Kabuki Dance of the Black Swans
Ed Coyne talks with Sprott’s John Hathaway about gold, the Fed’s next moves, the U.S. dollar, the debt ceiling and a flock of black swans.
Ed Coyne: Hello and welcome to Sprott Radio. I'm your host, Ed Coyne, Senior Managing Partner at Sprott. With me today is one of our returning guests, John Hathaway, Managing Partner and Senior Portfolio Manager at Sprott. John, once again, thank you for joining Sprott Radio.
John Hathaway: My pleasure.
Ed Coyne: John, before we dive into your most recent Gold Report titled Connecting a Few Dots, I thought the listeners would enjoy your view and comments in a recap of what happened in 2022. Can you spend a few minutes talking about last year before we dive into this year?
John Hathaway: Sure. I thought last year was going to be a great year, and it was for the first half. Then the Fed started to get really highly verbal about crushing inflation, raising interest rates, and so from mid-year 2022 basically into the end of the third quarter, gold took it on the chin. This narrative of the Fed hiking rates and a strong U.S. dollar translated into a weak gold price.
John Hathaway: Just off the top of my head, I think from mid-June until the end of the third quarter, gold traded down from the mid-$1,900s to 1,600, where it made, in my mind, a very important bottom. Since then, it's rallied into the end of the year to end up flat. This is a year in which other safe havens — bonds would be the prime example — had one of the worst years in post-war history.
John Hathaway: Obviously, stocks did poorly, and crypto was, to put it politely, a disaster, so gold rose to the top of the heap. As I said in my year-end note, I think gold was the macro winner for the year. That's notwithstanding a lot of volatility getting from point A to point B.
Ed Coyne: Let's dive into your year-end commentary because I think you do a great job talking about what to think about in 2023, and what potential speed bumps are out there. We've seen all assets get off to a pretty good start this year. But along with all the assets doing well, gold and gold equities are right there. They're some of the better performers year-to-date. What should some of the investors out there be thinking about? Walk us through your insights and what you see in the coming quarters — or even years.
John Hathaway: [Special Note: the Fed did raise interest rates 25 basis points on Feb. 1, 2023, following this recording.] I think everybody is transfixed with what the Fed will do. The FOMC meeting is coming up. Are they going to raise 50 basis points or 25 basis points? What will the message be? All of that. I think that is the center stage in terms of investor attention. In my mind, what has gone on, though, is that despite all their tough talk — and it is just tough talk — the 2-year note, which is probably the best indicator of where interest rates are headed, has rallied substantially from mid-4% down to close to low 4%. That tells you that the Fed is ultimately going to pivot. When the Fed pivots, I would expect just about everything that we can think of will rise, at least temporarily. That would include stocks, certainly bonds and maybe especially gold.
Why is that? Because that was the headache for everybody last year: the Fed raising rates. That cut valuations of everything across the board. As I said in my previous comments, gold was the only survivor after what was admittedly a very rough ride in 2022.
Ed Coyne: It's interesting when you think about gold's performance. Conventional wisdom has always been rising rates, strong dollar, weak gold. Certainly, that happened initially, but rates are continuing to rise — or they're stronger than they've been in a long time — and yet, gold's rallying on that. We saw the same thing at the end of 2015 and early 2016 when rates started rising and gold and gold equities were rising.
What do you make of that? Why has that been the case for the last two times the Fed has tried to tighten? I say attempted because this may or may not be working. It seems like inflation is still there, but the last two times the Fed's attempted to tighten, gold's done quite well in that environment. What are you making of that?
John Hathaway: Gold is discounting lower rates. It doesn't wait for The Wall Street Journal to put it on the front page. It discounts well in advance. Why will we have lower rates, I think, is the real question. Getting back to your question about speed bumps for investors this year, in my opinion, we are at the very beginning of a serious recession. There are many indicators to support that. I will not go into more than a couple, but we saw a very weak retail sales number just a few days ago. We saw the Empire Index [Empire State Manufacturing General Business Conditions Index], which measures the New York State area, print a very weak number. The leading indicators, PMIs — there are many things that would tell you that we are in the early stages of a recession.
