Time for gold?
Not financial advice. Full disclaimer available here.
Summary:
Gold has done a great job at preserving purchasing power over time.
Gold does well when confidence in the monetary system fades. Historically, gold has had a negative correlation with the US dollar.
Fear, uncertainty and negative real interest rate tend to benefit the gold price.
Gold is scarce and the supply outlook supports higher prices.
Prior bull markets have lasted for over a decade.
Physical gold does not have counterparty risk and can be traded outside of the financial system.
Gold is very much under-owned by investors.
Gold is a great portfolio diversifier because it is uncorrelated with conventional financial instruments.
Gold is likely to outperform US equities over the next 5 years.
While fiat currencies come and go (the current monetary system is only 50 years old), gold has been money for 5,000 years. Gold does not change; it lasts forever; it is indestructible. Thanks to these unique chemical properties, gold has been used by affluent families to protect wealth for centuries.
Gold has done a great job at preserving purchasing power over time. The classic example is that a 1-ounce gold coin bought a fine men's suit a 100 years ago and still does today. In contrast, the strongest paper currencies, the Swiss Franc and the US Dollar, lost over 95% of their value in that time period.
You may be wondering: why gold? Why not another metal such as copper? Well, gold is special. Gold is the only element in the periodic table that has value just because people say it has value. Although gold has industrial applications, it is so rare and so beautiful that 90% of the demand comes from investment and jewellery.
According to the World Gold Council, there are about 200,000 tonnes of above-ground gold stocks known to exist. This is less than 1 ounce of gold per person. Not only is gold hard to find, but it’s also difficult to extract. Therefore, supply has historically grown by 1.5% to 2% a year on average. Interestingly, this growth rate is similar to the rate of population growth and the rate of inflation targeted by central banks.
Gold & central banks
Central banks have a love/hate relationship with gold. On one hand, they hold it on their balance sheet and are net buyers as a group; on the other, they try to dismiss its importance in the media to maintain confidence in the monetary system.
Prior to 1971, gold was world money. It was a neutral settlement asset that countries could redeem against foreign reserves. This standard kept governments in checks and forced them to exercise at least some degree of fiscal and monetary discipline.
Today, easy money is the norm and the money supply is expanding at a rapid pace. Central banks need to keep interest rates low so that governments can service interest payments on the giant amount of debt they have accumulated since 2007. At the same time, they are borrowing even more to try to stimulate economic activity.
This set up is bad for bonds and good for gold. Gold does not yield anything and has a negative carry (because of storage fees). However, its supply is scarce and cannot be inflated away, unlike dollars or euros which are printed by the trillions these days. To put that in perspective, the total market cap of gold is estimated to be around 12 trillions dollars.
More importantly, real yields on sovereign debt are actually negative, meaning that the nominal interest rate is below the inflation rate. For example, the 10-year US treasury (the world’s benchmark for pricing securities) is currently yielding 1.5% while the latest CPI print is 5%. In other words, investors are guaranteed to lose 3.5% pa if they hold the bond to maturity. In comparison, the management fee for holding GLD — the largest gold ETF — is 0.4% pa. Therefore, gold wins in this environment even though it has no yield.
I am oversimplifying a bit because inflation is not a constant and the Q2 reading was expected to be high given the massive deflationary event we had this time last year. However, we know that central banks want negative real interest rates because that’s the only way governments are going to be able to pay off their debts. This is known as a soft default and it has been done before. The US kept rates artificially low during and after world war II to assist with deleveraging.
If history rhymes, there will not be an opportunity cost for holding gold over treasuries for a while because the people pulling the strings want to let inflation run. Therefore, we can argue that some of the demand for bonds will shift towards gold. Given that many portfolio are build on the risk parity model of 60% stocks & 40% bonds, the tailwind for gold is potentially huge.
Supply & market cycle
Gold might be a monetary asset driven by fear and real interest rates but it’s also a commodity. Therefore, it’s important to look at the supply side of the equation to have a balanced view on the price of gold.
Barrick Gold, the second largest gold producer in the world, estimates that global production will be around 120 million ounces in 2020. It has been slowly rising in an uptrend since 2009 when ~80m ounces were extracted from the ground.
That was bad news for the gold price from 2011 to 2019. The good news is: confidence among gold producers is still low. And, in the natural resources business, when confidence is low producers tend to underinvest in exploration.
So, the question becomes: can supply still match demand in the future? Barrick foresees a steady and continual decline, year after year, from 2020 until 2029, where production comes in at a little more than 60m ounces, half of what it is today.
Here are some more numbers from Marin Katusa, a natural resources investor well-respected in the gold community.
As you can see, the number of major gold discoveries is diminishing together with the number of ounces discovered per unit of capital spent on exploration. To sum up, the gold industry spent 58% of its budget from the last thirty years within the last decade, yet found only 7% of the gold.
It is always possible that advances in technology could drastically change the supply outlook for gold and put downward pressure on the price. This happened to the oil market with the shale revolution in the US, which transformed the nation from a net importer of oil to a net exporter and the world’s number one producer. Check out the February newsletter for more insights on oil.
It’s good to keep an eye on the miners to gauge where we stand in the cycle. Right now the sentiment is starting to turn positive but I think we are still very early. When the industry begins to throw money at projects that make no economic sense whatsoever, it will be a time to exit.
