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Axel Merk: All Roads Lead to Gold

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Negative real interest rates, the risks of holding cash, the implausibility of the Federal Reserve’s plans to raise rates and the coming of market instability — all these factors strengthen the case for investing in gold in the analysis of currency funds manager Axel Merk.

The investment strategist’s latest shareholder newsletter is consistent with past warnings about investing in an era of financial repression.

A key antagonist in that narrative is zero interest rate policy (ZIRP), but Merk emphasizes that that unloved (by savers) policy has been replaced with an even more repressive environment of negative real rates.

Subtracting headline inflation from the nominal interest rate, Merk shows that negative real rates have prevailed since the financial crisis, but highlights the fact that real rates in the U.S. are actually lower than in the eurozone.

Because deflation has recently taken root there, subtracting a negative consumer price index value actually generates a low positive value for European interest rates.

The key investor implication of this trend is that holding cash can no longer be considered safe, particularly for dollar investors.

Merk argues that gold — often decried for its zero percent yield — “may be a formidable competitor when real interest rates are negative.”

While many investors value the convenience of cash because their daily expenditures are priced in their local currency, Merk, who launched the Merk Gold Trust ETF in May, next assesses expectations for future earnings.

“It’s not that gold will change, but the currency in which it is valued,” he says, pointing out that gold has averaged an 8.3% annual return with 0.02% correlation to equities over the past 44 years.

Not only has gold held fast against a depreciating currency, but it has retained purchasing power. “a gallon of milk or a suit cost about as much in gold 100 years ago as they do today,” he adds.

Cash’s ability to do that is jeopardized not only by inflation but by a CPI that Merk suspects of underreporting inflation.

In that context, Merk next looks at future inflation expectations, which are trending downward in both the U.S. and eurozone, and he is discomfited by the current talk about raising rates.

“In the U.S., [former Fed chairman Ben] Bernanke historically announced another round of QE when [inflation declined toward] 2%. So while the ECB turns on the printing press, the Fed, looking at similar trends, shrugs them off, blaming low oil prices… Never mind that this way of looking at the data is supposed to filter out the short-term effects of oil.”

Only high real rates would pose a threat to zero-yielding gold, but Merk argues that real rates are under continuing downward pressure.

A key reason is long-term deficits. Looking at Congressional Budget Office projections, Merk shows that spending as a percentage of GDP is set to rise substantially in the coming decades, with deficits rising correspondingly.

“In our analysis, in a decade from now, the U.S. may be paying $1 trillion more a year in interest expense alone should the average cost of borrowing go back up to its historic levels,” thus providing a powerful incentive to keep real interest rates low so the government can continue financing essential expenditures.

As Merk colorfully adds, “the biggest threat to national security may be the deficit because there may not be any money left for the defense budget. Let’s not scoff at Greece and Europe: the U.S. has related challenges.”

As an aside, when the currency manager expressed his concern about the U.S.’s ostensible inability to have positive real rates over the next decade, a Fed policymaker said “this outlook is unrealistic as it wouldn’t provide a stable equilibrium. My response: I never suggested this would be stable.”

Merk considers the structural reforms that would solve U.S. budget problems politically unrealistic. Moreover, he warns, not for the first time, that both the government and consumers today have a common incentive to want to debase the currency — for the first time in U.S. history.

All these factors suggest to Merk that prudent investors should be increasing their allocation to gold, the subject of a webinar the portfolio manager plans for investors this month.

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