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The Investment Case For Gold - Myths And Narratives

|About: SPDR Gold Trust ETF (GLD)
Summary

Long-term outlook for gold remains constructive as global dynamics point to new era of higher inflation, populism.

However, short-term outlook remains uncertain as the Federal Reserve likely to continue tightening monetary policy.

Both bulls and bears often have distorted views on the investment merits for gold.

In this article we will review the relative investment merits for Gold (NYSE:GLD) both over the shorter-term as well as over the next several years. Specifically, we will address some of the perennial myths and narratives that tend to be put forward by both bears and bulls when it comes to making (or arguing against) an investment case for gold. We will put forward our own view of the key fundamental factors that investors should focus on when contemplating an investment in gold.

Earlier in the year we wrote an article where we suggested that allocating some capital to gold in one’s overall portfolio could be prudent. The main reason was as a hedge against escalating trade tensions and the continued impact from rising Western populism on future policy formulation. A second and perhaps more important reason is more fundamental in nature as it relates the prospect of declining gold supply in the next decade.

The following article provides a good overview of the current situation as it pertains to future gold supply. Below is an extract from one key paragraph that –

“If you look back to the 70s, 80s and 90s, in every one of those decades, the industry found at least one 50+ million ounce gold deposit, at least ten 30+ million ounce deposits and countless 5 to 10 million ounce deposits. But if you look at the last 15 years, we found no 50 million ounce deposit, no 30 million ounce deposit and only very few 15 million ounce deposits”

We follow several gold mining companies operating in many jurisdictions around the world and very few of them have a growing production profile. Our analysis suggests that this all points to the need for a step change higher in exportation and development expenditure which in turn probably requires a higher gold price. The World Gold Council has estimated that a price of $1500 per ounce is probably required in order to ensure that current production levels are sustained over the next 15 years. 

As the chart below shows, exploration expenditure remains well below the 2011/12 cycle high. More importantly, despite the increase in exploration expenditure since the early 2000s,  the quantum of new gold discoveries has declined significantly. 

However, in the article we penned earlier in the year, we also cautioned that over the shorter-term while the Federal Reserve was likely to continue tightening monetary policy, gold could underperform. We also noted that an intensification in the evolving trade war was not automatically negative for the US Dollar. In fact, a sound argument can be made that if the imposition of tariffs reduce the US trade deficit, it could regardless of any short-run inflationary impacts, ultimately prove US Dollar positive.

Since we published that article, this has indeed proven to be case, with gold and gold mining equities in particular, substantially under-performing. However, this does not alter our longer-term constructive view on the outlook for the gold price.

As we have outlined already, longer-term supply dynamics call for higher gold prices over time, while beyond the shorter-term, the macroeconomic backdrop will become increasingly supportive for the following key reasons –

  • As the vast majority of developed economies age, their fiscal expenditure from pension and healthcare obligations will rise over the next decade

  • As interest rates normalize, the interest burden for most national governments will also increase at the same time.

 Source: WSJ, The Daily Shot

  • Ageing economies will also increasingly face labour shortages, with Japan being the poster child for this evolving phenomenon, but certainly likely to be joined in the next decade by Europe and the US.

 

Source: Capital Economics

  • Tighter labour markets will eventually lead to accelerating wage inflation and sustained cost-push inflation. Nevertheless, overall growth (due to stagnant or even declining working-age populations) will remain lacklustre. This could usher in a new era of “stagflation” in the 2020s, similar in some ways to the 1970s.

  • Rising populism leading to the imposition of trade tariffs and the dismantling of global supply chains will exacerbate these “stagflationary” dynamics, the opposite of when increasing globalization acted as a major long-term disinflationary force in the 1980s and 19990s.

  • Nationalist populist policies that limit immigration will exacerbate labour shortages and lead to even higher wage growth or wage inflation

  • Populist policies amid a slow-growth environment could lead to calls for higher government expenditure and interference with the mandate of the central banks in these countries - resulting in sustained negative real interest rates.

Nevertheless, despite these longer-term dynamics that ought to prove supportive for the gold price, it is very likely that we are not yet at that inflection point where we can confidently say we are in a new bull market for gold and by association gold mining equities. US labour markets remain tight and the Federal Reserve is sure to continue hiking interest rates over the next six to 12 months.

