Gold has gained 66% in the last two years and just hit a new all-time high of $2075 last week, before pulling back sharply by over $200 in four days
Gold has gained 66% in the last two years and just hit a new all-time high of $2075 last week, before pulling back sharply by over $200 in four days
Gold has gained 66% in the last two years and just hit a new all-time high of $2075 last week, before pulling back sharply by over $200 in four days
While commentators are referring this as a new bull market, gold hit its previous all-time high of $1921 all the way back in 2011, proceeding to lose -45% of its value over the next 5 years, and giving investors near-zero returns over the last nine years. This kind of volatility is normal with commodities, which is why most investors ignore the sector, and for the ones that allocate in it, it is normally a very small percentage of investors’ portfolios compared to bonds and equities.
The rise in gold, driven by the most recent global experiment in central bank helicopter money to partially alleviate the impact of the COVID19 lockdowns, has rekindled investor interest in the metal as an investment.
The most commonly held view on gold is that it’s a relic of the past, and should be avoided. It doesn’t pay any income, costs money to store and insure (for physical gold), and is impossible to value. No one can objectively tell whether gold at $2,000 an ounce is cheap or expensive.
On the other side of the table, you have the ‘gold bugs’. They are long-term fans of the yellow metal, through thick and thin, viewing it as the only form of real money, and a must-have in the current environment of excessive debt. The more extreme gold bugs recommend only physical gold as a hedge against a complete meltdown of our over-leveraged derivative-based financial system, even favoring a return to the ‘gold standard’, an environment where all government debt has to be backed by gold, effectively ending the money printing presses of the central banks.
The reality is more in the middle of these two extremes.
The current central bank policies have gone so far from the gold standard that realistically it is unlikely any country will ever subject its central bank to be handcuffed in its ability to issue debt. A century ago when most countries were still on the gold standard, recessions were much deeper. Limiting central banks’ ability to provide liquidity to banks during a crisis meant that bank failures were far more common.
With each bankruptcy, savers risked losing their cash stored at the bank. Bank runs were much more common as depositors would queue to withdraw money when rumors that their bank might fail started circulating. These actions often became self-reinforcing, causing many financial institutions to declare insolvency overnight. The best way to reassure depositors in such times is to put a guarantee on the cash deposited to avoid bank runs, and the best guarantee is a government-backed one. While gold bugs may argue that such an environment prevents moral hazard by the central banks, imagine going back to such an era where all your cash savings in a bank were potentially at risk for every economic downturn.
During the 1930s Great Depression, countries that left the gold standard earliest recovered the fastest, and we have never looked back since then. Investors interested in a deeper analysis of the gold standard can read Golden Fetters by Barry Eichengreen, which makes the convincing argument that the gold standard fundamentally constrained economic policy and aggravated the recession.
Instead of a return to the gold standard, we are much more likely to see global over-indebtedness resolved by inflating the value of the debt (thereby reducing its principal value), together with some form of yield curve control (near-zero interest rates not just on cash, but extended out to longer bond maturities) to keep the interest affordable.
Gold allocation in portfolios is minuscule compared to equities and bonds. It is prone to long periods of alternating bull and bear markets, and unlike other commodities, it has limited industrial uses. However, it does benefit from the perception of it being a store of value, given its resilient property of being the most non-reactive of all metals. This store of value means that at times, though not all the time, it benefits from investor flight to safety. This is particularly important at times of high political tension and potential military conflict like we have now.
Irrespective of who wins the US Presidential election in November, the anti-China rhetoric is unlikely to cool off anytime soon, so investors need to prepare for years of escalating tit-for-tat economic warfare that can potentially spill into military confrontations. This environment, coupled with zero interest rates where there is no opportunity cost of holding gold vs. cash, is a perfect storm that benefits gold.
Before rushing to add gold in your portfolio, it is important to note that the biggest argument against holding gold long-term is correct. Looking at a 200-year inflation-adjusted chart of gold would show that gold prices are firmly anchored at 0% returns, with small periodic outperformance periods which have all eventually erased. The argument that gold, unlike paper money, cannot be created anymore and therefore should go up in value is correct in an environment where the supply of paper money keeps increasing each year. However, the pace of appreciation will in the long run approximate the inflation rate, historically at around 3% p.a. If this relationship continues to hold true, and even gold bugs would be hard-pressed to explain why it shouldn’t, any big bull market in gold will eventually crash back to the long-run inflation rate.
The other side of the coin is that if investors are not looking at the current move in gold as purely a speculation to catch the current upward wave, an allocation to gold in a portfolio has significant diversification benefits. In his most recent book Anti-Fragile, Nassim Taleb describes the concept of things that are ‘anti-fragile’, that get stronger during a crisis. In an investment portfolio, true diversification only comes from adding anti-fragile assets. Emerging market debt and private equity, for example, offer no diversification in a crisis, because they are fragile investments that suffer in the same way equities do. The best example of an anti-fragile instrument would be volatility, which always rises during a crisis, though a cost-effective volatility strategy is difficult for individual investors to implement.
Gold, given its multi-millennia history of being seen as money, benefits from flight to safety during both periods of military conflict, heightened geopolitical risk, paper currency debasement, and negative inflation-adjusted interest rates. Our current environment fits all these criteria.
Many investors have difficulty sticking to an all-equity portfolio given the high levels of emotional stress during every large downturn. The most critical variable in whether an investor achieves his financial goals is the ability to stick to their strategy through all the ups and downs. If reducing portfolio volatility helps investors stay invested, an allocation to the gold that is actively rebalanced (by reducing after large gains, and adding after sharp sell-offs) would achieve this goal.
By LEONARDO DRAGO
Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.
