HardAssetsInvestor

Mike Norman, Hard Assets Investor (Norman): Hello everybody, and welcome to HardAssetsInvestor.com. I’m Mike Norman, your host. Today my guest is David McAlvany of the McAlvany Financial Group, returning to the show. Nice to have you back.

David McAlvany, CEO, McAlvany Financial Group (McAlvany): Good to be back, Mike.

Norman: I’ve been reading some interesting commentary recently, talking about the shifting macroeconomic perspective globally. We’ve had this big commodity super-bull market over the past seven or eight years. A lot of it’s been driven by booming demand from emerging countries as well as central bank monetary operations, which a lot of people believe is the printing-money idea, and that’s bullish for commodities.

But now, suddenly, a shifting of the wind, so to speak, in the sense that we see China’s economic growth slowing down, some of their economic policy now pulling back from massive infrastructure development and that sort of thing; more domestic spending geared toward narrowing income disparities — not the sort of thing that would create a great boom for commodities, necessarily; and central banks; now the Fed QE off the table, reluctance on the part of the ECB to continue their extraordinary monetary ... how does all this factor into the bigger picture, especially given the fact that  commodity prices are still pretty lofty? How does it look? Are we going into a change in the macro-environment that could undermine some of the strength in materials prices? What do you think?

McAlvany: Well, your traditional driver is supply and demand. And so — what has been driving your commodities ... you have to factor in China, over the last five, six, seven, eight, 10 years. And with slowing growth there, to the 7.5 percent range, the best folks that I read from Asia view that growth slowing to about 3.5 to 4 percent over the next two to three years.

Norman: That would really be a hard landing for China — 3.5 to 4 percent, right?

McAlvany: Exactly. And so you're looking at the traditional factors — supply and demand — negative on the commodities space, particularly your industrial commodities. I think there is that other ‘X’ factor. There's a lot of pundits out there that like the idea of central bank printing: QE3, QE4, QE5 to infinity. That’s what’s going to be what reprices all commodities to higher prices.

I think that’s a very slow-burn story. That’s not something you can go out and bet on tomorrow and expect any reward on. So ultimately, commodities may be repriced in light of devaluation of currencies. But that may be 36, 48 months out. You're talking about sort of the last-ditch effort by central bankers to revive an economy after they have done everything they possibly could.

I think you hit the nail on the head: What we’re seeing is a changing macro-picture, from growth dynamics over the last five to seven years, to really slowing growth. Europe is not back on its feet. In fact, it’s again rolling over. You look at the latter part of 2012, and as you move into 2013-2014, you’ve got major head winds for the U.S. economy.

Norman: So as an investor, how do you approach it now? Whereas in the prior years you want to be aggressive, price trends are moving higher, maybe now we throttle back for the next several years because economic growth is slowing down. You’ve got a lot of fiscal contraction. How do you approach it as an investor? Is this a good time? Do you just sort of hunker down? Do you use this as an opportunity to continue to accumulate in certain areas? What do you say?

McAlvany: I think accumulation in certain areas makes sense. But I would be very cautious. If you look at the global equity markets, they really rolled over a year ago and haven't recovered. If you're looking at Taiwan, if you're looking at the Hang Seng, if you're looking at a number of the Asian markets — the Philippines market being an exception — they have all traded off and are nowhere near their peak. So, weakness, anticipating more weakness — that’s the story.

Norman: But the U.S. market made back pretty much all of its losses since 2007.

McAlvany: It did.

Norman: It didn’t make a new high, but it erased most of the losses.

McAlvany: And certainly, with the S&P above 1370, and the Dow flirting with the 13000 range, I think what you’d have to argue is that investors have counted on the Fed. And they’ve counted on the Fed knowing that you have the equivalent of Greenspan put in place, with Bernanke. There is not going to be tremendous weakness on the downside. That’s the belief.

