During 2018, we started to sound a bit like a broken record. We felt the Fed’s dual policy agenda of simultaneous rate hikes and balance-sheet reduction was too aggressive in the context of a global economy bloated with debt and addled far too long by salves of quantitative easing and zero-interest-rate policies. We even questioned whether the Keynesian academics at the Fed fully appreciated the direct and measurable impacts of quantitative tightening on global money supply. All the way through December’s unanimous decision by the Federal Open Market Committee (FOMC) to hike fed funds for the fourth time in 2018, our concerns gained very little traction in consensus circles.
How quickly things can change. In the four weeks following the December FOMC rate hike, the Fed executed one of its sharpest policy U-turns in memory. Indeed, the Fed’s tonal shift has been so profound, it is difficult to square recent comments from Fed governors and regional bank presidents with their stated positions only a few weeks prior. What could possibly account for such a dramatic about-face from such a characteristically deliberative body? Is the explanation as simple as the 19.6 percent decline in the S&P 500 Index 1 between Chairman Jerome Powell’s “long way from neutral” comment on Oct. 3, 2018, and Secretary Steven Mnuchin’s convening of the President’s Working Group on Financial Markets on Christmas Eve?
In our experience, the contemporary Fed is always hyper vigilant about signs of financial stress with the perceived potential to evolve into debt deflation. To us, S&P 500 air pockets are but a symptom of a far more troublesome underlying condition: insufficient credit creation to sustain inflated paper claims. Once equities complete their current Pavlovian bounce, consensus will need to confront the more sobering implications of the Fed’s policy reversal. The Fed is far too tight and has already tripped the switch on long-
overdue debt rationalization.
Similar to early 2016, when global financial markets were destabilized by the Fed’s initial Dec. 16, 2015, rate hike, the gold price responded quickly to market fallout from Chairman Powell’s early October overreach, and has remained in steady uptrend ever since. It’s important to note, gold’s advance has not been derailed by the S&P 500’s 18.1 percent bounce from Dec. 24, 2018, through Feb. 15, 2019. To us, gold’s performance clearly signals Fed policy error, and we believe spot gold is coiling for spirited advance as global central banks pivot back toward easing. For gold investors, this is the mix of real-deal fundamentals on which spectacular gains are based.
Given the seminal nature of catalysts now in play for precious metals, we felt the timing appropriate for a comprehensive review of factors driving the gold price. We have compiled our Top 10 List of fundamentals supporting a portfolio allocation to gold in 2019.
- Gold has been the best-performing global asset for 18 years
We often marvel at investor apathy toward gold’s investment merits. Especially in institutional circles, gold is generally viewed as an archaic asset offering negligible portfolio utility. To us, it is remarkable gold could remain such an institutional outcast after posting the single best performance of any global asset for 18 years running. Since 2000, not only has bullion outperformed traditional investment assets in cumulative total return, but gold’s ongoing bull market has also proved to be highly consistent in its annual progression. The average of gold’s annual performance in nine prominent currencies has been positive in 16 of the past 18 years.
Given gold’s fringe standing in much of the investment world, it is interesting to note gold bullion’s cumulative performance since 2000 has trounced the S&P 500. Gold’s cumulative gain from Dec. 31, 2000, through Feb. 15, 2019, totaled 385.42 percent, versus a 110.23 percent advance in the S&P 500 price level and a 201.15 percent gain in the S&P 500 total return.
- Paper claims have decoupled completely from productive output
The Federal Reserve under Alan Greenspan, Ben Bernanke and Janet Yellen facilitated trillions of dollars of credit creation atop a fairly consistent GDP denominator. While timing is uncertain, it is inevitable the U.S. financial system will eventually rebalance to the degree that GDP can productively support total debt levels. Only two possible routes exist for the U.S. debt burden to be recalibrated to underlying GDP: default or debasement. Because gold can neither default nor be debased, it is an ideal portfolio component until such time as the U.S. financial system rebalances.
- Central banks are admitting tightening is no longer possible
Since the Fed’s about-face on rates, the biggest riddle in financial markets is what could possibly have served as the underlying trigger. Was it the S&P 500 swoon, pressure from President Donald Trump or some signal of financial stress not yet publically disseminated? We suspect it was a combination of all three. Whatever the true mix of catalysts, the message has been received not only by the Fed, but also by all global central banks, which have discarded in unison their collective resolve for policy tightening.