The Fed, of course, is waiting to see unemployment rise because that is its key indicator. Obviously, labor is a big component of inflation. My two cents on this are that they're just going to overdo it. They will lead us into a very deep, prolonged recession, which has not been discounted yet.
This is maybe a two-part play. The first part would be that the Fed pivots and everything rallies. And then investors, economists and policymakers will look at, "Well, why did the Fed pivot?" That's because the economy is really in trouble. Many, many black swans are out there that would come home to roost in a prolonged recession.
But the endgame of that is that beyond a pivot — which is just turning down the heat on hawkish rhetoric and pausing interest rate increases, I think that what we're going to get some time in 2023 is that the Fed's going to have to turn on the fire hoses and the spigots will be wide open. And we'll be back to the old playbook of zero interest rates (ZIRP) and quantitative easing (QE), not quantitative tightening (QT).
That would be a 180-degree turnabout from consensus, but I think that is where we're headed. If that's right, gold should make new highs. Gold stocks should benefit from that, obviously, because of widening margins and profitability.
Ed Coyne: One of the things being talked about now is about moving the goalpost on inflation from 2% to 3%, or maybe even 4%, and changing the rules based on where the new goalpost is going to be.
What do you think of that? If the Fed were to say, "Okay, you know what? We don't think 2% is the right number. We think it is 3%." Is that part of the pivot you're talking about, or is that something completely different that would change the landscape? What's your view on that, if that's even a probability based on some of the stuff I'm reading and what you're starting to hear in the financial media?
John Hathaway: That certainly could be part of the scenario for a pivot, changing the 2% target to 3% or 4%. That certainly wouldn't surprise me. But also, look at what is happening. They're changing the method of calculating CPI (consumer price index) once again. I mean, they've done this many times. Not they. This is the U.S. Bureau of Labor Statistics, which has changed the methodology many times since 1980.
If you go back to the methodology of calculating CPI in 1980 and use it under today's conditions, inflation would not be at the purported 6% or 7%; it would be running in the mid- to low-10% range. The pivot can take many forms, but the Fed would have egg on its face if it just openly pivoted, so it'll probably do it in subtle ways that are not obvious to the everyday observer.
Ed Coyne: One of the things you're hearing a lot now is the debt ceiling. Debt's another thing investors keep discussing and what that means. Depending on what circle you're sitting in, A, is the sovereign debt bubble deflating? And B, does that matter anymore?
Depending on what circle you sit in, it seems like debt is irrelevant. We can just write it off, whether it's student debt or whatever the case may be. Most people forget that there's somebody on the other side of that debt. They expect to get paid for that, so writing it off isn't an option. What's your view on that? What's your take when people are casual about the debt ceiling or the level of debt that we have as a country?
John Hathaway: It's not taken seriously. Politicians don't take it seriously. I mean, it's just a kabuki dance on raising the debt ceiling. You see a few hardcore, hard money types in Congress putting up a brave front, but they'll raise the debt ceiling at the end of the day.
In my mind, the biggest black swan of all — there are a bunch of them — is that when you think about the issuance of Treasury debt, which would result from not just where we are today, but a longer recession than anybody expects. And then, on top of that, foreign holders of U.S. debt are sellers, and they've been net sellers, buyers of gold, net sellers of Treasuries. The numbers don't add up.
In my mind, there's no way that interest rates in a free market – given the math of a bigger deficit, no market or less of a market in terms of foreign investors for Treasury debt than their net sellers, that interest rates. And then this idea that the Fed can reduce its balance sheet from where it is today, $8 trillion, back to who knows what number they're targeting. The numbers really don't add up.
To me, that's where I think the rubber could hit the road in terms of a Fed pivot and then basically throwing in the towel on this sort of anti-inflation war path that the Fed has been on. Basically, I think we're off to the races with gold.
