Editorial: QE-related price distortions

In a presentation at the Toronto Resource Investment Conference on Sept. 12, David Franklin of Sprott Asset Management said that after a tough first half “we have turned the corner,” and investors can take advantage of price distortions in the market caused by quantitative easing.

Some of the best opportunities can be found in precious metals, he argues. “As soon as Germany requested its gold back, look at what happened to inventories — they fell off the table,” he said. “This is only circumstantial evidence, but the way we interpret this is that Germany requested its gold back, and someone had to enter the market and deliver. Complicating this was the voracious appetite for gold from the Chinese.”

Another shortage can be found in the bond market. “In this debt-fuelled world of ours, who would think there would be a shortage of bonds?” he remarked. “But 55% of the entire universe of bonds is owned by the central banks . . . the central banks also own two-thirds of the government bond market. Quantitative easing has sucked the market dry of bonds. This year . . . the Bank of Japan is buying more bonds than it is issuing, so there are very few bonds available for investors. What happens if the central banks all of a sudden start selling bonds?”

To illustrate his point, he turned to the squid market in Japan. What Japan did by devaluing its currency with quantitative easing and destroying the yen, which has fallen by about 15% against the U.S. dollar, he explained, is hurt the country’s fishermen. Now every boat that goes out to catch squid loses money. But the fishermen didn’t stop fishing, he said, they went to the government and got a fuel subsidy instead. “Here is a price distortion as a microcosm of the impacts of QE,” Franklin said.

And price signals no longer correlate with the realities of supply. “The gold price is not the price of gold. We see huge premiums paid in Shanghai for gold to entice supply, and the price of squid is not high enough to justify the act of fishing for it.”

Franklin noted the S&P 500 is trading at 16-times forward earnings, and so the market is fully valued, in contrast to decreasing gross domestic product estimates, which are moving down for the third and fourth quarter. “So here is another market where prices are completely distorted,” he said.

As for uranium, Franklin cited a Cameco presentation in February in which the miner said that there was not enough supply to meet 20% of the world’s uranium demand, and that management had no idea where this uranium would come from. In addition, Cameco recently pushed back production from Cigar Lake for another year. So the fundamentals for uranium look good. “Does [the pricing] look like a market with a 20% hole in it? No, not at all. There are some dynamics in uranium that show this is an unsustainable point.”

Franklin noted tin is in its fifth year of shortage and that its price has shot up by nearly 15% in the last three weeks, after Indonesia, which produces most of the world’s tin, changed the rules to force miners to sell their tin in the local market before it can be exported. “The largest producers said: ‘No, we’re not going to do that,’” he said.

While 70% of the world’s platinum supply comes from South Africa, Franklin calculates that at current prices of US$1,450 per oz., the top producers “lose US$300 to US$400 for every ounce produced. So platinum production is dropping, as it should. Platinum production has almost turned into a work-welfare program, and that’s going to continue. As an investor, you look for these kinds of opportunities. You don’t buy the miners, because they’re losing money. You buy the platinum.”

Similarly, there’s a huge hole in the palladium supply, Franklin argued, and that is why palladium has been the top-performing precious metal so far this year. “When you look at these numbers it’s astonishing. You see a 1 million oz. deficit in palladium. There are only 6.5 million oz. palladium produced a year — so one-sixth of the market is gone . . . Is it going to get better? This deficit will persist until 2020.”

Platinum is the second-best performer this year. Franklin doesn’t expect platinum will hit the 1 million oz. deficit until 2016 or 2017, but he sees huge opportunities as an investor, particularly given the rebound in the car industry, which is the biggest platinum group metals consumer. “As a precious metal investor,” he said, “the dynamics could not be any better.”