As the chart below shows, a record net number of small businesses in the US have been raising the wages of their workforce. It is challenging not to envisage this feeding through into higher service inflation at some point.

 

Source:NFIB

Furthermore, given recent signs (see JP Morgan Global PMI below) that global growth momentum may have already peaked, the disparity in relative interest rate expectations (between the US and the Rest of the World) may yet intensify even further.

 Source: Trading economics

Furthermore, although there are genuine concerns regarding the widening in the US fiscal deficit, a larger fiscal deficit on its own is not necessarily a sufficient reason to take a negative view on the US Dollar and positive view on gold. A fiscal deficit, no matter how large it is relative to GDP, if it is comfortably financed by domestic household and corporate savings (think of Japan), will not lead to a wider current account deficit (or even higher inflation), which is one of the primary drivers of a weaker currency over time.

As we can see in the chart below despite the significant increase in US household wealth since the Global Financial Crisis ((GFC)), household savings rates remain quite high in a historical context at around 6% of disposable income (for the US). 

In fact, if the widening fiscal deficit leads to higher inflation AND higher interest rates, but a current account deficit that remains static or narrows, then it may even lead to a stronger currency or at least temporarily. This in some sense is what we are already seeing, given the transformative impact the US Shale revolution has had in terms of reducing US oil imports, discussed in greater detail in a prior article here.

As such, we think the inflection point will likely only be truly reached when either for economic reasons (a surge in the US Dollar) or political reasons (interference from the White House or Congress) the Federal Reserve is forced to cease or pause its tightening cycle. The inflection point could also occur once we observe a definitive and marked widening in the US current account deficit.

However, at present this has not yet transpired and as noted earlier trade tariffs that reduce imports into the US could even lead to a modest narrowing in the deficit.

 Source: Trading economics 

Now that we have clarified our own position and investment case for gold, let’s address some of the myths and narratives that remain pervasive when it comes to the investment thinking as it pertains to Gold

Gold Bull Myth 1 – FIAT money is worthless and not backed by anything hence one should own gold (or lately cryptocurrency*)

 FIAT currencies are not worthless. FIAT currency is credit money or IOU’s that are issued by commercial banks in a double-ledger accounting process. On the other side of the ledger in which the FIAT currency is created (these days electronically) is a loan or asset. Typically, it is a loan supported by an asset (home) or the commitment to future economic activity and hence cash flows.

FIAT currency works well because it is explicitly backed by the sovereign and it is the ONLY currency that is legal tender and in this sense it really reflects the entire outstanding credit pool in an economy and by definition a large proportion of an economy’s assets and cash flows. Think of FIAT as one share in a very large exchange-traded "credit" fund backed by the assets and cash flows of the entire economy.

Private credit (tradeable IOUs) issued by a private bank would only be backed by the specific asset or cash flow at an individual level or institutional level. Imagine the monetary chaos that would ensue from fluctuating private currencies trading on the potential for default. Some often cite the 1800s in the US as an “Utopian” vision for what a world with privately issued currencies could look like. What these commentators forget is that invariably these currencies were backed by gold reserves held or owned by these private institutions who also generally ensured full convertibility. This was really nothing more than a gold standard.

Gold itself can serve as valuable (as it has) store of value and as a basic type of money (as it has in the past when economies were far simpler). However, it cannot serve as a credible form of money in a modern economy that require large and efficient credit markets. This in turn naturally requires a highly elastic money supply. And thinking you can run a modern, highly complex economy without credit is akin to thinking we can produce the same volume of agricultural output if all the farmers in the world went back to using an ox and plough. 

Gold supply is fundamentally inelastic while credit is elastic and therefore far more amenable to relative price, interest rate and ultimately financial stability. A gold standard can appear stable for a time because it loosely acts as an anchor for relative currency values. However, if credit continues to expand in the background (as it would have to in order to support a growing and modern economy) and it does so far in excess of the available supply of gold reserves or backing, it will eventually collapse leading to financial panic.

This is essentially what happened in the 1920s and 1930s. Simply put, tying the growth in money supply in a modern and complex economy to the arbitrary supply fluctuations of the gold mining industry, simply does not make economic sense. As nominal GDP grows, credit needs to grow too and limiting credit or money supply growth will lead to deflation in the economy. An economy with credit facing deflation means that debtors have to repay a fixed nominal debt with declining nominal cash flows or asset values. This will very quickly lead to a self-reinforcing deflationary bust.

