Gold: Beyond Brexit

| About: SPDR Gold (GLD)
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After 3 years in a bear market, there are increasing signs that a new bull market in Gold prices is starting in 2016.

Gold prices have rallied in June on Brexit anxiety but this event is only a short term momentum play and investors must not forget the long term fundamentals of Gold.

History shows that Gold is a commodity currency, a store of (real) value and that it performs better than Fiat currencies in periods of negative real interest rates.

Gold will thrive in the current environment of over-indebted Nations, with economies slowing down, where unemployment remains high and in which Central Banks balance sheets are skyrocketing.

Where we stand

After the 2009-2013 bull market, Gold (NYSEARCA:GLD) (NYSEARCA:IAU) (NYSEARCA:PHYS) (NYSEARCA:SGOL) (NYSEARCA:UGL) (NYSEARCA:DGP) (NYSEMKT:GTU) has been in a bear market for the last 3 years. However, as the year goes by, there are increasing signs that a new bull market is starting in 2016.

When looking at the past 10 years, we can see that it has paid off to follow the trend. In fact, a golden cross in February 2009 marked the beginning of the last bull market and a death cross in March 2013 signaled the start of the last bear market. Note that in March 2016 we saw a new golden cross:

Source: StockCharts

Is this just because of Brexit?

Brexit has been blamed for almost everything that has happened in financial markets during the last couple of weeks (from Bonds to Stocks and from Currencies to Commodities). There's no doubt that it has played a major role in increasing volatility and investor's anxiety and as a consequence Gold prices jumped from $1.220 at the start of June to $1.290 today (the same happened with all other safe havens such as the German bunds, the Swiss Franc or the Yen).

When comparing the VIX with Gold Prices the positive relation between the two is undeniable as Gold tends to rally whenever there's a jump in the volatility index. In fact, we also saw this relation between the two in January and February 2016 when Gold prices rallied from $1.060 to $1.220 and the VIX posted readings above 20.

Source: StockCharts

Sure that if the UK votes to leave the EU we're going to see a jump in the VIX and Gold prices, but it is also certain the opposite will happen in case it remains. Even though I think (as most do) the British will be reasonable and decide to stay in the EU, I'm also convinced this is the outcome that is priced in the markets today and as a consequence the biggest pay-off is in taking the opposite (less likely) bet.

However, as the latest polls are still unable to clearly identify the winner, this is a momentum play and I'll leave it for traders. While being aware of the impacts of this decision, long-term investors must look beyond Brexit and understand the fundamentals of Gold.

Is Gold a Currency or a Commodity?

There has always been some discussion on whether Gold is a currency or a commodity. In order to answer to that question we must look to the demand side and see who is buying Gold.

Source: World Gold Council

The uses of Gold as a currency in Bars and Coins, ETFs and by Central Banks accounted for 35% of 2015's total demand and despite the decline in the last 3 years it has increased sharply from the 10% it represented in 2006.

The use of Gold as a commodity in Technology accounted for 8% of 2015's total demand and it has been decreasing steadily over the last 10 years.

Still, during the last 10 years Gold has been mainly used in Jewelry. Even if demand by this industry has remained stable over the last 10 years, it's importance decreased from 75% of total demand in 2006 to 57% in 2015. At first glance investors could say that the use of Gold in Jewelry is a commodity investment but, just like Diamonds, Gold is used in this industry because it is historically a timeless store of value and this is (supposed to be) one of the properties of a currency.

In the end, I see Gold more as a currency than a commodity: technically speaking it is a commodity currency and a (real) store of value in contrary to Fiat currencies. This is why, the demand for Gold as an investment (bars, coins, ETFs and by Central Banks) has been rising. Also, as the demand for Gold in Jewelry has been stable and its use in technology is slowly decreasing, the main driver of Gold prices (during the last 10 years and certainly in the next 10 years) is investment demand.

Gold and the History of money

Let's start with a bit of history as a reminder (as Winston Churchill once said: the farther back you can look, the farther forward you are likely to see) because in order to understand Gold, investors must understand the origins of money.

Gold has been used as a currency for centuries and it has been widely accepted as money in every single country of the World. The first coins go back to Greece, Persia and China in the 6th century BC. By then, unlike modern coins, ancient and medieval coins had the face value of their metal content.

Although History also has its share of Fiat currencies ("paper" money imposed by Government law), these experiments eventually collapsed due to inflation. All these regimes began in periods when there was lack of "real" (commodity backed) money but significant funding was needed. The first records go back to China in the 11th century AC when the conversion into Gold was no longer allowed in practice (as more notes were printed, inflation became evident and the currency became out of favor despite the Government attempts to enforce it). Spain had a similar fate when it created an emergency paper currency to fund the conquest of Granada in the 15th century. In the 18th century, the USA created the continental currency to fund the war effort but the currency depreciated so rapidly that it gave birth to the phrase "not worth a continental". Other failed experiments include Holland in the 17th century, Sweden in the 18th century and New France (Canada) in the 18th century. Some lasted almost a century, others just a few years but they all eventually collapsed.

