Gold- Elementary Dr Jekyll or Elemental Mr Hyde ?

Gold has always been seen as an emotional or irrational investment.

?CONCLUSIONS

Gold is the antithesis of Central Banks printing money and has no counterparty risk

Gold allows a hedge against excessive fiscal and monetary spending, now and in the future

Gold offers a deflation and inflation hedge against compromised Central Banks

For 30 years, perhaps it was rational to avoid Gold and trust in fiat money

In the last 20 years, Central Bank profligacy has undermined the credibility of paper money

During the stress of COVID lockdowns, Governments have borrowed and spent without constraint…but this piper must be paid eventually through some kind of default 

Gold and gold mining shares seem to be a good hedge for the next market cycle

Introduction

Over the last 50 years, investors have been able to diversify their portfolios across many new investment opportunities both listed and private, liquid and illiquid. Early in this process, many funds had traditional positions in Gold and precious metals due to the “backing” which those metals gave to the credibility of the currency. With President Nixon taking the Gold Standard away from the US Dollar in the summer of 1971, all currencies effectively became “paper money” only. With global debt levels low, interest rates reasonable, the need for a position in Gold disappeared and the brake on global money growth through gold reserves was eliminated. In the early 1980’s President Reagan deregulated and liberalised the banking industry, which boosted the US housing market. Then, President Clinton repealed the Glass Steagall Act in 1999 which allowed US Investment Banks access to the deposit balance sheets of US Retail Banks. With much of the world following and becoming more global and intertwined, we have experienced a boom in leverage and debt over these last 50 years with little control over the expansion and use of credit. Even a Global Financial Crisis (GFC) has not stopped the increase in credit and, indeed, the Central Banks globally have aided and abetted this pattern through record levels of Quantitative Easing (QE) and zero levels of interest rates. And now a global pandemic has appeared in 2020…

Elementary Dr Jekyll…

A barbarous relic

Keynes himself thought that Gold had long outlived its monetary usefulness as he guided the global financial system towards a new hegemony under Bretton Woods. Whilst Gold had always played a key role in the governance and credibility of state governments from the time of the Pharoahs, more democratic governments were seeking a core, dynamic and accessible currency to underpin their economies.

Not a credible currency

Chairman Bernanke denied in 2011 that Gold was money, arguing that it was no longer used as a medium of exchange, nor a unit of account. There was and is no doubt that Gold remains a store of value, especially in many Emerging market economies like China and India where wealth is often hoarded in Gold. And yet, in 1966, Alan Greenspan thought that Gold was money as it was scarce, durable, divisible and not easily fabricated, noting somewhat ironically that money can be printed! Despite being removed as the global anchor of the banking and currency system, Gold has risen nearly 50 times in value over the last 50 years, perhaps suggesting it is a hedge to all that printed money.

No yield

Gold offers no yield or return and sometimes has high storage costs and wide buying and selling spreads. Thus, over the last 50 years, many investors have sought to maximise their investment returns from their portfolios leaving less and less room for Gold. Institutional weightings have fallen from c 3% of assets in the 1980’s to near zero today and higher allocations would support higher Gold prices.

No uses

Warren Buffett was often quoted as noting that Gold has no productive uses unlike farmland or company assets and that it was strange to value something which was dug out of the ground, refined, only to be placed back in an underground vault afterwards. Indeed, it is true that Gold, other than for jewellery, has few purposes whilst Silver does play an important role in many industrial areas, like batteries, semiconductors, solar and medicines and could be very important for the fast-growing new green and solar energy solutions. However, few realise that Warren Buffett bought a huge amount of silver in 1997 expecting demand to far exceed supply and re-use, only to sell out in 2006 at a reasonable profit before it doubled again in 2008.

Central Bank holdings

Until the last decade, most Central Banks have ignored or minimised the importance of their Gold holdings, now that all their currency was fiat in nature and have often sought to generate some return by lending their holdings to the markets. At the turn of the millennium, Gordon Brown, the Chancellor of the Exchequer in the UK, sold half of the UK’s Gold reserves, preferring to diversify into other currencies like the Euro and lessen the volatility of the reserves caused by movements in the Gold price.  Indeed, with many OECD Central Banks reducing their holdings, they had then to agree to limit their sales to only 400 tons per annum. Priced around $275 an ounce then, many believe the decision to sell the UK’s Gold was a poor one as it approaches $2000 in 2020. Moreover, many Emerging Market Central Banks have also disagreed with the UK as they have been consistently adding to their Gold reserves over the years so that there is now a strong aggregate buyer from a sector which once was a clear seller. Thus, as the World grows and matures, it is clear that many newer Central Banks see Gold as a positive part of their asset allocation and not just a relic of their old asset base. Moreover, if the US Federal Reserve was hoping to return to a gold-backed currency standard, its 8000 tons of Gold would need to be valued at over $20,000 an ounce!