Now the reality is, I think we’ve seen the best we’re going to see, in terms of earnings, as we come into Q2, as we move toward Q3 and Q4. I think this is where the rubber meets the road. All the productivity gains … we’ve had businesses that have been managed much better over the last two or three years. And it’s all coming down to being beneficial to earnings. But I think that story is completely in the numbers already.

Norman: You mentioned it might be a good time selectively to look at certain markets. Which ones would those be?

McAlvany: Well, a low-real-rate-of-return environment has always favored gold as an investment.

Norman: Still gold?

McAlvany: I would still be long gold. Silver is interesting on a longer-term basis, with a lot more volatility of course. So for someone focused on both asset preservation and growth, I think I’d prefer gold of the two metals. But I think, as you look at gold relative to gold stocks, you look at the XAU, and divide it by gold, or the other way around, you're at about a 10-to-1 ratio. The worst we’ve seen that ratio get in 30 years is 11-to-1. So you're scraping the bottom of the barrel.

And you're looking at companies that are making massive amounts of money at these prices. And these prices aren't the elevated prices of $1,800-$1,900 an ounce. So I think on investment demand, we could see the spot price move back toward $1,900, maybe even see new highs by the end of the year. And you’ve got companies that are not only leveraged for that growth, but have been sorely neglected. So I think if and when we see the general equity market roll over, that’s when you want to be buying the gold shares as a group, and maybe even just buy the index.

Norman: But doesn’t the fact that a lot of companies are still making massive amounts of money — to use your own words — doesn’t that suggest that they can't all make massive … it just doesn’t happen that way. Doesn’t that sort of speak to the fact that maybe there's going to be a correction there, that maybe some of those companies are in the sector, and they're going to have to get weeded out, you get a pullback in the price?

McAlvany: I think this is where — if anyone’s been playing on land speculation, or the explorers or the juniors —you get hurt really bad. Because time is not on your side. It’s an option that is “expiring,” whereas your majors, they are making money. And they're the ones that can look at these exploration plays and juniors and pick them up for a song in this kind of environment, where they can replace resources, they can do all things proactive on the merger and acquisition side, at very inexpensive prices while they're still making money. So, $1,600 gold and $30-and-change on silver — the significant companies are making a lot of money.

Norman: What about $1,400 gold? I heard from people in the industry that cost of production for South African mines is around $1,400 an ounce. And historically, what we’ve seen in commodity markets is a reversion to the cost of production. What if it goes down to $1,400, $1,300? Does that have a negative impact on a lot of these companies that are highly profitable right now? Or is that still a good number for them?

McAlvany: I think it’s still a good number for your North American producers, some of your South American producers. As I said, Mike, it’s a real concern for the South African producers. So that’s not only in the gold space, but in platinum as well. They're digging platinum out of the ground, but it’s costing them a pretty penny to do it. So I would not be interested in that geography. There's a different geography for the miners that still makes sense.

Norman: So gold definitely has an economic aspect to it. There's also the quasi-currency aspect, where people want to own it as a hedge against uncertainty or inflation. What about base metals? What about something like copper? That’s really an economic story, right? Would that make you a little bit more cautious?

McAlvany: It makes me very uncomfortable, because I look at the upside and downside, and I think, well you're about right in the middle. If you have 17 percent upside, you probably have 23 percent or more on the downside. And I’m just not comfortable with that, whereas, again, something like gold, if you said, well there's 10, maybe 15 percent on the downside, you probably have 50 percent on the upside. So it’s skewed in your favor in terms of the risk and reward, whereas a lot of your industrials, that’s where the concern is. I think you’ve got more downside at this point, because the growth story is not supportive.

Norman: I want to go back to the central bank monetary operations, where we’ve seen this pattern of behavior where the central bank, the Fed or the ECB will announce QE or LTRO. The markets get a pop, and then suddenly it all sinks right back down again. To me, it’s perfectly clear why: Because those operations really don’t stimulate anything. There's no addition to aggregate demand. There's no increase in economic activity. So once you get these portfolio shifts, once they die out, we get back to the reality that everything is really slow.

