I think it is fair to say that most people in the Western world don’t actually understand what gold is all about. Over the past fifty years we have been inculcated into believing that it is a material used for personal adornment or perhaps as a minor industrial application. Very few now think of it as money.
My own interest in gold started around the mid-2000s, a few years before the 2008 banking crisis. Ironically the article that actually piqued my interest was about silver rather than gold but the two are usually referenced as behaving in a similar manner. I had some funds to invest and had started to undertake some research into potential targets. My journey through various funds, investment trusts, equities, bonds and all the other potential resting places for a substantial but not life-changing pot was often punctuated, or perhaps diverted, by discussions about gold. And so it started.
When Nixon reneged on the U.S. commitment to maintaining a gold-backed currency in 1971 the West effectively entered the modern era of ‘fiat’ money:
There are currently no currencies directly backed by gold which is one of the reasons why we often see some dramatic volatility in their relative values. What a currency is worth is driven by a whole host of factors, the sum of which equates to traders’ perception of its value. The US dollar (USD) has increased in value by 15 – 20% over the past eighteen months against a basket of currencies, while the GBP has dropped five or six percent against the USD in recent weeks. There are lots of reasons for these moves but they all add up to a view that the USD is a ‘safer’ store of value at the moment while the Great British Pound (GBP) is seen as a ‘risk’, partially down to Brexit nerves. Without gold as an anchor, a fiat currency can and often does go to zero. We have also yet to see the impacts of the estimated $13 – $15 trillion of ‘printing’ that has taken place since 2008. True, much has been offset by general shrinkage in the global credit markets but the fact remains that there are still trillions of freshly printed currency sitting as ‘excess reserves’ at the U.S. Fed or swilling around the financial system. In virtually every other instance of currency debasement, deflation precedes a period of inflation so we may yet see some turmoil of the inflationary kind.
Which brings me back to gold which is often seen as a bet against price inflation; Kyle Bass, a famous hedge fund manager, has also suggested that: “buying gold is just buying a put against the idiocy of the political cycle. It’s that simple!” Gold haters tend to draw attention to the fact that gold doesn’t usually pay any interest. This is true but has become a somewhat academic point in Japan and parts of Europe where ‘negative interest rates’ are paid. A bar of bullion is a far more attractive prospect than a commitment to pay the bank interest for holding your money. Thus the ‘war’ between the fiat ‘paper bugs’ and ‘gold bugs’ has started to switch direction.
A few years ago Ben Bernanke, the former U.S. Fed Chairman, was asked by libertarian congressman Ron Paul whether gold was money:
His response was both entertaining and illuminating. Entertaining in the fact that the subject of gold is taboo in central banker circles and illuminating in the bizarre nature of the response. Bernanke did not believe that gold was money and yet admitted that the 8,000 tons or more held at Fort Knox and West Point is held as a matter of ‘tradition’. This tradition has been more than kept alive in recent years by central banks in Russia, China and other Asian states who seem more than happy to exchange their US dollar treasuries for a ‘harder’ asset like gold. On a net basis since 2008 central banks have actually increased their gold reserves with China reputedly acquiring multiples of the amounts they have actually declared. So although ‘officially’ the USD remains the most liquid and ‘hardest’ of fiat currencies if you want to preserve wealth and value for the longer term then gold would seem to be the only option, especially in a world where a few billion Indian and Chinese people hold a slightly more traditional view. Paper currency may be OK to buy the groceries but if you want to preserve wealth for the next generation, gold is the only game in town, even land and property is secondary.
Whatever its appeal fully investing in gold is just as much of a risk as going ‘all-in’ to any asset class. The better known investors will usually suggest that a proportion of your portfolio should be invested in gold. This proportion seems to vary from around 5% to a maximum of 20 – 25% at the more extreme end. None suggest anywhere near 100%. The gold element of my own retirement fund is a fund itself, investing in the ‘majors’ (mining companies) in the gold sector. Since reinvesting my portfolio in the latter half of 2015 it has outperformed all of my others (up 27% in six months) and forms a disproportionate element of the overall fund, which now requires some realignment. After 3 – 4 years of appalling performance we seem to be seeing a new bull market, at least in the mining stocks themselves. Nonetheless you have to look at it in context. Gold increased more than six fold between the early 2000s and 2011 but then dropped by over 40% subsequently. Even today it is still 36% below its 2011 peak.
As with most other major commodities gold is priced in US dollars. Thus a miner operating in South America will substantially benefit if the USD moves up against a local currency. For example, a producer in Chile incurs costs in Pesos but will benefit from gold revenues priced in USD. In recent years the Peso has decreased in value from around 450 to 730 to the USD.
Furthermore, the price of oil has decreased from over $100 to around $40bbl. It is not therefore surprising to see the large gold miners show some dramatic increases in prices over the last six months, despite the fact that gold still languishes in the $1200 – $1300 band. The ‘smart money’, the early movers, have already identified the potential and have taken positions; the institutions are no doubt checking the sector out and a year or so from now perhaps the ‘retail’ investor will take notice. Even now the gold sector is still down about 80% from the highs of a few years ago, when gold hit $1900/oz; it trades at around $1220 as I write this.
One aspect of gold that causes considerable distress to the ardent gold bug is that COMEX, and to some extent the LBM paper markets. Most gold today is traded as a contract rather than as a physical transaction. What this means is that ‘paper gold’ can be created at will to meet market demand. The market seems to work on a fractional basis or leverage. So long as there is enough physical gold to meet the claims of those actually wanting physical, the market can continue without any significant disruption. In the past year the ratio of claims to actual physical has been in the 350 – 400 region which obviously creates a certain amount of risk for participants. Commercial traders appear to remain unconcerned about this situation and continue to take short or long positions in the commodity, mostly rolling over these contract positions like clockwork on a monthly basis. It is entirely possible that this situation could be maintained for months or even years, that is until some extraneous instability elsewhere in the financial system ripples through to the gold market. In which case all bets could be off and a rather dramatic re-pricing could be in order.
I don’t expect drama during 2016 but it does look like the four year bear market in gold has ended. There will be ‘ticks’ both up and down during 2016 but it does look like the theme of an increasing price is slowly taking hold. As at the end of March / early April 2016 the gold buying season is still some months away and yet the ‘correction’ after the Chinese New Year celebrations has been muted compared with the last few years. There will be some volatility as speculation increases on whether the FED will add another 25 basis points its rate in June although beyond that it looks unlikely that there will be any more tinkering prior to the US presidential election. A combination of a new gold buying season starting in August and a few speculation free months on the US FED funds rate should translate into a fairly robust performance in gold in the latter part of the year.
Whatever your views on gold, both on its status as a currency and on its expected performance over the next year or two, it remains unwise to ‘over-invest’, whatever the prospects. It may also help to regard of it as a form of money, whatever Ben Bernanke declares in public, rather than as simply another asset. An ounce of gold will still pretty much buy what it could in Roman times. You can’t say that for either a USD or a GBP which have both depreciated by well over 90% in the last century.
The gentleman pictured is called Datta Phuge. In 2013 he was reported as ‘splashing out on a £14,000 gold shirt in the hope that it would attract female attention’.
Not sure if it worked…..