*Last year we published a detailed Q&A on why cryptocurrencies for both technical (i.e. power consumption, scalability) and fundamental reasons could and would not serve as credible forms of money.

Gold Bear Myth 1 – Gold is a barbarous relic and has no useful utility nor does it pay an income or dividend

Gold has a value as long some people desire to own it in whatever form, usually jewellery. Very loosely we can say that the intrinsic value of any commodity including gold is the marginal cost that would be incurred in order to find and mine new supplies. As we have discussed in this article although the cost of mining gold in existing and established gold mining operations is around $1000 per ounce, the cost of finding and developing new resources is probably a higher, perhaps as high as $1500 per ounce.

This would then represent the marginal cost of new supply and the best indicator for the relevant intrinsic value for gold at this time. Furthermore, as inflation accelerates so too ultimately does the cost of mining gold. At its most basic, this is the central reason that gold acts as hedge against rising inflation and remains a credible store of value.

Looking at the demand side, given the potential growth in the emerging market middle class (particularly India), it is hard to come up with a bearish case for gold demand over the next two decades. A study by the Brookings Instiution (cited by the same World Gold Council publication referenced earlier) has estimated that as much as 170mn people will join the global middle class every year over the next 17 years. 

If any market participant wants to come up with a bearish narrative for gold it can only really come from a view that existing investors in gold including the world’s central banks (or those that still own gold) will become major net sellers for a sustained period of time. As we have discussed in this article already, the evolving macroeconomic backdrop suggests that the investment case for gold will remain favourable and therefore it is equally challenging to come up with a credible scenario that would see a massive and sustained liquidation in gold investment holdings.

Further to this, all investors should remain cognizant of the fact that the United States remains a large net debtor. This means that foreign investors own more US financial assets (debt and equity) then resident US investors own foreign assets. The chart below shows that foreign portfolio liabilities amount to about 100% of GDP ($20trn), while foreign portfolio assets amount to only around 70% of GDP.

Source: Bruegel, Working Paper, September 2017

This leaves a fairly large gap of around $6trn, at least in terms of more liquid portfolio assets (so excluding fixed direct investment). Furthermore, there is also no guarantee that domestic US investors would repatriate their foreign portfolio assets if the USD weakened substantially. Therefore in reality the quantum of portfolio assets that could be liquidated over a fairly short time period could far exceed $6trn.

Nevertheless, the US’s gross investment position is not necessarily a definitive negative factor for the US Dollar either. In part it reflects capital inflows or investment from foreigners looking to participate in the relatively higher equity returns that have been generated by the US since the GFC as well as relatively higher interest rates on offer or at least relative to those found in Europe and Japan. As long as US financial assets offer foreign investors an attractive return coupled as well as deep and liquid capital markets that make buying and selling relatively easy, there is no reason for a “run” on the US Dollar.

However, an intensification of the nationalist populism that has emerged since the election of Donald Trump in 2016 could eventually pose a serious risk to the relative attractiveness of US financial assets and by implication the US Dollar. For one thing, should the US fiscal deficit continue to widen its entirely possible that the country’s sovereign debt ratings could be lowered. Large net sales of US assets by foreign investors would undoubtedly lead to a weakening of the US Dollar, at least for a period of time until the selling abates.

Thus far the large corporate tax cut implemented in the US has further bolstered corporate profit margins and therefore the equity market. Furthermore, a robust US economy has led to a higher bond yields. These factors have continued to attract foreign capital into the US, despite the shift in political culture.

Also worth noting is that large foreign institutions or even central banks, don’t have any realistic alternatives. The capital markets in most emerging markets including China are still not sufficiently developed or liquid enough to accommodate the vast pool of global savings including the reserves held by central banks. Europe’s capital markets are deep and liquid, but the intransigence of Europe’s elites when it comes to implementing far-reaching and needed structural reforms to finally mitigate (in the minds of investors) any chance of the European Union or the single currency breaking up, continues to undermine confidence in the region.

Nevertheless, as many American voters seem to have forgotten, it has been the steadfast commitment to a free market economy and certain democratic norms including human rights that have been the pillars on which the success of the American Republic has been founded. The subordination of these primary ideals, namely democracy, freedom of expression (including the protection of the press) and association and protection against the arbitrary rule of law (and the executive) for the sake of secondary policy goals such as the appointment of a more “liberal” or “conservative judge” or limiting immigration or even a tax cu or spending increase, is the start of slippery slide downhill.

