Valuing gold from an investment perspective can be tricky as there is no obvious yield. It may sound counter-intuitive, but we believe that it is necessary to think about money creation to understand why gold might be useful to investors.
What’s the Point?
For most professional investors, the shiny metal is a relic of the past that serves little useful purpose in today’s complex and sophisticated investment landscape. We believe that part of the problem of how gold is perceived lies in too much emphasis being placed on what gold is (a metal with no apparent intrinsic value), and too little discussion about what almost all other financial assets are (paper promises to pay). What is interesting is that, for most of human history, precious metals were a superior form of ‘money’ to IOUs; today, it is the reverse. We would argue that much of that change in perception is the result of stability and ‘progress’ in an economic and societal sense, but (and it is a big but) finance is not science, and, however sophisticated we may think we have become, we tend to make the same mistakes (generally involving money debasement and leverage) over and over again.
The stark truth is that most money is credit and is created by commercial banks. Unsurprisingly, banks create the kind of money that suits them at any particular time. This is why they need to be regulated and why, if policy is not well thought out, much of our credit growth can consist of claims on non-productive assets that do not support future GDP. As our ‘financialization’ theme identifies, the recent history of persistent loose monetary policy has created strong incentives in the financial system to emphasize financialization over taking risks to finance the real economy. As Bernstein puts it, “the growth in claims on the future productive capacity has grown faster than the productive capacity itself,” which means that we are piling more and more liabilities on a slowly growing productive base.
It is in this context, of one person’s asset being another’s liability, that the monetary authorities’ view that inflating asset prices (via quantitative easing, for example) also inflates ‘wealth’ seems to us to be somewhat fallacious. In aggregate, it does not – indeed, like all inflations, it is better described as a wealth transfer. Moreover, asset-price inflation has significant costs (such as inequality and financial distortion), some of which are already apparent in the fractious nature of politics in much of the Western world. The costs in terms of misallocation of capital are likely to emerge when the asset-price tide goes out.
We have consistently argued that policymakers have risked stoking the third major bubble in the last two decades, and it appears to us that the Federal Reserve’s ‘pivot’ to a more dovish stance in response to the market’s winter swoon all but confirms it. The scale of the financialization of the US economy is breathtaking. Bank of America Merrill Lynch reports that the value of private financial assets is approaching six times GDP, whereas a range of 2.5-3.5 times was normal for the 50 years before 2000. The financial-market tail now really does wag the real-economy dog. If the market goes down, so does the economy.
Why Hold Gold?
With this in mind, the key factor for gold is that it is not anyone’s liability; it is not a promise to pay, and is thus not part of the credit system. This makes it a good insurance policy in times of credit stress, and thus a good diversifier in a portfolio context. In addition, gold cannot be printed at will (it is increasingly difficult and costly to extract), the supply of gold is fairly flat, and the stock/flow dynamics are quite different from industrial commodities in that annual production is tiny in comparison to the amount of gold in circulation. Moreover, gold has physical monetary attributes (principally lack of degradation) which have been proven over thousands of years. Some may think that that is irrelevant in today’s digital world, but with cyber-security breaches presenting more and more issues, we do not think physical assets are a feature of the past just yet.
As an investment, the ‘barbarous relic’ has tended to keep its value in real terms over the (very) long term. However, we need to be careful with returns statistics over extremely long time periods. What are important are time periods that represent sensible investment horizons, and there is no doubt that gold has had multi-decade periods where its price performance has been poor. We are therefore not suggesting that gold is an asset for all seasons unless one plans to live forever!
When Would You Want to Hold Gold?
Traditionally, there are a number of reasons you may wish to hold gold. For example, if there was a reasonable risk of monetary inflation or debasement, or if the credit system looked shaky, or if the prevailing monetary system was under strain, or even if the faith in central banks to levitate asset prices was to be found wanting.
The following are just some (of the less extreme) scenarios that we believe are reasonably plausible in the months and years ahead:
- In the recent past, we have had lots of monetary inflation (central banks have printed something like $12 trillion since the global financial crisis) and asset inflation, but hardly any consumer-price inflation. The next cycle, or the down leg of this one, is likely to see efforts to create inflation redoubled. Using monetary finance to reflate real economies rather than reward asset owners is already being talked about (‘modern monetary theory’ and the like).
- The current credit cycle is a monster with all the usual characteristics, such as excessive leverage, lax investor protection (covenants falling away) and dubious accounting (EBITDA adjustments). China is currently setting a world record for corporate leverage.
- The Trump administration’s keenness to eliminate bilateral trade deficits seems to us to be at odds with the current monetary system (a de-facto US-dollar standard), which relies on the US doing just that in order to provide the world with a supply of dollars.
- Central banks are short on traditional ammunition to counter the next crisis.
Subtle changes in the world order, away from multilateralism to more polarization, may also be spurring central banks (such as in China and Russia) to increase their reserve holdings of gold.
As a final thought, it’s worth considering how investment has changed over the last few decades. The ‘great levitation’ in asset prices has combined with modern financial theory and computing power to create a system (as described in our ‘Perspective on returns’ piece) where the end saver or investor is likely to invest in a ‘structure’ linked to an index which is someway removed from the underlying assets. In this world, ‘price’ is the key determinant of worth, and historic price volatility is the primary measure of risk.
The problem for gold in the institutional portfolio context, and why it is perhaps more suited to the individual investor, is that price is not always relevant; investors who want a generalized ‘insurance policy’, or central banks that want to diversify away from fiat currencies, also see value in other attributes that are independent of price. This concept is more likely to be understood by investors in the developing world rather than those of us in the West who have experienced the most stable period in human history.
That is not to say that institutional investors (and particularly wealth managers) should not consider a holding in gold. However, we believe they should not expect it to perform in a conventional manner, and should perhaps think of it more as a ‘currency’ that they are choosing to denominate a portion of their assets in, and which should retain its acceptability, liquidity and value in times of stress.
Bernstein: Global Quantitative Strategy: A strong case for holding gold
 Bank of America Merrill Lynch
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