Cash Chronicles is in residence in Las Vegas this week so it only makes sense I talk about hedging bets. What better way to bring on a discussion about hedging and good old wagers than talking about gold?
It only took about a decade but gold is back in the conversation again. In the years following the Great Recession from 2009 to 2010, gold rallied from around $900 an ounce in 2009 to around $1,900 an ounce in 2011. What drove this rally and what does it mean for the price of gold today?
It always helps to put things in context. There were two main factors which drove the last gold rally which we have to take into account. The first is that the last recession came on the back of a global commodity rally which was being fueled by China. Almost all commodities, gold included but also including copper, iron ore and oil were seeing a rally in the early 2000’s. Exxon Mobile was the largest company in the world by 2006. When panic hit in 2008 and 2009, gold briefly dropped as there was a flight to safety. However, as investors feared a return of high inflation and unemployment, or stagflation, on the back of unprecedented Fed intervention, gold shot through the roof over the next 2 years, topping out around that $1900 an ounce.
The rally fizzled out in 2012 though 2017 and gold fell to as low as around $1,100 an ounce in 2015. The attractiveness of gold had been sapped with the massive rally in the stock market. It wasn’t until late 2018 that gold started to pick up again and has only now returned to the levels last seen in 2011. Stocks trounced gold returns during this period more than doubling in value from 2012 to 2017 while gold fell by almost 40%.
Source: goldprice.org
Indeed, this is a phenomenon we have seen time and time again. Over the last 100 years, adjusting for inflation, gold has returned about 1.1% annually while US stocks have returned about 6.5% annually. There is no reason to think this dynamic is about to change either, but rather we have to start to understand the motivations behind the most recent gold rally and the rationale for having it into your portfolio at all.
Why Hold Gold?
I find it fascinating that human behavior, despite all that we have learned over the past few hundred years, doesn’t differ too much from our economic decisions thousands of years ago. According to some economic historians, an ounce of gold has been able to buy the same amount of bread since the times of Nebuchadnezzer in ancient Babylon.
Gold doesn’t yield anything, as some of the most famous investors have noted, so it doesn’t produce any value in itself but it’s not the value in gold that makes it worthwhile to invest in, its how people value it, especially in times of turmoil that can make it useful. Just by the inverse nature of its return which I noted above, there is a case for holding a bit of gold in your portfolio of stocks and bonds as it can reduce volatility while providing an upside in hard times. So purely from a diversification point of view, there is some logic to holding a bit of gold.
In contrast to the run up to the last gold rally, this time we are in a commodity slump super cycle which may have ended only this year. Up until recently, commodities had not recovered fully from the crisis and in the case of oil, have taken a hammering from the outcomes of global politics. It seems rather that the recent rally is being driven by gold as a safe haven and fears of inflation again as a result of that massive Fed intervention and growth of the money supply.
Inflation Fears
Initially during the Covid panic, I feared that the massive changes coming to supply chains may spark inflation. This has become more of a medium term (2-5 year) worry, in the immediate aftermath of lockdowns until today, what we are really seeing is deflation despite all the quantitative easing. This is because demand for money has dropped off even as supply has ramped up. Expected inflation from consumers has remained low and low expectations are the key to maintaining low inflation. The only danger to this is that food prices have started to creep up faster than overall inflation. Since food is something we all need and more front and center of our inflation perceptions, there is a risk that rising food prices could raise overall inflation expectations, even though this hasn’t manifested itself yet.
There has been a lot if hype though, expecting that inflation will rear its head again. I now believe that this fear is based on a historical narrative that has little to do with our present rally and also has a precedent in modern times that a lot of commentators seem to be ignoring.
In the 1970’s, the US pegged the value of the dollar to gold and then other currencies were pegged to the dollar as part of the Breton Woods system. Well the US tried to cheat their way into paying for the Vietnam war by printing money since the 60’s and the outcome was a slow lurch towards the collapse of the Breton Woods system. Once France and England asked for their gold back, Nixon just went ahead and took the US off the gold standard. The dollar no longer needed to be artificially pegged to the dollar and the subterfuge of keeping the gold price artificially low was removed which sparked a rally which saw gold increase in value by 7x that decade. Throw in inflation, attempted price controls and an oil embargo and you have the recipe for high inflation and high gold prices. It took Paul Volcker coming in and destroying inflation with high interest rates during the Carter, and then Reagan administrations (Carter never gets credit for hiring Volcker in the first place).
The point of telling this story is that we aren’t facing a situation like this today. The world is richer, more interconnected, floating exchange rates are not a new phenomenon and inflation is subdued. The old magic number of 100% debt to GDP as a danger zone seems to have been discarded as rich world governments realize what Japan realized 20 years ago: with low rates you can issue much more debt and the cost to service that debt is about the same.
In fact, issuing debt and using the central bank to monetize it with inflation remaining low is nothing new as we can all see with Japan. I am now firmly in the camp that, barring a big jump in inflation expectations by the public in the near term, we are looking at years of ever higher debt and low inflation in the US. I see a repeat of a search for safe havens in the next year or two, while stocks will be poised to retake the mantle in terms of asset class returns after that.
We Will All be Japanese
Japan been able to manage for over a decade with debt to GDP at the highest levels in the world at around 200%. They manage this by holding it themselves. Foreigners would likely demand better than losing their money to lend to the Japanese government, so many foreigners just hold the bonds for hedging purposes or idle yen that they hold. Foreigners only make up around 8% to 10% of the lenders to the Japanese government.
Source: Nikkei News
In contrast, foreign creditors hold around 30% of all US federal debt, a figure which has been falling for the past few years.
So how is Japan able to hold so much debt domestically? Well the government has a monopoly on regulation and they can simply classify their own assets as “the safest” and force institutions to hold a higher percentage of them. Take a look at the holders of JGB’s to get an idea of where this is headed in the US.
As you can see, the central bank, insurers, banks and government bodies hold the majority of Japanese government bonds (JGB’s). The US is slowly shifting towards this model currently, with the Fed buying up to 70% of treasury issuances in the past year.
As long as the public doesn’t mess it up by suddenly changing their inflation expectations, which the Fed can influence by controlling interest rates, we are looking at a period of ever increasing debt levels and low expectations, very similar to what Japan has experienced.
In this type of environment, fear will eventually subside, especially if a vaccine for Covid is discovered and widely distributed in the next 6 months and the rally for “panic assets” like gold will fizzle. What assets can we expect to see rally? Well we have seen tech rally but on the back of massive fiscal spending and low rates we are looking at a repeat of the early 2000’s when rates fell after the dotcom bust and spending ramped up post 9/11. This points to a weakening dollar and a rally in foreign assets. Just look at the long term shift in Japan’s asset holdings to get an idea of what is in store.
You can see that despite being notoriously risk averse, Japanese investors are nonetheless shifting away from government bonds and towards foreign securities and equities to seek out higher returns. I look for this long term trend to retake the narrative in the US post Covid.
Back to Gold
So where does that put us in terms of gold? In the short to medium term this rally should have legs. Look for the media to continue the retail herd piling into gold at ever higher prices. A change in the Covid situation and continued low inflation could then puncture this rally and I would be surprised to see it last longer than another year or two. So if you are looking for diversification, gold still isn’t bad but it may be time to start to also slowly shift towards cyclical and foreign stocks to be in a position to take advantage of a weakening dollar and continued low rates.
The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.