Ed Coyne: In that environment, one of the things that gripped the headlines last year, and it's the opposite of that this year, is the U.S. dollar — the strength of the dollar last year and the weakness of the dollar this year. Gold has seemed to have a negative correlation to the U.S. dollar over history. But certainly, in the last year or so, we've seen that when the dollar would rally, gold would soften. Now the dollar's softening, and gold's rallying.
What's the future for the dollar? I hate to ask you to pull out the crystal ball, but investors constantly ask me, "Wait, if the dollar is strong, why own gold?" What's your thought on that?
John Hathaway: That's the biggest load of crap I've ever heard.
Ed Coyne: I like that. Okay.
John Hathaway: If that was an inverse relationship, you have to explain to me how in U.S. dollars, gold was $300 an ounce 20 years ago, and now it's $1,900 today. There have been periods when the dollar was strong, and there have been periods when the dollar was weak, but that's just against other crappy currencies. There's no inherent strength to the dollar. It's a trade for the quants to position long U.S. dollar/short gold, which they do. It's a big macro trade that worked for at least three or four months last year.
But if you look at a 20-year span, or even a 5- or 10-year span, gold has been on an upward trend for 20 years, and that's against the U.S. dollar. It's a liquid, safe, hard asset versus a defective paper currency. That story is not over. I think we're on the cusp of something much more dynamic than we've seen. You could call it regime change, which Paul Singer did in his latest letter to his investors.
We could be on the cusp of a major realignment of global currencies. Call it a sovereign debt crisis, but the implications are very good for gold. There are many signs of that, looking at central banks being strong buyers of gold and no longer holders — or more net sellers — of U.S. Treasuries. If you just focus on that one thing, you can come up with a very positive outlook for where gold prices could be, not just in 2023, but maybe looking out for the next three or four years.
Ed Coyne: You're certainly seeing that in the BRIC nations, how they're thinking about gold going forward as a potential alternative currency. Let's maybe address the geopolitical side of the equation as well. We've talked mostly about the financial implications and interest rates and so forth, but you can't talk about gold without talking about geopolitics. What are you seeing on that side of the table? What should people be concerned about or concerned with regarding geopolitics?
John Hathaway: I think the person that put it best was Zoltan Pozsar of Credit Suisse [Global Head of Short-Term Interest Rate Strategy]. He said we are in the dusk of the petrodollar. This gets back to what I was talking about earlier: the issuance of Treasuries will continue to rise because of entitlements and fiscal deficits. That means more Treasuries out there have to be bought by investors.
But in the past, what we've done — this is getting to your geopolitical angle — is that we've recycled our deficits in the petrodollar system. This is where trade surpluses of, let's take Saudi Arabia, for example, or China, which would be another example, were recycled into U.S. Treasuries. That was the bid for Treasuries. That's going away.
As that goes away because of what Pozsar calls "the dusk of the petrodollar." This gets into the BRICs, finding alternate ways to settle trades and all kinds of commodities, which means the bid for the U.S. Treasuries is weakening at a time when the supply is increasing.
I can't emphasize this enough. There are a lot of black swans, but I think that is the biggest one of all. How that plays out, we don't know. But in my mind, there's no way that the Fed can allow interest rates to go where they would in that big mismatch of supply and demand without being heavy manipulators, as they've been for the last 10 years. That means further expansion of the Fed balance sheet.
Ed Coyne: It seems like gold's returning to what it always has been, but I think more people higher up the food chain are realizing that gold is really getting enhanced in the monetary policy. It is an alternative currency. It's being viewed that way. I'd love to hear your thoughts on this. I’ve got to believe that will continue as areas like China and others continue to expand. I've got to think at some level they will move away from the U.S. dollar. They see the benefit of assets like gold for oil and that sort of thing. What's your view on that? Is that a moment in time, or do you think that's a seismic shift that you're seeing in global economics?