The reason why these regimes failed was not the absence of convertibility into Gold itself but the excessive "paper" money printing due to recurring deficits. As a consequence, until the early 20th century the Gold standard prevailed, even if during the 19th century the regimes shifted from commodity currencies into representative currencies (notes convertible into Gold). In fact, Gold was used to back currencies and the international value of a currency was determined by its fixed relationship to Gold (Gold was used to settle international accounts).

However, the history of money changed in the 20th century when Gold was replaced by Fiat currencies. As a consequence we saw continuous devaluations of the dollar (and all other currencies) against Gold (and the other precious metals). Let's see.

When the Gold Reserve Act was enacted in 1934, the United States were enduring the great depression and President Roosevelt needed to increase the money supply in order to fight the deflationary pressures from high unemployment (sounds familiar?). The act restricted Gold ownership, banned Gold exports, halted the dollar convertibility into Gold and devalued the dollar to $35 per troy ounce from $20.67 per troy ounce (a 40% devaluation! ouch!).

In contrary to common belief that it was the Keynesian fiscal policy that spurred the economic recovery in the following years, Friedman and Schwartz explained that the 8% annual GNP growth rates in the US between 1933 and 1937 was primarily due to the growth in the money supply M1 which increased by 10% per year during the same period. Today, economists agree that both fiscal and monetary policy played their part in the recovery.

After World War II, the Bretton Woods agreement signed in 1944, marked the beginning of a new World order. This treaty created the IMF, the IBRD (today's World Bank) and a new international monetary system in which the dollar replaced gold in international payments and as a reserve currency. At the time, the US controlled 2/3 of the World's Gold and it guaranteed the convertibility of dollars into Gold at $35 an ounce so the dollar was as good as Gold (in a way it was even better than gold as it also paid interest). Note that under the Bretton Woods agreement the dollar convertibility into Gold was allowed (not required).

During the 1960's the defense of the $35 per ounce peg became increasingly difficult as the US public debt and Government deficit increased due to the Vietnam war, the cold war, the space run and social welfare public programs. As a consequence, the dollar Gold coverage decreased from 55% to 22% and in 1971 the convertibility of dollars into Gold was unilaterally terminated by the United States. Other states followed and Switzerland was the last country to abandon the Gold standard in 1999 (at the time Gold backed 40% of the Swiss Franc).

Gold vs. Fiat currencies

When looking at the dollar index which measures the performance of the dollar against a basket of other Fiat currencies including the EUR, JPY, GBP, CAD, CHF and SEK since 1967 we see that despite the slightly negative trend it has remained most of the time in a trading range between 80 and 100 (with a maximum of 160 and a minimum of 75).

Source: Trading Economics

However, if we look at the dollar price of Gold we see that the dollar has been consistently loosing value across the years. In fact, the Gold compounded return since the dollar convertibility into gold ($35) was abandoned by the US in 1971 until today ($1.290) is at 8.3% per year.

Source: Trading Economics

It is true that in contrary to Fiat currencies, Gold pays no interest. Still an 8.3% compounded annual return is way above the compounded official US CPI increase since 1971 of 4.0% per year. Before rushing into conclusions that Gold is not only storing value but also gaining value note that I mentioned "official" US CPI.

Source: Trading Economics

Another important point is that this secular bull market in Gold occurred in 2 major hiccups: the first between 1971 and 1980 when prices increased from $35 to $600 and the second between 2000 and 2013 when prices jumped from $250 to $1.800. However, in the 20 year period between 1980 and 2000 Gold prices lost more than 50% from $600 to $250.

To understand the performance Gold in each of those periods we must look at real interest rates (nominal interest rates minus the inflation rate). In fact, Gold prices go up whenever there are negative real interest rates ("paper" money savings loose purchasing power) and go down whenever there are positive real interest rates ("paper" money savings gain purchasing power).

In the 1970's, we saw negative real interest rates during most of the decade and as a consequence Gold prices rallied.

Source: Trading Economics

In contrary during the 1980's and in the 1990's the FED funds rate was consistently above the inflation rate. As "paper" money savings gained purchasing power, the dollar value of Gold decreased.

Source: Trading Economics

Most of the years between 2000 and 2013 posted negative real interest rates and as a consequence investors shifted back into Gold once again in order to maintain their purchasing power.

Source: Trading Economics

Since 2013, we all remind what happened to interest rates in the US: almost nothing. Still, the FED announced the end of quantitative easing in 2014 and has been promising rate hikes ever since. Regarding inflation, it decreased from 2% to 0% in 2015 (specially due to dollar strength against other Fiat currencies that same year) and is now on its way back to 2%.

