When markets go bump in the night

When markets go bump in the night

Part 1

"Gold has worked down from Alexander's time. . .When something holds good for two thousand years, I do not believe it can be so because of prejudice or mistaken theory." – Bernard Baruch

We should not be surprised that the long-standing troubles at Deutsche Bank would appear to be coming to a head now. For global financial centers, October is often the cruellest month – a time when stock markets and whole economies have been known to go bump in the night. The Panic of 1907, the Crash of '29, Black Monday 1987, the Friday the 13th crash 1989, the Asia Crisis of 1997, the downturn of 2002 and the launch to bear market in 2007 – all took place in the month of October.

Deutsche Bank's train wreck is being compared to the Lehman Brothers meltdown in 2008 as an event that could derail other international banks both in Europe and across the pond in the United States. "In our opinion," says Nikolaos Panigirtoglou, JP Morgan market strategist, "it is not so much funding issues but rather derivatives exposures that are more likely to trouble markets going forward if Deutsche Bank concerns continue. This is especially true if these concerns propagate into a confidence crisis inducing more rapid unwinding of derivative contracts." This past June, the International Monetary Fund issued a report citing Deutsche as "the most important net contributor to systemic risks" followed by HSBC and Credit Suisse.

Similarly, a recent report from the United Nations Conference on Trade and Development (UNCTAD) warns that "There remains a risk of deflationary spirals in which capital flight, currency devaluations and collapsing asset prices would stymie growth and shrink government revenues. As capital begins to flow out, there is now a real danger of entering a third phase of the financial crisis which began in the US housing market in late 2007 before spreading to the European bond market." [Emphasis added.]

Gold firmly established its reputation as a hedge against disinflation and related systemic bank risks in the aftermath of the "Lehman moment" in 2008. An important component of gold's rally this year has been capital flight from the global financial system pushed by the low-to-negative interest rate environment and the potential for resulting instability in the global banking sector. That flight to safety is likely to be compounded if the potential matures to major banks being pushed against the ropes. Deutsche Bank in this respect could be the first in a series of titanic financial sector disasters, much like what happened in 2008-2009.

As we ponder whether or not a third leg of the financial crisis might be upon us, we should recall that in the wake of the Lehman Brothers bankruptcy gold more than doubled in value over the ensuing three year period. As was the case with Lehman Brothers in 2008, the public discussion on Deutsche Bank earlier this month immediately went to whether or not it would be bailed out by the German government, Bundesbank or the ECB. Of course, in Lehman's case the answer was "no" and many believe that witholding the bailout launched the 2008 financial crisis.

At first blush, European authorities including the German government rejected the idea of a bailout, though few believe that notion would prevail if push came to shove. The fact of the matter is that even if Europe would concede to a bailout, it would not necessarily reverse the negative effects on markets. Stocks dropped precipitously in the wake of the 2007-2008 crisis and gold ultimately ran to all-time highs despite the U.S. federal government's bailout measures.

Note also the initial gut-check drop from the $1000 mark early in the crisis. Gold dropped as major players were forced to liquidate paper gold holdings to cover losses in other parts of their trading books. At the time, the mantra for gold and silver was "buy the dips." Many did just that and learned first-hand how gold acquired the safe haven reputation referenced by Mr. Baruch at the top of the page during a financial crisis launched on another October morning back in 1929.

(Please see Part 2 below – "Too big to fail or too big to bail")

Russia to add 200 tonnes of gold in 2016

Russia, the third largest gold producer, will add another 200 tonnes of the precious metal to its national reserves this year according to Anton Navoi of the Russian central bank. "The central bank is buying gold because it is profitable. We are a country that is third in the world in terms of gold production, and we have the ability to buy it using our national currency, in contrast to other countries, which do not have such an opportunity." This thinking parallels similar tactics with respect to gold in China, the largest producer of gold in the world. So it is that the first and third largest producers both channel most or all of their production. In China's case, all of its production (492 metric tonnes, 2015) remains within its borders. In Russia's case, 200 tonnes of its 242 tonne production (2015) remains within its borders.

We post a table of world gold production by country annually (See below) at the USAGOLD website. In the twelve years our survey covers, China more than doubled its gold mine production and rose to the top slot, while South Africa cut its production in half and fell from first to seventh. The United States and Australia held steady in and around the two and three slots over the eleven year period until 2014 when the United States slipped to the number four slot. Russia climbed from number seven in 2006 to number three in 2014. Also noteworthy, Russian in-ground reserves went from 5000 tonnes in 2014 to 8,000 tonnes in 2015.

Gold ETF volumes on the rise, silver at all-time highs

October is not only the month when markets have been known to go bump in the night, it is also marks the start of the annual gold buying season. Sift through the annual gold demand reports issued by the World Gold Council and you will see that it is an outlier when the period October through March does not produce the highest demand and that includes for investment purposes.

As reported in last month's issue (and it is worth repeating for our newer readers), many among Wall Street's best and brightest have already registered grave concern that the bubble on Wall Street is about to burst. The includes Bill Gross (Janus Funds), Carl Icahn (Icahn Enterprises), Paul Singer (Elliot Management), Robert Schiller (Yale University), Russ Kostereich (Black Rock), Ray Dalio (Bridgewater Associates), Jeff Gundlach (Doubleline Capital), Jim Cramer (CNBC), David Stockman (former Budget Director), Stanley Druckenmiller (Duquesne Capital) and Jacob Rothschild (RIT Partners) – just to name a few. Many in this group are gold owners primarily through ETFs, most big fund managers go-to venue.