Besides the supply and demand fundamentals, market technicians also have a bullish outlook for gold. The log chart below suggests that we are only about 3 years into the current bull market and the last 2 bull markets have lasted over a decade.
Another useful visual tool is the infographic from Sprott which you can find here.
Gold in a portfolio
Gold is a safe haven asset that investors turn to in times of crisis and social unrest (i.e. 1970s). Fear is a big driver of the gold price. Gold is a secure place to park money when there is uncertainty in other markets. Conversely, when confidence is high, gold tends to do poorly. Therefore, gold is a great portfolio diversifier because it is uncorrelated with conventional financial instruments, i.e. stocks and bonds.
Investors can custody and trade gold outside of the financial system without a third party. It’s an insurance policy against failures of all sorts, including: currency collapses (Argentina), natural disasters (Bahamas) and banks bail-in (Cyprus). For this reason, billionaires and finance tycoons usually allocate a percentage of their wealth to physical bullion.
With most proponents advocating a 5-10% allocation, gold is very much under-owned. According to a Credit Suisse report, global net worth is estimated to be about $400 trillions while the gold market is around 12 trillions. This means that the overwhelming majority of investors are not in gold. The large pools of capital held by pension funds and insurance companies do not own gold. Not yet…
Personally, I have about 20% of my portfolio in gold. I see a lot of market turmoil ahead and therefore I expect gold to do well. I think it will outperform equities in the next 5 years, never mind bonds. For me, gold is also a form of savings. I look at my gold position the same way I look at cash, namely: a striker on the bench.
I want to point out that I did not just put 20% in gold overnight. I first initiated a small position in 2018 and added to it periodically. The last time I bought a sizeable amount was in early April of 2021. At that point, the gold price was effectively back to where it was prior to all the fiscal and monetary stimulus that took place in 2020. That did not make sense to me.
Still, 20% might seems like a lot for most investors (unless you are a gold bug). So, let me explain further. I am a European based investor and historically gold has not been as volatile in European currencies as it has been in relation to the US dollar. This is because gold and the dollar have had a negative correlation; that is, when gold goes up the Euro tends to appreciate against the dollar. Therefore, assuming those dynamics don’t change, I won’t gain as much as a dollar-based investor if gold takes off but I also won’t suffer the same drawdowns when it sells off.
I hedge out my gold holdings with a USD cash position of roughly the same size. Yes, I have plenty of dry powder! This is a tactical allocation because of my bearish view on equities. Every time there is panic in the world, the dollar appreciates substantially. Here is a good chart from Brent Johnson of Santiago Capital highlighting this:
As long as the dollar remains the world’s reserve currency, Brent does not see that changing and I happen to agree with him.
Note that I choose to express my bullish view on gold in the most simplistic and least risky fashion by focusing on the bullion instead of playing the miners and royalty/streaming companies. I avoid the miners because it’s such a tough business and the royalty companies because they never look cheap enough for me (though my performance would have been much better had I bought Franco Nevada or Wheaton Precious Metals).
Circling back to the appeal of having assets outside of the financial system, it makes sense to consider what other assets you have when deciding on what percentage of your portfolio you might want to allocate to gold. For example, I don’t own any real estate; if I did, my allocation would probably be closer to the 5-10% recommendation of most gold advocates.
My point here is not that you should allocate 20% to gold but rather how I got to that number and why I believe it’s conservative for me. I plan on rebalancing out of gold once opportunities in traditional financial assets become more abundant. I don’t have a stop loss in case I am wrong; so the thesis for owning gold would need to be seriously challenged for me to sell.
Risks
Gold is political. In 1933, president Roosevelt notoriously banned US citizens from owning gold. The good news is: if powerful institutions go through such length to retain control, it implies that gold is very valuable and has a place in an investment portfolio. The bad news is: if gold is a danger to central authorities, they will fight it.
As we touched on earlier, banks and governments have an interest in suppressing the price of gold in order to maintain confidence in the system. Right now, the gold market is relatively small so it is allowed to coexist along with fiat currencies. However, if gold was to challenge the status quo too much, then central planners might intervene.
History shows that bullion banks have been manipulating the market for a long time. JP Morgan notably got caught and fined on several occasions. The fiscal authorities can hurt the yellow metal too (with taxation). As a collectible, gold is already subject to a different capital gains tax than other assets in many parts of the world. Lastly, governments will use narratives such as ESG to discourage gold ownership.
Although I cannot think of another asset that has stood the test of time better than gold, I would submit to you that the world does not need gold. What people need is a reliable store of value and gold is not alone.
Bitcoin shares many of the properties of gold: it’s liquid, immutable, fungible and portable. In addition, the average millennial investor is more comfortable with the idea of owning a digital asset. Whether Bitcoin is actually better is up for debate but the point is: gold does have competition. If you are interested in this topic, watch Saylor vs Giustra.
Final thoughts
There is a market regime where gold does well and I think we entered that regime in late 2018 when the Fed became dovish again. In addition, the supply and demand fundamentals together with the chart support the gold thesis. Therefore, investors ought to consider gold in their portfolio, bearing in mind that ownership comes with a different set of risk than most traditional financial assets.
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