So why do people keep looking at this and saying, “Oh, this is inflationary. This is a stimulus. We’ve got to buy these things,” when, in fact, we keep seeing this pattern repeated over and over again?

McAlvany: Well, the banks are responsible for creating credit. And you’ve got liquidity that’s coming from the central banks. But that liquidity, and this is where I think investors have connected too many dots, and they’ve done a poor job of doing it, investors are assuming that when a central bank is creating liquidity — if in fact that’s what they're doing — that it’s ultimately going to work its way into the economy, and you're going to see growth. But it’s not making its way into the economy.

Norman: Right.

McAlvany: The lending mechanism is broken. You’ve got most of your European banks and U.S. banks taking excess reserves and putting them right back with those central banks, respectively. And it’s not making its way into the larger economy. So there is no growth in the economy because there is no growth in credit. We’re watching the death of credit in front of us, which, frankly, is very deflationary.

Norman: Right.

McAlvany: So when you're looking at liquidity created, it’s not enough to say central banks are creating liquidity; ergo, there is growth in the economy. I would love to see it, but it’s not happening — mainly because the banks themselves, commercial institutions, are more concerned with rebuilding their own balance sheets. And they're happy to redeposit with the Fed. It’s a safe position for them.

By the way, does that indicate that there is any real healing in the banking industry, when they won't lend brother-to-brother, sister-to-sister? The interbank lending mechanism is gone. It’s been replaced by the Fed. It’s been replaced by the ECB. So you're looking at a very unhealthy banking situation, which, again, feeds into liquidity that’s not making its way into the economy.

Norman: Yes; it’s interesting that that story is still out there over and over again. But yet we see it really doesn’t play out to the expectation.
I want to talk a little bit about oil. There's obviously a lot of geopolitical factors right now: You have Iran. You have Saudi Arabia, really, as the price setter at the margin, as sort of the last guys with any spare capacity. They don’t seem to want to lower prices very much at all. Where do you see oil prices going?

McAlvany: I think, as you look at the macro picture — slowing again in Europe and Asia and in the U.S. — you’ve got a destination of about $80. I think that’s a reasonable price for it to be trading at. Anything above that is fear premium, relating to Iran and other Middle East tensions.

If you're looking at the supplies here in the United States, we’ve seen inventory increases week after week after week after week, with minor exceptions here and there. But it’s not like we don’t have plenty of oil. The consumer is wondering, “Well, if there is plenty of oil, why am I paying so much at the gas pump?” And it’s because there is a totally different market.

Gasoline is not oil. The finished products — and the East Coast is a classic case in point — bringing in Brent versus dealing with West Texas, you're paying a higher price for Brent. And it’s squeezing the margins. You’ve had Sunoco, ConocoPhillips, a number of major refiners just shut down and say, “We’re out of the business. We don’t want to have anything to do with it.”

And so you’ve got high gas prices on the basis of refining constraints. Meanwhile, we actually have tons of crude. We have plenty to go around right now. Now, if you put us back into that global growth cycle, maybe we have real demand or supply problems.

Norman: That might be several years away. Anyway, bottom line, how do you call it now? Good opportunity to just selectively increase your exposure if prices come down over the next 12 months?

McAlvany: Back to oil?

Norman: Or in general, commodities as the asset class?

McAlvany: It’s got to be very specific. Because I think, at this point, it’s going to be supply-and-demand driven. You can't paint with a broad brush stroke and assume that inflation is repricing all assets. You do have investor demand, which is impacting supply and demand within the gold space. Other than that, I’m very cautious with the rest of the commodities.

Norman: All right: very cautious. David McAlvany, thank you very much. That’s it for now, folks. Hope you tune in next time. This is Mike Norman saying bye-bye.