There Ain't No Cure For Gold Fever 2.0

Last week, the U.S. economy channeled its inner Mark Twain, declaring that reports of its demise have been greatly exaggerated-?inflation played it cool, retail sales, jobs all came in better than expected. Amid this backdrop, there was a surprise and quiet breakout - Gold closed the week with another all-time high, surpassing $2500.?

In fact, Gold and Gold Miners are among the best performing ETFs ytd:?

But wait, there's more than just returns. Turns out, a 50/50 gold/stock portfolio produces better risk-adjusted returns in the past two years, demonstrating the power of gold as an effective hedge.?

So, what’s behind this move? Yours truly might have a few insights to share: A few months back, I laid out the structural bull case on Gold, and why it deserves a place in portfolios. Perhaps it's time to dust off that article and re-sharing this as this week's CIO Musings for your perusal.

Recession or not, I think we are in the Golden Era!

There Ain't No Cure For Gold Fever

(Original substack link here)?

Gold's quiet breakout in March is perhaps the most significant yet under-appreciated market development in recent weeks. The decisive move above 2000 had been 4 years in the making and completed the metal’s consolidation phase that started in 2011. Gold's narrative in March wasn't scripted by retail speculation - but by keen observations of the upcoming sea change in monetary policy shifts.?

In this post, I aim to synthesize insights from past musings on monetary policies, economic cycles, and the interplay between fiscal policies and commodity markets, to understand where gold is heading and how asset allocators should weigh gold to build robust portfolios.?

Warren’s Pet Rock?

Warren Buffett famously expressed his disdain about Gold as an investment. His views are rooted in the belief that gold is a non-productive asset, which means it does not produce anything or generate any income merely by holding it, unlike investments in businesses, stocks, or real estate that can produce goods, services, or income through rent or dividends.?

It is true that Gold doesn’t produce anything - but Gold should be thought of as a currency. The cost of holding Gold as a currency is that it doesn’t pay any interest, and the returns come from currency appreciation, or, on the flip side, the depreciation of the alternative reserve currency — the USD.?As such,?the real interest rate of USD is the fundamental costs (or returns, in periods of negative real rates) of holding gold.?

Gold's Epochal Cycles Since 1971?

Since the US abandoned the gold peg in 1971, Gold went through four distinct market phases that had corresponded to significant shifts in fiscal and monetary policies in the US:?

• The 1970s: Nixon's Legacy and Hyper-Inflation? The dissolution of the gold standard in 1971, leading to a decoupling from the US dollar, catapulted gold into a super bull market. This era was characterized by an annualized return of 35%, driven by oil crises, hyper-inflation, and a Federal Reserve that anchored real interest rates around 0%.? ?

• The 1980s-2001: The Great Moderation? With Paul Volcker's ascendancy to the Federal Reserve's helm in 1979, interest rates soared to 20%, inaugurating a period of "Great Moderation." This era saw gold prices wane by an average of 5% per year (similar to average real interest rates in that period), a testament to stringent monetary controls and fiscal prudence under Clinton's deficit reduction schemes.?

• 2001-2011: Fiscal Deficits and a New Dawn for Gold? The early 2000s heralded a fiscal policy volte-face, underscored by persistent deficits, the dot-com bubble's burst, and 911 attacks of 2001. This, alongside surging demand from burgeoning markets in China and India, marked the advent of another bull market for gold, delivering 20% annualized returns.? ?

• 2011-2023: A Period of Consolidation? In the past decade where monetary and fiscal policies were more of the same, Gold was in a relatively calm state as it digested the roaring returns of the preceding decade amidst a relatively robust U.S. economy and plateauing demand from China and India.? ?

• 2024-2034: The Upcoming Sea Change? According to?CBO projections, US fiscal deficit will be increasing persistently for the next 30 years, mostly attributed to mandatory spending on social security, healthcare and interest payments. There will be a sea change in US fiscal policies, which undoubtedly, will have monetary implications. Under CBO assumptions, net interest outlays will be 6.0% of the 8.3% budget deficit by 2052.?The US has to keep interest rates low! (Japan rings a bell??)?

The Golden Portfolio?

During the full post 2000 period, Gold had returned about 10% per year. If we take this as a base case, how much Gold should you own??

• Given the sea change in US fiscal deficit over the next decade, you’d probably agree with me that Gold would be preferred over US government bonds.?

• What about stocks? Gold offers similar expected returns and volatility vs stocks, so it’s reasonable to hold both, especially given the strong diversification benefits.?

• Global stock market cap is ~US$100 tr, while gold market cap is ~US$15 tr. So a simplistic starting point to think about?market-weight in a stock-gold only portfolio could be 15%, for someone who doesn’t have specific USD cash flow requirements.?