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October
18
2019

The Coming Inventory Liquidation
Simon A. Mikhailovich

Central banks are again willing to do «whatever it takes» to avoid a debt liquidation. However, this will not solve the underlying problem. The eventual unwinding is going to entail massive disruptions. What can investors do to protect themselves against the coming devaluation?

The left side of the balance sheet has nothing right and the right side of the balance sheet has nothing left. But they are equal to each other. So accounting-wise we are fine. 

Jacob Frankel, AIG Vice Chairman, 2008

The saying «a bird in the hand is worth two in the bush» describes the financial principle that a dollar today is worth more than the promise of a dollar in the future. Negative yields turn finance on its head by making the promise of a future dollar more valuable than a dollar today. Despite this making no sense, roughly $15 trillion in bonds currently have negative yields and the volume keeps growing. As yields turn negative, bond prices rise into absurdity. For example, Austrian 100 year bonds issued two years ago at 100 € with a 2.1% coupon have recently traded at 200 €.

What is going on? The law of supply and demand is at work. Whether it is currency, debt, savings or widgets: Price and value of excess inventory inevitably decline until supply and demand become balanced. We apply this law to explain consumer goods’ price inflation – «too much money is chasing too few goods». The same applies whether «goods» are consumer staples or financial assets.

This is what the global savings glut and the hunt for yield have been about – too much money and credit, both created ex nihilo, have been chasing too few real return opportunities. The excess inventory of financial assets and claims has been getting progressively marked down by commanding an ever-declining future return (yield). And now, after several decades of declining yields and rising nominal asset prices, negative yields are foreshadowing the end game – excess inventory liquidation.

It is no surprise that few are willing to admit what is coming. The red flags always get ignored until a liquidation event makes denial impossible – be it subprime mortgages, CDOs, or Enron: The story is always the same. As the fundamentals of a once successful enterprise deteriorate, meeting unrealistic expectations requires ever more leverage and, eventually, accounting legerdemain. The excesses are small at first but as they grow, the cost of admitting reality becomes unaffordable to the stakeholders. This is why they say that if you borrow $1 million, the lenders control you but if you borrow $10 billion, you control the lenders.

Whatever It Takes

With global debt at about $ 250 trillion, central banks are willing to do «whatever it takes» to avoid the liquidation; but one can’t fix a bad balance sheet without actually fixing it. The eventual unwinding will entail not only financial but economic, social, political and geopolitical disruptions as well. Perhaps this is why investors have been willing to suspend disbelief when faced with inanities like negative yields or «unicorns» – the fabulously valued businesses that neither produce profits nor show any path to ever doing so.

Similarly, even though no one disputes that many sovereign and corporate borrowers have «too much debt», few have embraced the obvious implication that such debt cannot be «money-good», which is what «too much debt» means. When investors used to say: «XYZ has too much debt», they meant: «XYZ is over-leveraged and its debt should trade at a discount». Today, the world is awash in debt that trades at a premium and yet its prices keep hitting 5000-year-highs while the yields keep falling to new all time lows.

What can one do to protect against the coming devaluation of financial claims and fiat currencies in which they are denominated? The first step towards solving a problem is admitting it, which the vast majority of investors has yet to do. The next step is to find assets that meet, at a minimum, the following three criteria: genuine scarcity, a price that does not reflect the bubble and, given the scope of excesses across the financial system, it ought to be something that does not rely on the financial markets and counterparties.

Gold: the sophistically simple solution

Physical gold is one of the few assets that meets all three criteria.

Firstly, real gold (unlike gold derivatives) is genuinely scarce and, because discoveries take over ten years to bring to production, new supply cannot be increased in the near term. Better yet, unlike most commodities whose supply increases in response to higher prices, the supply of gold available for sale often declines as prices rise. This is because investment demand for physical gold, and its price, are inversely correlated to confidence in the financial counterparties and fiat currencies. Whenever the rising price of gold is a consequence of lower confidence, fewer holders of gold are willing to sell their safe haven asset, even as demand from those who do not own gold increases.

Secondly, unlike financial assets that are priced at or near record highs, the gold price in dollar is far below its high, especially in real terms. Western investment demand is rising but, so far, it has been mostly demand for gold derivatives rather than physical gold. Based on my recent conversations with wholesale gold dealers and Swiss refineries, the summer rally has not been accompanied by rising direct (non-ETF) demand from Western investors.

If anything, many retail investors have been selling into the rally leaving both the dealers and refiners with excess inventories. Anaemic investment demand suggests that gold prices embed significant positive asymmetry if or when gold becomes widely desired as a safe haven.

Finally, physical gold is the only cyber-immune, tangible financial asset that is universally negotiable and, unlike all other financial assets, does not rely on the financial markets and institutions. Such properties may not be in high demand under normal conditions but their value increases exponentially with rising systemic risks, which makes physical gold an effective out-of-the-money option on a systemic crisis. This option is especially valuable since gold has a positive real carry in a world of negative real yields, never expires, never becomes impaired or worthless and has no counterparty risk.

If the above described a Wall Street-designed complex derivative product à la «portfolio insurance» it would have sold like hotcakes, but it has not happened to gold. For investors steeped in complexity and technology, the idea of storing gold bars in industrial vaults has felt too simple.

Therein lies a generational opportunity. As this latest financial folly comes a cropper, the same old lesson is about to be re-learned yet again – in finance, as in life, «simplicity is the ultimate sophistication».

Simon Mikhailovich is a contrarian investor and entrepreneur. He grew up in Leningrad, USSR, and at 19 made it to the US as a stateless refugee with $100 and a suitcase. Simon graduated from Johns Hopkins University in 1983 and worked in the investment department of the USF&G Corporation business. In 1998, he co-founded a successful investment firm that focused on special opportunities in corporate credit, CDOs and credit derivatives. Having predicted and profited from the financial crises of 2000 and 2008, in 2014 Simon co-founded The Bullion Reserve to provide an institutional structure for holding gold reserves in a way that ensures compliance, liquidity and independence from financial institutions and markets. Simon has been married for over 30 years, lives in NYC, and has two grown daughters. He is an avid student of history and a competitive sailor.

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