Source: trading Economics

It is true that real interest rates remained negative over these last 3 years (even if not by as much as until 2013) so Gold should have continued its rally or at least remained stable. I think the main reason for this setback was that investors took the FED promises of monetary tightening seriously. Also, the 0% inflation readings during 2015 and consequent deflation fears didn't help. Finally, if you look closer, you will see that Gold measured in other major currencies (euros for example) has actually kept its value pretty well.

Reasons to be bullish on Gold for the years to come

One of the reasons to be bullish on Gold is that the FED has failed to deliver its promises and is starting to lose its credibility among investors. In fact, from the 4 rate hikes for 2016, we saw zero increases and half of the year has already passed by.

This happens at the same time that inflation in the US is picking up once again and from what is happening in the commodity markets it is likely to increase even further: oil jumped from $27 in February to $50, iron ore increased from $40 in December 2015 to $55, soybean recovered from $860 at the start of the year to $1140 in June, sugar rose from $0.10 in July last year to $0.19 today (among other examples).

But not only real interest rates remain negative. Today, negative nominal interest rates also seem to be the new norm in a big part of the developed world (have a look at Japan, Switzerland, Denmark and Germany), so the cost of opportunity of being invested in Gold has never been lower.

Also, as the world economies slows down (from China to South Korea or from Japan to the Euro-Zone), many countries are increasing efforts to devalue their currencies in order to export themselves out of an economic slump. In order to do so, the solution is the same everywhere: print "paper" money (but let's call it QE, monetary stimulus, increasing money supply, lower interest rates or bond buying program to be politically correct as we don't want people to panic). Instead of structural reforms, they're looking for the easy way-out at the expense of their trading partners and competitors.

Furthermore, all around the World, over-indebted Nations look at inflation as the only way of reducing their debt burden (inflation is the hidden tax). In fact, how can a State pay a 100% public debt to GDP ratio when its economy is struggling? I mean, if the State is running a 2.5% primary fiscal deficit and has to pay other 2.5% interest on existing debt, its nominal GDP has to grow by 5% for its debt to GDP ratio not to increase even further. These are all random numbers, but the message is this: whenever a debt haircut is impossible due to systemic risks, fiscal tightening alone will take decades (and in the end it may not even work), so the only solution is inflation. When you look at Public finances in the US, Japan or in Europe, can these States afford an increase in nominal interest rates by their Central Banks? Of course not! Central Banks lost their independence from politics a few years ago and it won't be restored any time soon. The recent surge and growing acceptance of Bitcoins worldwide is partly due to Central Banks lack of independence and credibility (but this is another story).

Finally, the unemployment remains very high and as we know from the Philips curve there is an inverse relation between unemployment and inflation (at least in the short term). So, one more reason to carry on printing "paper" money. Note that the statistic we have to look at is not the non-farm payrolls, the jobless claims nor the unemployment rate but the labor force participation rate which is still decreasing. Baby boomers retiring, more uber drivers and more apartments for rent at Airbnb could explain part of the decline but the main reason is that the economy remains weak.

Source: Trading Economics

In Summary

Gold prices have rallied in June on Brexit anxiety but this event is a short term momentum play and only a glimpse in the secular story of Gold across centuries.

History shows that Gold is a store of value as it protects your purchasing power. It also shows that Gold increases in price against Fiat currencies whenever real interest rates are negative.

We live in an over-indebted world (both private and public sector), economies are slowing down, unemployment remains dangerously high, we're seeing Central Banks balance sheets skyrocketing and we're getting negative real (and frequently even nominal) interest rates from our savings.

3 things are certain in life: death, taxes and inflation. Inflation is not a risk for investors if it is covered by nominal interest rates. However, inflation alone is not enough to get us out of this mess and negative real interest rates is what decision makers are looking for. You shouldn't underestimate Central Banks willingness and ability to boost inflation: they will not only get what they are wishing for, as they will overshoot their targets and be happy with that outcome. This is why Gold should be part of your portfolio.

In fact, at the end of 2015, the stock of Gold above ground was estimated at 188.000 tonnes while mine production was 3.200 tonnes, so the stock of Gold should increase by only 1.7% per year. In contrary, the FED, the ECB or the BOJ can create "paper" money in one single click and increase the stock of Fiat currencies by the amount they want while keeping low interest rates at the same time (incredible nonsense!).

Here's a graph of the Gold mine production from mines existent pre-2010 and new mines that started operating the following years (this is just the annual flow, not the stock):

Source: World Gold Council

And here's a graph of the FED and the ECB balance sheets (this is the stock not the annual flow):

Source: Bloomberg

Now, which currency do you prefer?

Disclosure: I am/we are long GOLD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.