- The return of negative interest rates
In unison, global central banks are swinging quickly and hard back toward an easing posture. The world is quickly refocusing on the likelihood and utility of negative interest rates. The global total of negative yielding sovereign bonds has exploded 56 percent from $5.733 trillion on Oct. 3, 2018, to $8.944 trillion on Feb. 15, 2019. Already within $1 trillion of its September 2017 high, how large will the ultimate supply of negative-yielding sovereigns become in the unfolding cycle? Although it is only one of many factors influencing the gold price, correlations confirm gold is taking notice of the global pivot to negative rates.
- Fed credibility under siege
Although we recognize U.S. Fed power borders on the divine, we have always found the proposition that 19 individuals, no matter how capable and well supported, might possibly price the world’s reserve currency more efficiently than free markets to be a fairly absurd notion. Sidestepping our perceptions of Fed governors and regional bank presidents, both individually and as a deliberative body, we have detected since early 2018 distinct erosion in the Fed’s factual credibility.
- Deteriorating U.S. fiscal position
One of the least kept secrets in global financial markets is the deteriorating fiscal position of the United States. Everyone knows the Trump Administration’s Office of Management and Budget (OMB) now forecasts $1 trillion-plus budget deficits in fiscal 2019, 2020 and 2021. Everyone knows OMB assumptions for GDP growth in those years are likely a bit optimistic (3.2 percent, 3.1 percent and 3.0 percent). And everyone knows post-tax-cut federal receipts are already lagging advertised projections.
- Gold versus U.S. dollar as strategic reserve
Central bank demand for gold soared to a multi-decade high in 2018, rising 74 percernt year over year, the highest level of central bank net purchases since the dissolution of the Bretton Woods Agreement (1968–1973). There is no question President Trump’s penchant for sanctions has energized longstanding rancor toward the dollar-standard system. As recently as 2000, 72.7 percent of global foreign-
exchange reserves were denominated in U.S. dollars. By year-end 2018, the U.S. dollar had shrunk to 61.9 percent. We believe the declining use of dollar-denominated assets by global central banks has less to do with direct supply/demand impacts in currency markets than with the symbolic impact on the U.S. dollar’s hegemonic status.
- Global policy uncertainty
Since 2016, the twin shocks of Brexit and the Trump presidency have bookended near continuous political turmoil in global markets. Investors have become inured to the daily twists and turns of President Trump’s seemingly erratic decision-making and Prime Minister May’s Sisyphean negotiations with both the European Union and her own parliament. Indeed, investors’ increasingly thick skin to political headline risk may be leading to underestimation of potential black swans forming on the horizon.
- Dormant volatility
Important components of our 2019 gold investment thesis are the lingering imbalances from eight years of quantitative easing and zero-interest-rate policy. Artificially depressed interest rates always distort time preferences and foster malinvestment. In the instance of the post–great financial crisis Fed, these imbalances have become epic in size and scope. At Sprott, we adhere to the theory that volatility generally signals change. We believe isolated outbreaks of volatility during 2018 served as early signposts of profound change in financial markets — the unwinding of eight years of volatility-suppressing quantitative easing and zero-interest-rate policy. What is being vastly underestimated by investor consensus is the stored force of volatility suppression during these past eight years.
- Gold as noncorrelating portfolio asset
In documenting an objective record of gold’s portfolio utility, one logically begins with gold’s traditional profile as a safe-harbor asset. It goes without saying gold’s safe-haven reputation accrues from bullion’s established history of relative outperformance during periods of financial stress. Gold has done a masterful job of insulating portfolio capital from sharp declines in U.S. equities during the past three decades of financial crises.
Institutional focus on noncorrelating assets has directed trillions of dollars of investment capital toward hedge funds and specialized investment partnerships in disciplines such as real estate, private equity and venture capital. A more recent trend, however, has been mounting investor backlash against elevated fees charged by alternative managers in the context of mediocre investment returns (not to mention onerous liquidity and lock-up provisions). In short, a marquee consideration for today’s pension and endowment stewards has become whether the fees, lockups and obfuscation of alternative investments are truly worth their while.
Even more challenging to the industry status quo, gold bullion has rivaled the performance of alternative asset indexes while simultaneously displaying far-lower correlation to these vehicles than either stocks or bonds. The correlation between prominent alternative asset indexes and the S&P 500 Index has averaged 80 percent over the decade through 2018. By way of comparison, the 10-year correlation between these same indexes and spot gold has averaged only 9 percent. At an 80 percent correlation rate with U.S. equities, high-priced and unwieldy alternative vehicles seem hardly worth their freight.
Trey Reik is senior portfolio manager for Sprott Asset Management.