Good as Gold

Harry Rogers CFA

02 December 2019

The world has accumulated the highest peacetime debt in history. To quote 13D Research:

“Since 2007, global debt has surged $116 trillion to $244 trillion currently – an increase of $128 trillion. Global debt is now three times global GDP. By comparison, global nominal GDP has only risen from $58 trillion to $85 trillion – an increase of $27 trillion. In effect, the world economy has added $5 of debt for every $1 of nominal GDP.”

This chronic over-indebtedness crowds-out economic activity, limits growth and aggravates the gap between “have’s” and “have not’s”. Relief will come in one of two ways. Either we pay off our debts or we inflate them away. The former implies a deflationary depression, making it politically unpalatable. This leaves the latter, with both Central Banks and Governments doubling down on reflationary policies; we have not heard the end of QE and its ilk. As Central Banks print money to openly finance the fiscal largesse of Governments, the endless creation of new money will (further) debase currencies and drive down real interest rates.

If you can envisage this inflationary narrative, there is a strong argument for considering both gold bullion and gold mining equities as part of a diversified portfolio of investment assets.

Firstly, gold is, and always has been, a hedge against inflation. With a relatively finite supply of bullion, it serves as a store of value; it is impossible to “print” more gold and the supply is not subject to the short-term imperatives of populist politicians.

Real interest rates are also a key driver of gold demand. If inflation exceeds nominal yields, you have a negative real yield (the difference between the two). When real yields are negative and/or falling, gold has historically attracted the interest of investors. Indeed, the global stock of negative yielding debt and the gold price are increasingly correlated as the “store of value” characteristics of bullion once more come to the fore. Looking at current nominal and real yields, their decline is well advanced. At the end of September, over $15 trillion of global bonds traded at a negative yield. As inflation has held up better than yields, real rates have also tumbled. This has underpinned the rise in bullion prices during the first 9 months of 2019 and, with the authorities looking to keep rates low, looks set to continue as we move into 2020.

Gold can also be an effective hedge for equity market turmoil; since 1973, gold has outperformed stocks in 9 of the 10 largest US equity market sell-offs. The one exception was the early 1980s, when real interest rates were at record highs and global equities were historically cheap; the complete opposite of today.

Gold is also deeply unloved at this time, prompting a contrarian argument for portfolio exposure. At various times over the last year, speculators have established record short positions whilst investment demand has remained in the doldrums; the largest gold mining ETF has experienced net outflows for the year-to-date despite gold outperforming world equities (to end August). Interestingly, several major Central Banks continue to build their gold reserves, as they diversify away from the US dollar; China and Russia to name but two. On a more technical note, the price ratio of gold to silver touched a 25-year high in July; historically such an extreme has been a reliable portent of a multi-year rally in both metals.

Turning to gold-related equities, the correlation of gold and gold miners has been positive and relatively stable on a 3-year rolling basis since 1998. From a $1,900/oz peak in September 2011 to the end of 2015, gold lost over 40% in US$ terms; the NYSE Gold miners index fell 80%. The higher drawdowns suffered by mining stocks was a function of over-valuation and excessive enthusiasm which led to poor management and weak balance sheets.

As the market maxim goes, the cure for low prices is low prices. Management teams have been replaced, balance sheets repaired and valuations have plummeted. Mining stocks now offer an effective proxy to the bullion price; if you have a positive view on gold and a suitable risk appetite, the related equities offer the prospect of higher returns. Cognisant of the risks inherent in mining businesses, we prefer active managers (not trackers) with a strong focus on quality; in assets, jurisdiction and management.

Gold and gold miners are cheap and unloved. Conversely, “safe” bonds offer little or negative yields and equities are over-valued; egregiously so in places. As the authorities aggressively ramp up their efforts to inflate away our debts, the risk that they generate runaway inflation and debase fiat currencies intensifies. If markets start to price in this possibility, even if it does not come to pass, bullion and gold miners may be one of the few safe harbours.

Harry Rogers CFA, Investment Manager, Bentley Reid

This article first appeared in the STEP Journal in December 2019.