The subordination of these primary ideals that underpin any free Republic coupled with growing political and cultural polarization no doubt represent the greatest threat to the continued long-term survival of the American Republic or at least in its current form (it is not impossible to conceive of one or several states seceding from the Union at some point in the next 30 years).

Its not too late for the political and social culture to change and shift back to a more unified and stable pattern, but neither can we be certain that the tide will shift back either. As the Republican party, traditionally seen as the party of small government, free trade and free markets, slowly submerges and morphs into a nationalist, isolationist party, the risk of an eventual radical and harmful shift in US policy will grow with each passing year.

Gold Bull Myth 2– “De-dollarization” will lead to a large rise in the price of gold

The threat of “de-dollarization” is another common theme that is often cited as a reason to be positive on gold and by implication bearish on the US Dollar. This theme has been around for at least a decade is centered on the notion that as countries transact directly in other foreign currencies and not specifically in the US Dollar when engaging in cross-border transactions, this will have a large and negative impact on the demand for US Dollars.

Both Russia and China have recently made efforts to “de-dollarize” their financial systems. China recently launched an oil derivative priced in Yuan and in 2015 introduced its own transnational payments system (CIPS), while Russia in 2017 introduced its own payment system interacting directly with CIPS. However, the global (ex-US) transactions demand (for commercial activity not investment activity) for US Dollars only represents a very small % of the overall US Dollar stock or demand. Far more important as we have highlighted, at least in our opinion, is not the currency in which foreigners choose to transact but the currency in which they choose to invest their savings including the world’s central banks.

One way to think about this is to estimate the total value of transactions you may carry out personally in any given year from your bank account. For most people, the total value of transactions in a calendar year is probably a multiple of their average bank balance during the year! We don’t think a few countries banding together such as China and Russia and transacting directly with each other in Yuan or Rouble will have any real material impact on the US Dollar. Nor will pricing oil in Yuan or Rouble. If Country A sells oil and receives Yuan proceeds what is more important is what they decide to do with those proceeds, keep it or exchange it for US Dollars in order to purchase a US financial asset. 

If the world’s central banks, which still hold some $6.5trn in US Dollar assets, all decided to simultaneously sell these assets it would undoubtedly have an out-sized and negative impact on US bonds and the US Dollar (assuming they chose to convert their US Dollar proceeds into another currency) However, this would be a political and not economic decision. The reason that 62% of the world’s central bank reserves are still held in US Dollar assets is because US capital markets are so deep and liquid. This feature is in turn a function of the size of the US economy and to secondary degree a function of its stage of economic and financial development. 

If you are the Japanese central bank sitting on $1.259trn in reserves and would like to hold these reserves in a foreign currency - but also one that provides some kind of yield - there are simply very few alternatives if having the ability to liquidate your portfolio quickly is also important. In fact, you only really have the US Dollar or the Euro as an option. The currency composition of global reserve assets is intrinsically a function of the relative size, depth and liquidity of the various relevant major economies capital markets. 

Given that the US is likely to remain the world’s largest economy for the next decade and following that more than likely the world’s second largest for a very long time yet, US Dollar assets will continue to constitute a large portion of total global reserve assets, barring perhaps a profoundly disastrous political earthquake (such as secession). Over time as China and India’s economies grow and their own capital markets become more developed and liquid, it is possible (and likely) that an increasing share of global reserve assets will be invested in these currencies.

Therefore, merely as a function of the relative growth in the size of these countries’ economies and capital markets, the relative share of US Dollar reserve assets will decline. But it will not be a disaster nor politically driven. In fact, we note that the Russian central bank has recently sold all of its US treasury bonds, without a noticeable impact on the US Dollar or US bond yields.