The charts below quantify the current inventory at the major ETFs – a long list of some 40 funds that store gold and silver in physical form. The Gold Ounces Held chart shows that we are surprisingly not far from the roughly 10.5 million ounce high of 2013. The rebound happened quickly. The more interesting chart, though, is the one on silver total ounces held – 938 million ounces and running at all-time highs – an indication of institutional interest in gold's traveling companion.

Just after the 2008 financial crisis, investors began to accumulate silver for much the same reason that they buy gold, i.e., as a vehicle for long-term asset preservation. Our volumes at USAGOLD in silver began to rise accordingly. Many view silver as having more upside potential than gold – an analysis that seems to be reflected in the charts.

The seven ages of gold

"The Seven Ages of Gold," says the Official Monetary and Institutions Forum, "contains detailed statistics plotting long-run changes in central banks’ policies on buying and selling gold over seven distinct periods during the past two centuries, each lasting an average of around 30 years. The latest ‘Rebuilding’ Period VII has been underway since the financial crisis in 2008. In these eight years, central banks in both developed and developing countries have shown a new fondness for the yellow metal, rebuilding gold’s importance as a bedrock of most countries’ foreign reserves."

There are three components to the change in central bank activity in the gold market. The first is actual purchases in the open market. China is the primary participant but others, like Mexico and India have been players. The second is the nationalizing of internal production. China, the leading producer, and Russia, the third largest producer, both channel mine production into national reserves. The third is the abstinence from sales and leases. Once a major contributor to the supply, central banks no longer offer metal for these operations in any significant volume. All three components have an important impact on the supply available for ordinary purposes in the private sector like jewelry, investment, etc. Eventually, these trends will affect prices when you consider the second part to this equation, i.e. production has levelled out and there has not been a new discovery of any significance for a very long time.

Part 2
Too big to fail or too big to bail

According to Financial Times, a significant portion of the Deutsche's assets is based on prices that are "not observable" – in other words, on assets that have not been properly marked-to-market because there is no price input data to value them. Kevin Dowd, a professor of finance and economics at Durham University, says this means there is "huge uncertainty about the value of its capital." FT goes on to state that "investors are in the dark on the big questions, such as the level of "counterparty risk" attached to the bank's derivatives' positions.

Fortune's Geoffrey Smith put it bluntly: "Deutsche is frighteningly indispensable. It’s a counterparty to virtually every major bank in the world, in virtually all asset classes." One cannot be certain what that really means. Does that make the bank too big to fail or too big to save? Then there is the prospect of bail-ins as opposed to bail-outs in which case bank bond holders and even depositors could be tapped for the rescue operation. That possibility, by itself, might be enough to ignite an old-fashioned bank run in the weeks ahead.

As hedge funds began to move capital out of Deutsche Bank in late September, many saw the exodus as a sign that confidence in the bank was beginning to slip to new low levels. “The issue here is now one of confidence,” Chris Wheeler, a financial analyst with Atlantic Equities LLP in London, told Bloomberg. “That’s what’s going on here. The thinking is ‘Deutsche Bank is fine, but there’s a slim chance it might not be, so why leave my money in there?’” In other words, things might not be "just fine" and the chance for another Lehman Brothers-style event is probably more than just "slim."

Bloomberg reports a gross derivatives exposure for Deutsche Bank of €46 trillion and €41 billion after netting and collateral. The €41 billion exposure represents about 20% of the bank's €215 billion in capital reserves, and that of course assumes that its derivatives positions are not marked-to-myth. Financial Times' Martin Wolf describes Deutshe Bank as more an investment bank cut in the mold of a Goldman Sachs than a retail commercial bank. "All banks are weak," says Wolfe, "but some banks are weaker than others. This is the chief lesson of the market turmoil surrounding Deutsche Bank."

For current and would-be gold owners, there is an additional concern: Banks like Deutsche, because of the interlocking counter-party risks, can create serious problems in the commercial banking sector even though they might not be, in the strictest sense, a "commercial bank." That is something which with governments and central banks will need to wrestle if and when the time comes. As Deutsche's collapsing stock price is telling us, this is not some small matter. In the meanwhile, the risks to the global banking system are deep-rooted, even implacable, and worth hedging if you happen to be a conservative investor. In addition, Deutsche Bank is one of several potential hot spots in the banking sector. The next black swan could come unannounced from some other bank or financial institution not even on the radar screen at present.

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FINAL NOTE
An enlightened minority

"For all its problems, the current dollar-based non-system has been far more resilient than the Bretton Woods gold-exchange standard, which never operated as White* intended. And the real alternatives — a classical gold standard, in which interest rates are driven by cross-border gold flows; or a supranational currency, like Keynes advocated at Bretton Woods — are likely to remain too radical politically. We are, therefore, almost surely stuck in a fiat dollar world for some time to come." – Benn Steil, Council of Foreign Relations

Long-time readers of this newsletter will recall previous articles on Benn Steil's gold advocacy.  Steil sees gold being utilized in years to come as a reserve asset to offset the risks associated with central banks holding national currencies, rather than it being used as direct backing for the dollar.  In turn, his thinking is closely allied with that of Nobel Prize winner, Robert Mundell, who recommended the European Union use gold as a reserve component in structuring the euro.

The same logic applies to individual investors. As long as fiat money (money that is not backed by gold) is the coin of the realm, individual investors would be best served by putting themselves on the gold standard. Such a course of action would make you part of an enlightened minority that understands the true nature of fiat money and the true value of gold ownership. Fiat currency is subject to the economic and monetary policies of the nation state issuing it. Gold is not. Gold, therefore, is the natural hedge against state-sponsored currency debasement. It is the "long time to come" part of Steil's statement that should be taken to heart.

*Harry Dexter White (1892-1948), American economist and senior Treasury Department official, considered the chief architect of the Bretton Woods Agreement (1944)