MICRO UPDATE: GOLD (GLD, IAU)
“To me the gold price takes the form of a very uncomplicated formula, and all you have to do is divide one by ‘n.’ And ‘n’, I’m glad you ask, ‘n’ is the world’s trust in the institution of paper money and in the capacity of people like Ben Bernanke to manage it. So the smaller ‘n’, the bigger the price. One divided by a receding number is the definition of a bull market.” - Jim Grant, Grant's Interest Rate Observer
For centuries gold has been considered a store of value. It was treasured by humans long before it ever became money in the form of gold coins around 700 B.C. Gold’s malleability, scarcity and luster made it a natural trading medium. Its portability and permanency gave rise to our modern day understanding of using currency in exchange for goods and services. When banknotes or paper currency were first introduced, they were seen as a promissory note to pay a debt in precious metals.
Recently, gold has been under attack by some very smart and well respected individuals. Ben Bernanke refused to acknowledge that gold was money when questioned by Senator Ron Paul last year. Warren Buffett stated that gold has no utility and equated its value to the “greater fool” theory (our words, not his) in his most recent annual report. Lastly, Buffett’s long-time business partner Charlie Munger was quoted saying, "Gold is a great thing to sew into your garments if you’re a Jewish family in Vienna in 1939, but I think civilized people don’t buy gold, they invest in productive businesses." So if one buys off on all this reasoning, then people who invest in gold are like moths to a flame that are captivated by nothing more than a shiny rock. We have a different view on gold and its utility value as part of a well-constructed portfolio built on our Diversification 2.0 framework, and we see three major tailwinds working in gold’s favor right now.
The developed world is awash with too much debt. The response to this problem has been to pile more debt upon debt in hopes of stimulating the economy and growing out of the problem. Although this has been successful in keeping us out of a double dip recession or a true depression, it has done little in creating escape velocity for many economies. We appear to be in a very unsustainable cycle where governments either take on more debt or central banks print more money to manufacture growth. As soon as the stimulus ends growth rolls over, and more fiscal/monetary intervention is required to stave off recession 2.0.
Since paper money is nothing more than a sovereign’s promise to pay a debt based on their “full faith and credit,” it is no wonder that fiat currencies have been tanking against hard assets like gold and commodities. Unlike paper money, gold is not a government liability. President Herbert Hoover was once quoted saying, "We have gold because we cannot trust governments." As debt-to-GDP (or more importantly debt-to-tax revenue) continues to escalate and central banks continue to fire up the printing presses to monetize these debts, gold will continue to shine as Jim Grant points out in the opening quote. Oddly enough, a senator from Nebraska laid out this same line of thinking over 60 years ago in reference to the fiscal responsibility of the US government:
“The taxpayer is completely outmatched in such an unequal contest. Always heretofore he possessed an equalizer. If government finances weren’t run according to his idea of soundness, he had an individual right to protect himself by obtaining gold.”
That senator was none other than Howard Buffett, Warren’s father.
Interest rates are at historically low levels in most developed countries. In the US, bonds have been in a 30 year bull market as short-term interest rates have dropped from the low teens to essentially zero. Today’s interest rate environment is a product of the Federal Reserve’s easy monetary policy, which is in place to stimulate the economy by lowering the cost of borrowing (which only works if people actually want to borrow more money, but that is a discussion for another day). Keeping interest rates artificially low while inflation eats away at people’s purchasing power is known as financial repression and it is during these periods of time where gold has shown its true luster. The chart below shows the average year-over-year returns for gold and silver for different real interest rate environments.
A real interest rate is the nominal rate minus current inflation. Today’s real interest rates are negative since nominal short-term rates are at zero and core inflation is still running at 2% - 3% (not to mention food and energy inflation). It is in these periods of negative real interest rates where gold has done the best. Given the Federal Reserve’s promise to keep short-term rates at zero until at least 2014, this tailwind still has some legs.
One of the biggest shifts in the global economy over the past decade has been the uprising of developing nations. Today, emerging markets account for over 60% of the growth in global GDP, which has created a burgeoning middle class. Many of these countries, like India and China, have a storied history with gold, which has long been seen as a status symbol of the elite. This has created a very natural and ever growing demand for gold as more and more people join the ranks of the middle class and want to show off their status to the world. The chart below shows the strong correlation between the per capita growth in GDP of India & China over the past decade with the price of gold. The slope of the line would indicate that the price of gold increase by $1 for every $2 increase in GDP per capita in these two countries.
In addition to being a status symbol (e.g. jewelry demand), gold is also a staple investment for people in emerging economies who have limited access to financial markets or other investment options to hedge against inflation, which is a prevalent concern in any rapidly growing economy. These two demand factors (jewelry and investment) combined to make the emerging market consumer the largest demand source for gold over the past decade.
Although this chart is somewhat out of date as central banks are no longer net sellers of gold and ETF demand continues to increase, there is no denying that the “love trade” in emerging markets is a significant tailwind for the price of gold.
As a cautionary note, there are other factors that are not as supportive for gold. Since peaking in the middle of the last year, the price of gold has continued to make “lower lows” and “lower highs” which is a clear sign of a downtrend for a technical analyst or momentum trader. In addition, a recent Gallup poll found that one out of three Americans thinks gold will be the best performing long-term investment. This is the definition of a consensus trade which can leave one vulnerable to sharp sell-offs once sentiment changes and the crowd all heads for the exit (something we’ve already been experiencing as of late). Despite the recent breakdown in trend and the crowded nature of the trade, we think the fundamental arguments for holding gold far outweigh the negatives which is why we recently choose to increase our position in the metal for clients’ portfolios where it was deemed suitable and appropriate
Season Investments, LLC
We want Transparency to be one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. Regular Macro Updates will address our economic and capital market viewpoints and discuss top-down portfolio positioning. Also watch for Micro Updates which convey our reasoning behind specific investments. Lastly, we do a series of Q&A posts based off questions we receive which can benefit our broad investment community.
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