the body
of this report, we have outlined our reasoning as to why each of these assumptions may be short-sighted. In our view, cumulative
and immutable imbalances (debt levels, valuations, dollar liquidity) will soon test recent sentiment shifts, we expect decidedly in
gold’s favor. While we are not stocking canned goods, oiling muskets, or bottling water, we are suggesting that a modest portfolio
allocation to gold has never been more prudent.
A consistent theme at investment conferences during 2016 has been the compression of investment returns. Especially in the
pension and endowment world, very few institutions are achieving chartered rates of return. While institutions might have
expected historically to achieve real rates of return of 5% on equities and 2 ½% on bonds, the realities of achieved returns during
the past several years are tracking (at the high end) roughly half these historical levels. We believe the root cause for compressed
returns is far simpler than much of the sophisticated quantitative analysis we have encountered. The United States has a structural
debt problem, and the Fed has employed ZIRP for eight years to forestall rationalization of this untenable debt load. As every
student of economics is aware, marginal returns gravitate towards marginal costs. The longer the U.S. economy operates in a
ZIRP environment, the closer to zero will migrate the sum-profit-total of U.S. economic agents. Recognizing this, the Fed has
telegraphed for years a desire to normalize rate structures. Consensus has recognized the Fed’s poor track record in achieving rate
normalization but, in our view, has failed to grasp the true impediment to higher rates. It is not popular to suggest U.S. debt levels
cannot sustain higher rates, but we believe these are the root facts.
During the past decade, global productivity has collapsed to its lowest level in the modern financial era. Optimists shrug off these
statistics as outdated and unreflective of vast productivity enhancements enabled by the internet, I-Phones and social media. We
cite this example (which we will develop further in our February report) as a metaphor for a broader condition in global asset
markets. Most investors sense that there are looming risks in financial markets and troubling impediments to healthy global
growth. Yet, the relentless performance of the S&P 500 Index has reinforced the inclination to ignore these nagging concerns. In
the institutional arena, excessive bearishness or even adoption of defensive and hedged strategies can handicap performance
and introduce career risk. To us, an allocation to gold is a powerful tool to help insulate portfolios from potential dislocations in a
complicated financial world. In essence, a gold allocation can provide a bit of cheap insurance to any ongoing investment program.
We continue to marvel at gold’s lack of sponsorship in the institutional arena. During the past hundred years, even a modest
portfolio commitment to gold has been proven to push total portfolio returns further to the right along return frontiers for any
reasonable asset mix, generating equal returns with less risk and standard deviation, or superior returns with equivalent risk
and standard deviation, versus identical portfolios without a gold investment component (World Gold Council). During the past
16 years, gold’s non-correlated and market-leading returns have provided invaluable portfolio alpha in an increasingly challenging
investment environment. During the next several years, mounting monetary, economic and financial imbalances, which appear to
be approaching important tipping points, suggest gold is a portfolio-diversifying asset worthy of serious consideration.
We view corrections in gold markets during the fourth quarter of 2016 as fairly standard retests of early 2016 breakouts from
established downtrends. To us, underlying fundamentals suggest significantly higher gold prices during the next several years.
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While we view the investment merits of gold equities as substantially different from those of gold bullion, we expect the shares
of high-quality gold miners to provide significant portfolio leverage to any advance in the gold complex in future periods. Given
inherent volatility, we are loath ever to cite specific targets or forecasts for future performance in the gold sector. On the other
hand, we have for the past 15 years dedicated our firm’s resources to exhaustive analysis of underlying fundamentals and future
prospects for gold and gold shares. We feel we have developed strong and informed perspective on valuations in the preciousmetal space.
