GOLD – The Simple Facts
When it comes to investing in gold, investors often see the world
in black and white. Some people have a deep, almost religious
conviction that gold is a useless, barbarous relic with no yield; it’s
an asset no rational investor would ever want. Others love it, seeing it
as the only asset that can offer protection from the coming financial
catastrophe, which is always just around the corner.
Our views are more nuanced and, we believe, provide a balanced
framework for assessing value. Our bottom line: given current valuations
and central bank policies, we see gold as a compelling inflation hedge
and store of value that is potentially superior to fiat currencies.
We believe investors should consider allocating gold and other
precious metals to a diversified investment portfolio. The supply of
gold is constrained, and we see demand increasing consistent with global
economic growth on a per capita basis.
Regarding inflation in
particular, we feel that the Federal Reserve’s decision to begin a third
round of quantitative easing makes gold even more attractive.
We see the Fed’s actions in the wake of the financial crisis as a
paradigm shift whereby the Fed is attempting to ease financial
conditions and encourage risk-taking by increasing inflation
expectations. Its policies will likely result in continuous negative
real interest rates because nominal rates will be fixed at close to 0%
for the foreseeable future.
To be sure, gold isn’t the only asset with the potential to hold its
value in inflationary times. For U.S. investors, at least, Treasury
Inflation-Protected Securities (TIPS) offer an explicit inflation hedge.
What’s more, TIPS tend to be less volatile than gold and, if held to
maturity, are guaranteed to receive their principal back – barring a
U.S. government default (which we see as incredibly improbable). Still,
history shows that gold is highly correlated to inflation and has unique
supply and demand characteristics that potentially lead to attractive
valuations.
A unique store of value
For more than a millennium, gold has served as a store of value and a
medium of exchange. It has broadly managed to maintain its real value,
even as various currency regimes have come and gone. The reason is that
the supply of gold is not at the whim of any governmental power; it is
fundamentally supply constrained. Total outstanding above-ground gold
stocks – the amount that has been extracted over the past few millennia –
are roughly 155,000 metric tons. Each year mines supply roughly 2,600
additional metric tons, or 1.7% of the outstanding total. This is why
gold can be thought of as the currency without a printing press.
The
downside of gold is that it generates no interest. One ounce of gold
today will still be only one ounce next year and the year after that.
Because of this, gold is sometimes referred to as a non-productive
financial asset, but we feel this characterization is misleading.
Rather, we believe gold should not be thought of as a substitute for
equities or corporate bonds. These have equity or default risk and
therefore convey risk premiums.
Instead, gold should be thought of as a currency, one which pays no
interest. Dollars, euro, yen and other currencies can be deposited to
receive interest, and this rate of interest is meant to compensate for
the decline in the value of paper currencies via inflation. Gold, in
contrast, maintains its real value over time so no interest is
necessary.
Today, the forward-looking return on holding U.S. dollars, and most
other major currencies, has been artificially lowered by the Fed’s
commitment to keep interest rates pegged at near zero for the next few
years; real yields on U.S. government bonds are negative out to 20
years. In such a world, we believe the desire and willingness of
investors to hold gold relative to other currencies increases
dramatically, creating the potential for continued price appreciation.
The real price of gold
Of course, investors must also consider valuation, especially since
some believe gold is overpriced. Figure 1 shows the inflation-adjusted
value of gold since 1970. There is no doubt that gold prices, which
averaged $1,630 in August, are high. However, in inflation-adjusted
terms, gold is 12% below its 1980 peak. Inflation in 1980 hit 15%
year-over-year, and inflation today is running much lower so some may
question the validity of comparisons to 1980. While we believe that
inflation over the next several years is likely to be higher, on
average, than it has been over the past 20 years and that the tail risks
are for much higher inflation, this speaks more to the outlook for the
nominal price of gold.
The price of gold in real or inflation-adjusted terms is less
affected by the rate of inflation and more impacted by the level of real
interest rates because as discussed previously, it is the real interest
rate that drives the relative attractiveness of holding gold relative
to other currencies. With real interest rates negative on average for
the next 20 years, it is of little surprise that gold is trading near
its all-time inflation-adjusted high.
Even the inflation-adjusted value of gold doesn’t tell the whole
story, however. Thanks to productivity gains and economic growth, per
capita GDP is significantly higher today than 30 years ago. Thus, the
average person today has more wealth and, all else being equal, can
afford to pay relatively more for gold.
To Chinese, gold has never seemed less expensive
Figure 2 shows the ratio of gold prices to per capita GDP in the U.S.
and China. In dollar terms, gold is still 34% below its 1980 peak, as
U.S. per capita GDP is higher today. Furthermore, this is a relatively
U.S. centric view, and considering that China represents the largest
source of global gold demand, we believe investors take an overly myopic
view at their peril. Chinese per capita GDP has grown at an 18%
annualized rate for the past 10 years, compared with just 3% per year in
the U.S. Thus, while gold might seem quite expensive to those of us in
developed economies, its price seems much less expensive to those in
faster-growing emerging economies like China.
Another way to think about the relative value of gold is to consider
what a return to the gold standard might look like. In other words, what
if the entire world’s gold were used to back the global supply of fiat
currency? Globally there are roughly $12.5 trillion in physical and
electronic currency reserves. Given that there are 155,000 metric tons
of gold above ground, this equals an approximate price of $2,500 per
ounce if all of the world’s reserves were to be backed by the entire
stock of above-ground physical gold.
Not really so pricey
These points lead us to believe that gold valuations are not as
stretched as a naïve look at its nominal price might suggest. Central
banks globally are seeking to depreciate their currencies in a
beggar-thy-neighbor attempt to stimulate their domestic economies (the
Swiss National Bank is a prime example). Therefore, we believe investors
should consider owning gold, precious metals and other assets that
store value as long as central banks continue to print and maintain
negative real interest rates.