John Hathaway: No, that's regime change, and it's happening before our eyes. I'm just astonished that so few people talk about it. But again, I think the implications are that the Fed will have to continue to manipulate interest rates by being the buyer of last resort for U.S. Treasuries.
Ed Coyne: It's amazing. We issue and buy our own debt all day long. I would certainly like to do that myself. I just haven't figured out how to do it without ending up in prison.
John Hathaway: Your credit is probably better than the U.S.’s.
Ed Coyne: Possibly. I don't know. I've got two kids just out of school that I'm supporting, so I'm not sure about that. I'll tell you this, you talk a lot at the end of your letter about groupthink and embracing gold – breaking those ranks. It does seem to be that people are still convinced that the S&P is the de facto way to grow net worth and grow the bottom line.
More and more investors need to be thinking outside the box. More and more investors, I believe, need to be thinking about things like alternative assets in general, with gold being front and center. What would you leave our listeners with as they go forward into this year? How to embrace assets like gold, and how should they think about that as they're constructing their portfolio in the future?
John Hathaway: This is what we all at Sprott have been saying and believing. It's a core belief that gold is a very effective diversifier against known and unknown risks. You could see that last year. By having a component of gold in your portfolio, your results would not have been as negative as they turned out to be if you didn't have gold. Gold is a diversifier against risk.
I also think that in the world, at least that I see in the landscape, it's a great macroeconomic speculation. If one can hypothesize that the dollar is in trouble – and we've talked about this through the last several minutes – then to think about a step change in the valuation of gold is not implausible. That means not only on the one hand it's a safe haven. I think that's indisputable over history.
But I also think we're at a point where it could be a great moneymaker – a great source of alpha in a mix of different investment strategies for just about everybody out there.
Two things: safe haven, never been a question about that. But is this a time when there's a huge investment opportunity? I think that is the case. I believe the high-octane way to address that – and I'm talking my own book here – would be to invest in mining equities because they have so much leverage to the scenario I'm talking about.
Ed Coyne: In the second half of last year, mining stocks in general started to do quite well. Year-to-date, they're up 2- or 3-times relative to the general equity market. Do you think that can continue? Do you think gold equities are in an attractive position to take advantage of that and continue to expand over time? We certainly say potentially, right? We're not guaranteeing anything here. But given the landscape, you like the mining stocks right now?
John Hathaway: Right. I mean, that's what I do. Our expertise is in analyzing companies that primarily produce precious metals, gold and silver. Again, if my thought is correct, that we are on the verge of a step change in where gold and silver trade, then you're going to get 2- or 3X that return from being invested in a quality, well-selected portfolio of mining equities.
Ed Coyne: John, what do you say to someone… I say this, and I'd be curious to get your view. I like to say gold and gold equities are two different investments. Gold is a risk-off hedge, low-cost investment and the gold equities are more of an opportunistic risk-on hedge. You're taking on additional volatility by owning mining stocks. Do you agree with that? How should an investor think about that when looking to construct one or both allocations within a portfolio?
John Hathaway: What you said is exactly right. Gold is a safe asset, period, end of sentence. Mining stocks have risks of various kinds. Again, we, in our investment process, sift through this daily. But if gold were to go up by, let's make it up, say, 20%, the leverage you get in mining stocks would multiply that by two or three times, so 40% to 60%, all hypothetical. But it’s not without risk, because mining gold entails certain risks, which we don't have time to enumerate. But rest assured that our investment team is fully cognizant of what those risks are for every company we invest in.
Ed Coyne: John, we'll probably tap your shoulder again, say around mid-year. Maybe we'll do a deeper dive, as you suggested, into gold equities and where we see our opportunities there. Always a treat to see you. Always a pleasure to hear from you. I know our investors like it as well.
Once again, download more information on our website for those interested in what John has to say in his reports. We encourage you to visit us at sprott.com and learn how we can be your alternative manager within the gold and gold equity space. Once again, my name is Ed Coyne, Senior Managing Partner at Sprott Asset Management, and you're listening to Sprott Radio.
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