Figure 21: NYSE ARCA Gold Miners Index (June 2000-Present)
10 months
THIRD
UPLEG
18 months
Correction
Phase 1
Correction
Phase 2
+103%
FIRST
UPLEG
Correction
Phase 3
b//
b//
c//
a//
-32% DROP
+210%
Index Value
15 months
+134%
SECOND
UPLEG
1,000
High = 1,553
Abs = +760%
Annz = +34%
b//
55% Retracement of
THIRD UPLEG
c//
a//
-33% Drop
c//
62% Retracement of
SECOND UPLEG
a//
-38% DROP
Low = 181
b// = Recovery Bounce Average : +44%
08
n-
Ju
7
08
b-
Fe
07
t-0
n-
Oc
Ju
6
07
b-
Fe
06
t-0
n-
Oc
Ju
5
06
b-
Fe
05
t-0
n-
Oc
Ju
4
05
b-
Fe
04
t-0
n-
Oc
Ju
3
04
b-
Fe
03
t-0
n-
Oc
Ju
2
03
b-
Fe
02
t-0
n-
Oc
Ju
1
02
b-
Fe
t-0
n-
01
c// = Last Downleg Avg: -30%
Oc
Ju
0
01
t-0
b-
Oc
Fe
00
n-
a// = First Downleg Average: -34%
SECULAR LOW
5 Yr Bear Market
-80% Decline
100
Ju
Corrections typically occur in a 3 wave pattern: “a-b-c”
55%Retracement of
FIRST UPLEG
Vertical axis uses a logarithmic scale.
Source: Bloomberg, Sprott Asset Management.
Along these lines, our study of past performance cycles suggests that the Q4 2016 pullback in gold equities is largely consistent
with historical patterns. After a sharp initial leg of advance during the 2000-2008 cycle, for example, gold equities suffered an
initial correction on the order of 38%, which demoralized gold investors and emboldened non-participants. Interestingly, the recent
pullback in the NYSE Arca Gold Miners Index from its 8/10/16 high close of 870.28 to its 12/16/16 low close of 529.09 measured
39.20%. While past performance is never a predictor of future results, we document in Figure 21, the strong performance of
gold equities subsequent to their second-half 2002 correction. With underlying fundamentals even more supportive in 2017, it is
anyone’s guess what the future holds.
At Sprott we have developed a suite of best-in-class products in all segments of the precious-metal space. From our passive
Physical Bullion Trusts through our actively managed Global Gold partnerships, we believe Sprott vehicles are the most innovative,
investor-friendly and best performing offerings in the marketplace. We welcome the opportunity to visit with all Sprott clients in
coming weeks to review their allocations to precious metals during 2017.
We are enthusiastic about gold’s prospects and we look forward to hearing from you.
Sincerely,
Trey Reik
Senior Portfolio Manager
Sprott Asset Management USA, Inc.
20/22
Sprott Precious metals watch
January 2017
Metal Prices
METAL
GOLD
SILVER
Platinum
Palladium
CLOSE
$1,204.15
$17.06
$963.53
$748.88
1 WEEK
1.1%
1.9%
-0.9%
-0.9%
YTD
4.5%
7.2%
6.6%
10.0%
1 YEAR
10.6%
22.2%
17.4%
51.3%
Source: Bloomberg. Prices as at January 18, 2017.
Sprott Physical Bullion Trusts
The goal of the Sprott Physical Gold Trust, Sprott Physical Silver Trust and Sprott Physical Platinum and Palladium Trust
(“the Trusts”) is to provide a secure, convenient and exchange-traded investment alternative for investors who want to hold
physical bullion. The Trusts offer a number of compelling advantages over traditional exchange-traded bullion funds.
