GOING FOR GOLD
Gold has historically been viewed as a store of value since the Roman Empire and is the original basis for our current monetary system. At the end of 2019 it was estimated that the total above ground stocks of Gold totalled 197,576 tonnes and that each year around 2,500-3,000 is mined to add to this stock.
The traditional Gold Standard fixed a country’s currency to a specified amount of Gold and thus fixed exchange rates between participating currencies; the flexibility was increased post World War II by the Bretton Woods system that centred around the Dollar as a reserve currency. This meant that whilst the Dollar was fixed to Gold at the price of $35 per ounce while other currencies were fixed but adjustable to the Dollar. However, by 1971 the Gold Standard and fixed exchange rates broke down and the convertibility of the Dollar to $35 ounces of Gold stopped.
Despite the link being broken, Gold continues to be valued by investors who view it as providing protection from inflation, recessions, currency debasement and equity market volatility. An old Wall Street saying recommends that you hold 5% of your Portfolio in Gold and hope that it doesn’t go up! As Ray Dalio has famously said, “If you don’t own gold, you don’t know history.” Or, as I like to say, “Gold: It does a portfolio good.”
There are also those who are strongly against investment in Gold; Warren Buffett once stated that “[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” Other suggest it provides no hedge against inflation, using it to protect against a bear market is gambling and you cannot time holding; and of course, if there is an apocalypse how will you carry it around to pay for things?
In recent years investors have started to look at other ways to provide protection against currency debasement and this has led to a significant focus from investors on Crypto Currencies, including Bitcoin. Whether these offer the security of Gold or are simply a passing fad for speculators remains to be seen.
What Drives the Price of Gold?
Assuming you want to hold Gold in a portfolio its is crucial to understand the key drivers of the price, and which indicators to watch to help decide how much to invest. The price of Gold will be influenced by interest rates, Monetary & Fiscal Policy, changes to the rate of inflation, exchange rates, and stock prices.
Gold pays no interest and holdings of the physical asset have storage costs; generally rising interest rates are bad for the price of gold as investors would prefer an asset that offers a virtually guaranteed return – why invest in Gold when you could receive a 4% on a cash deposit? Conversely falling interest rates should be positive for gold.
The ratio of the Copper Price/Gold Price has historically been a good indicator for US interest rates; from 2019 into 2020 these were declining creating a tailwind for the gold price. In contrast we now see interest rates likely to rise that could have a negative impact of gold prices. However, this basic rule is only true if inflation is stable; in the 1970s we saw high interest rates and high inflation - the gold price soared by over 600%.
Currently, whilst interest rates have been rising and look like they may continue to do so, the rate of inflation has been rising at an even faster rate. Long term real yields (the yield on 30-year US debt less the rate of inflation) are generally closely correlated to gold. The more negative real yields become the higher the price of gold; at present we see high inflation creating negative real yields of almost -4% and wonder why the price of Gold has not followed.
As well as monitoring interest rates and inflation, watching Monetary & Fiscal Policy is also crucial. If the Central Bank is using Monetary Policy and trying to stimulate the Economy by lowering interest rates this should be positive for Gold.
At the same time if Governments are running expansionary fiscal policies – spending on infrastructure, supporting failing sectors or meeting the cost of a pandemic – they are likely to start to run deficits. If Government does not collect enough revenue to pay for its expenditure, it runs a deficit and will issue debt to raise money for the cost of their spending.
Low interest rates and fiscal deficits are usually negative for a country’s currency; low interest rates do not attract inflows of money from overseas and widening deficits make investors worry that Government may not be able to pay their debt obligations.
When it comes to Gold the exchange rate and the strength of the Dollar is important as the price is denominated in Dollars; if the Dollar is weak and the value of your currency is stronger (say Sterling) then a weaker Dollar means you can buy more Gold for money and attracts investors.
Below we see two graphs - the top one shows the US Fiscal Deficit is wider than at anytime in the last twenty-five years; however, the US Dollar is yet to weaken. The bottom graph show how a weakening US Dollar drives up the price of gold – the blue line here is inverted so as the Dollar weakens it rises.
US Stocks can also help provide an indication of direction; the correlation between these two assets changes over time but one key indicator, the three-year change in the ratio of Gold to US equities, has been pretty accurate. When this changes from negative to positive the price of Gold has move higher.
We have excluded several technical indicators that we also use in our decision process as these are beyond the scope of this article.
June 2002
- US interest rates had fallen to 1.25% from 6.5%
- Inflation was rising from a very low base
- Fiscal easing was starting and a budget deficit widening
- The Dollar was at multi-year highs
- Three-year change in Gold/Stocks turned positive in Jan 2002
All six key points presented a positive picture for Gold and over the next four years gold returns 135%.
June 2013
- US interest rates at multi-years lows and starting to rise
- Inflation was stable
- The fiscal budget deficit was showing signs of narrowing
- The Dollar was strengthening from a low base
- Three-year change in Gold/Stocks turned negative
All six key points presented a negative picture for gold and having already lost 25% from its 2011 peak gold lost a further 25% and traded sideways until 2019.
where now?
At present indicators suggest Gold should rise; with perhaps only falling interest rates holding things back. To us, it would appear Gold is primed to do well in the coming years – as it did in the late 1970s – but there could be some pain in the short-term
We must also consider that Gold is a safe haven asset and unexpected extreme shocks can see the price increase regardless of other indicators; for example, overvalued equity markets falling substantially will see investors scramble for security.
What we can say is Gold is one of the few assets that has not risen in value significantly in the last ten years (the price is broadly similar to what it was in 2011) and for this reason alone it must be worth holding some.
final thoughts
Over thousands of years Gold has been considered a store of value, and whilst there are many more alternatives in today’s investment universe there still remains a case for investing in this asset. Understanding what drives the Gold Price and where we are in relation to history is crucial to deciding how much to hold at any given point.
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