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Holmes: Gold Prices Could Keep Rising

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here at the 2011 Morningstar Investment Conference joined by Frank Holmes. He is the CEO and chief investment officer of U.S. Global Investors. Frank, thanks so much for joining me today.

Frank Holmes: It's great to be here.

Glaser: So, I wanted to start off talking about gold, and that's a subject that you've written a lot about and that you know a lot about. It's had just a tremendous run over the past couple of years now. What's going to take the steam out of this rally? What could take gold prices and kind of bring them back down to earth a little bit?

Holmes: Well, we're big believers that government policies are precursor to change. When you go back and look at policies where you have negative real interest rates, gold starts to rise in that country's currency. So, then one has to sit back and say, "Well, why would a government have negative real interest rates?"

It's because they've been fighting deflation, and I've been running with this for a decade that gold would go to a $1,000 an ounce because of the battle for deflation. 

Further to that, whenever you have negative spending or sort of deficit spending coupled with negative interest rates, gold really starts to perform in that country's currency. And it's not the political party, it's the political policies because, one, in 1997 under President Clinton, there was a surplus budget. Two, there were positive real interest rates, that is, you earn 3% more than the CPI number, and thus gold was $250.

Glaser: So, if you're looking at gold prices the big driver really could be interest-rate policy. So you know when you're looking at the Fed right now, do you see any tightening of monetary policy anytime soon?

Holmes: No, I don't. If you go back over 400 years of history, there has been 47 such crisis, they last 16 months and we're a little more than half way through this one and the government has got to be very conscientious of basically dropping into another big recession. And I think that that's why the Federal Reserve has put a lot of money into the system, but there is no loans, so there is no money supply growth, so there is no inflation.

I think I agree with Schilling that we are going to maintain the sort of battle against deflation just like Japan has done, and with that gold will perform well. Now what's really exciting for gold and the upside and everyone is so focused on the fear trade, and I have been commenting on the love trade. The love trade is that 50% of the world's population has a gross domestic product per capita growing at 8%, and they love gold. They give it for birthday gifts, for weddings, for holidays, religious holidays.

So you have this GDP per capita rising for 50% of the world and you have the sort of structural change, unlike the 70s. Today China and India constitute 40% of the world's population; in the 70s they were isolationists. They had no global footprint, and Russia was behind the Iron Curtain. Today, not only that, but they're also embracing capitalism, Americanism, that's what the movie Slumdog Millionaire was all about. So, I think that this is very significant, the political policies of these countries. Furthermore, the world's population has doubled. So you have these huge drivers of fear trade along with the love trade.

Now, the fear trade, which is most interesting, is that central banks from Europe have been big sellers, and one of the things that's going to change in the fall is Basel III, which is going to change the Tier 1, Tier 2, and Tier 3 that these big banks have to keep for capital. Gold has always been carried at a discount, but sovereign debt has not been. So, basically the banks have been buying Greek bonds to get a higher yield. That's been a disaster. So starting in the fall, gold is going to be basically priced mark-to-market, not at a 50% discount. 

Central bankers are in fact going to continue for the past two years being net buyers of gold as a way to diversify. They're not going to buy 10% or 20%, but just a 3% increase in purchases of all central bankers in the world is very profound and significant to take gold to $2,300 an ounce. Where would that be? That would be its 1980 adjusted prices. So I don't think gold has had this exponential move like the tech boom or what gold did in 1980, so I think you're going to gradually see gold rise over the next five years.

Glaser: Another commodity that's had a nice rise recently, though has come down slightly in recent weeks, is oil. There has been a lot of unrest in North Africa and the Middle East, which certainly has contributed to some of that rise. But do you think that it's really a case of a temporary blip due to this unrest or is there more of a fundamental supply/demand in balance in the marketplace for oil right now?

Holmes: I think there is a big super cycle in the demand for commodities. As I mentioned earlier, in the 70s the world's population was half of what it is today. So, when you have economic robust growth then you have a sea change. Today BP came out saying that China surpassed the U.S. in the consumption and importing of oil. So, I think this is going to continue, and I think you can see oil at $200 a barrel five years from now. Also in the 70s was the creation of the Environmental Protection Agency, which is important for clean air and clean water; however, it drives up the cost to explore, to develop, to produce, or to ship any energy. So, when you have that, along with demand growth, we think it's very easy to see oil at higher prices.

Glaser: So, it sounds like investors should be prepared for expensive gold jewelry and for a lot of expense at the pump in the coming years.

Holmes: Buy in the dips and don't be afraid of the volatility. It's a nonevent, and volatility is only dangerous if you've borrowed against that asset class, but you can actually use volatility to your favor.

Glaser: Frank, thanks so much for your insights today.

Holmes: Thank you.

Glaser: From Morningstar, I am Jeremy Glaser.