Secure • Convenient • Cost Effective • Potential Tax Advantage for U.S. Investors
Sprott Physical
Gold Trust
NYSE ARCA: PHYS
Price
NAV
Premium/
Discount to NAV
TSX: PHY.U.CA
Price
Sprott Physical
Platinum and
Palladium Trust
Sprott Physical
Silver Trust
9.88
$9.90
-0.17%
$9.89
NYSE ARCA: PSLV
Price
NAV
Premium/
Discount to NAV
TSX: PHS.U.CA
Price
$6.50
$6.49
0.30%
$6.52
NYSE ARCA: SPPP
Price
NAV
Premium/
Discount to NAV
$7.52
$7.62
-1.44%
TSX: PPT.U.CA
Price
Total Ounces Held
1,780,586
Total Ounces Held
55,659,095
Total Ounces Held
Total NAV of Trust
$2,146,518,862
Total NAV of Trust
$951,815,325
Total NAV of Trust
$7.54
42,077 Pt
96,032 Pd
$112,535,146
Figures as at January 18, 2017.
To learn more about the Sprott Physical Trusts,
visit www.sprottphysicalbullion.com or contact us at [email protected].
21/22
About Sprott
Sprott Asset Management LP is a leading independent asset management company
headquartered in Toronto, Canada. The company manages the Sprott family of mutual funds,
hedge funds, physical bullion funds and specialty products and is dedicated to achieving superior
returns for its investors over the long term.
For more information, please visit www.sprott.com
Individual Investors
TF 877.403.2310 | E [email protected]
Financial Advisors
Sergio Lujan
TF 888.622.1813 | E [email protected]
Institutional Investors
Jalaj Antani
Vice President, Institutional Sales
T 416.943.8091 | TF 877.874.0899 | E [email protected]
www.sprott.com
This article may not be reproduced in any form, or referred to in any other publication, without acknowledgement that it was produced
by Sprott Asset Management LP and a reference to www.sprott.com. The opinions, estimates and projections (“information”) contained within this
report are solely those of Sprott Asset Management LP (“SAM LP”) and are subject to change without notice. SAM LP makes every effort to ensure that the
information has been derived from sources believed to be reliable and accurate. However, SAM LP assumes no responsibility for any losses or damages, whether
direct or indirect, which arise out of the use of this information. SAM LP is not under any obligation to update or keep current the information contained herein.
The information should not be regarded by recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your
particular circumstances. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading
intent of any investment funds managed by Sprott Asset Management LP. These views are not to be considered as investment advice nor should they be considered
a recommendation to buy or sell. SAM LP and/or its affiliates may collectively beneficially own/control 1% or more of any class of the equity securities of the
issuers mentioned in this report. SAM LP and/or its affiliates may hold short position in any class of the equity securities of the issuers mentioned in this report.
During the preceding 12 months, SAM LP and/or its affiliates may have received remuneration other than normal course investment advisory or trade execution
services from the issuers mentioned in this report.
22/22
0117029 01/17_SAM_ART_SPMW_E
The risks associated with investing in a Trust depend on the securities and assets in which the Trust invests, based upon the Trust’s particular objectives. There
is no assurance that any Trust will achieve its investment objective, and its net asset value, yield and investment return will fluctuate from time to time with
market conditions. There is no guarantee that the full amount of your original investment in a Trust will be returned to you. The Trusts are not insured by the
Canada Deposit Insurance Corporation or any other government deposit insurer. Please read a Trust’s prospectus before investing.
The information contained herein does not constitute an offer or solicitation to anyone in the United States or in any other jurisdiction in which such an offer
or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in
Canada should contact their financial advisor to determine whether securities of the Funds may be lawfully sold in their jurisdiction.
The information provided is general in nature and is provided with the understanding that it may not be relied upon as, nor considered to be, the rendering
or tax, legal, accounting or professional advice. Readers should consult with their own accountants and/or lawyers for advice on the specific circumstances
before taking any action.
Sprott Asset Management LP is the investment manager to the Sprott Physical Bullion Trusts (the “Trusts”). Important information about the Trusts, including
the investment objectives and strategies, purchase options, applicable management fees, and expenses, is contained in the prospectus. Please read the
document carefully before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. This
communication does not constitute an offer to sell or solicitation to purchase securities of the Trusts.