Elemental Mr Hyde…

Fiat or paper money

From the 1970’s onwards, the global economy has relied on fiat money, ie currencies which are issued by their Central Bank and which are backed by the tax raising abilities of their governments and not backed by Gold or something else. Just as many citizens of old were accustomed to their kings debasing the coinage of the realm by lowering the gold or silver content, so today more and more citizens are concerned that the purchasing power of their currency is being similarly debased by the QE and money printing of Central Banks, which now totals over $15 trillion to date around the world with more likely to be forthcoming. Moreover, when sovereign defaults have occurred, part of the solution is to either create a new currency or adopt an existing one, like the US Dollar, as a means of regaining monetary credibility. The ultimate collapse of fiat money has occurred often in our economic history but can be most remembered in the hyperinflation of Weimar Germany where paper money was value-less and Society collapsed destroying both careless and careful.

Currency Exchange Rates

Over the last few years, the USA amongst others has started to maintain a list of countries which are deliberately using the value of their currency as a weapon to increase their share of trade and exports – ie the lower the exchange rate, the easier to compete for export business. This “beggar-my-neighbour” behaviour is ultimately a zero-sum game and becomes a race to the bottom as policy makers and Central Bankers fight to keep their currencies low, by more and more QE. Investors seek to protect the purchasing power of their investments or savings by holding currencies which will not be depreciated by these policies and by holding Gold and Silver.

Geopolitics

It is clear that as the USA retreats from its global policeman role, we are left in a more precarious and volatile environment. This uncertainty would naturally encourage many investors to look for assets which are uncorrelated with the global economy and global risk markets, like Gold. With the USA now squaring off more aggressively to China, we could be entering a new Cold War, based around technology, which could also lift market volatilities and lead to more unexpected geopolitical events around the world.

Gresham’s Law

From Tudor times and even earlier, Gresham’s Law postulated that “bad money drives out good”, which can be defined as money which holds its nominal and commodity value. Bad money would be seen as money debased, corrupted or unable to hold its commodity value, like paper with some fancy printing on it! This debasement fraud would eventually be repudiated by society and after three equity crashes in 20 years, all met by lower interest rates and QE, perhaps the Gold price is showing signs of a similar paper repudiation. The monetary response to the COVID crisis can in no way protect many individuals and companies from insolvency. In fact, the liquidity boom is simply conspiring to keep many zombie businesses going which should be allowed to fail and be restructured, thereby simply creating more bad debts and bad money. Thus, it seems evident that good money is seeking traditional stores of value like Gold.

Negative real rates

During recent times, investors have become accustomed to the Central Bank policy of financial repression where interest rates are deliberately held below inflation as a way of both funding Governments cheaply at the expense of the private sector and of restimulating the economy. Since the Euro-Zone crisis of 2011, Europe has suffered from negative real interest rates of 2-3%, the UK of -3% and the USA is now around -1%. With negative real rates, investors can appreciate that Gold no longer suffers a “cost of carry” and is thus able to be used as a hedge against current and likely more negative real rates as the COVID recession depresses economies further into 2021. Indeed, Chairman Powell is likely to tell us from the Central Bank symposium this week that he will let inflation run hot, run for longer and driving negative real rates yet lower.

Modern Monetary Theory (MMT)

Many economists have been arguing for some time that Governments could not rely on just aggressive monetary policy, especially since the GFC, to engender an economic recovery. The COVID crisis has allowed Governments globally to go on a spending spree to soften the economic consequences, supported by a herculean effort from QE policies. MMT proponents and many left-wing politicians argue that as the tools which saved the economies from the costs of the GFC were not inflationary, thus borrowing and spending on a grand scale now will not affect it now. Central Banks have in effect become conflicted, all independence gone and have created a mirage of “free money” waiting to be spent, borrowed and spent again. The QE which saved us from the GFC was not inflationary as it stayed within the financial and banking sectors and boosted asset prices, leverage and ultimately real estate values. This new COVID QE is being directed fiscally into the real economy and is thus much more likely to generate inflation in the coming years, once the deflationary demand and supply shocks of the lockdowns have been worked through. Gold and most other commodities are beginning to suggest that inflation is coming. For now, Central Banks may continue to manipulate markets and implement yield curve control to hold bond yields down, but rising inflation will rapidly erode the asset base of investors if left untouched, especially as interest rates will not be allowed to rise.

Inflation

After a 50-year debt binge with a desperate need to maintain deficit spending for the next few COVID stressed years and constrained by the unfunded pension and welfare benefits of the Baby Boomers in retirement, investors need to realise that there are only 4 ways out of this conundrum globally.

(1)  Impose austerity, raise taxes (on the wealthy) to honour your debts, hurting growth 

(2)  Default on your debts or default on your future pension obligations, or both

(3)  Default through financially repressed inflation for 10-20 years

(4)  Allow hyperinflation to destroy society

Thus, politicians will always choose option 3, even though it actually hurts the poorer members of society most with occasional dalliances into defaulting on pensions, welfare and healthcare by scrapping indexation and raising contribution levels. With a future of defaults ahead, default by inflation stealthily together with low interest rates and low returns beckons and it is easy to see why many investors are allocating to Gold.

Books on these themes to read:-

The Deficit Myth – Stephanie Kelton

The Golden Constant – Roy Jastram

Gold: The once and future money – Nathan Lewis

When Money dies – Adam Fergusson