If we consider this table taken from Wikipedia which lists the 20 largest foreign exchange reserves and further assume that Russia’s reserves now no longer comprise any US Dollar assets, then from a political perspective it is really China’s holdings that represent the key remaining risk. Almost all of the other countries in this list are democracies with independent central banks (thus likely to follow a sensible and rational reserve policy) or allies of the US such as Saudi Arabia (or at least for now)

Rank

Country or region

(Millions of US$)

Figures as of

1

 China

3,087,000

Sep 2018[1]

2

 Japan

1,256,018

April 2018[2]

3

  Switzerland

800,389

May 2018[3]

4

 Saudi Arabia

506,400

July 2018[4]

5

 Russia

459,200

05 Oct 2018[5]

6

 Taiwan[6]

460,441

September 2018[7][8]

7

 Hong Kong

424,900

Aug 2018[9]

8

 South Korea

403,000

Sep 2018[10]

9

 India

399,609

05 Oct 2018[11]

10

 Brazil

380,738

Sep 2018[12]

11

 Singapore

288,044

June 2018[13]

12

 Thailand

249,312

April 2018[14]

13

 Germany

200,312

September 2017[15]

14

 France

175,890

December 2017[16]

15

 Mexico

173,022

January 2018[17][18]

16

 United Kingdom

164,210

31 March 2018[19]

17

 Czech Republic

144,142

September 2018[20]

18

 Italy

143,183

March 2016[21]

19

 Iran

132,600

31 December 2017[22]

20

 United States

120,493

27 July 2018[23]

Looked at it from this perspective and provided US political and economic policy remains sufficiently “mainstream” to maintain investor confidence, the quantum of central bank US Dollar reserve assets that could “flood” the market in a short space of time is really quite small relative to the size and depth of US capital markets and the savings pools (available to step in as buyers of US assets) of Western developed economies. This is hardly the kind of thing that should be keeping investors up at night.

Naturally if there is a loss of confidence in FIAT money more broadly (if economic and political pressures lead to currency debasement) then the share of gold in the composition of global reserve assets may increase too. In fact, both Russia and China have been buying and adding to their existing gold reserves, no doubt in part aimed at bolstering the credibility of their own currencies and making it more attractive for other smaller central banks to transact in Rouble or Yuan and hold their reserve assets in these currencies. In fact, there has even been talk that China is now loosely pegging its currency to the value of gold.

In the short-term this may indeed be the case and may therefore provide additional demand for gold which will further underpin our investment case , at least over the next several years. However, it is not a viable long-term policy option for China. As we noted earlier, tying the value of your currency or money supply to gold in the modern age means that you will ultimately link your domestic price level to the arbitrary fluctuations in the supply of mined gold and the real marginal cost of mining gold.

As an example, if declining gold supply over the next decade implies a large real price increase in gold, will Chinese authorities also allow the Yuan to appreciate in real terms verse other currencies? Unlikely in our opinion as it would devastate their export sector which remains an important pillar of their economy. Furthermore, China no longer runs a large current account surplus and if anything is now starting to experience net capital outflows. This makes it impossible for the Chinese central bank to continue accumulating foreign exchange reserves and by implication will also restrain its ability to add to its gold holdings.  

Gold and FIAT money narratives, when do the gold bulls get it right?

The main criticism that can be levied against the world’s central banks and therefore by association “FIAT” money is that central banks themselves have not conducted monetary policy sensibly or wisely over the past three decades. At the core of this is the dissociation between inflation or inflation-targeting and the growth in credit or money supply. Most of the financial crisis that have occurred in the past have had one common and important characteristic – excessive credit growth.

When credit (and by implication therefor the money supply) grows well in excess of the growth in nominal GDP for a sustained period of time it will almost always lead to three outcomes –

  • Eventual acceleration in inflation

  • Eventual widening in the current account deficit (or reversal from a surplus to a deficit) and large devaluation in the currency

  • An asset boom where the value of some or a class of asset is id up to unsustainably high levels and eventually crashes creating a banking crisis (because the loans that supported the asset boom go bad).

Smaller and more open economies typically experience all three of the above. The US experienced an unsustainable credit boom prior to 2007 and only experienced number three in the above list. This is mainly because it is the world’s largest economy, but also because foreign investors and banking systems (Europe) also had an exposure to the toxic loans that underpinned the mortgage boom in the US.

Nevertheless, this is not an argument against FIAT money, but really an argument for more responsible monetary and macro-prudential policy and regulation. A prudent investor should remain ever watchful of monetary policy and the evolution in credit and money supply trends. These are important indicators that can help avoid being exposed to another financial crisis and more importantly these are often times when gold does indeed serve its purpose of providing useful portfolio insurance or merely acting as a reliable store of value.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.