No asset generates a wider range of opinions than gold. Investor attitudes toward gold are not only diverse, they are generally held with surprising conviction. In fact, gold discussions have a tendency to heat up faster than most investment topics, because the gold conversation frequently draws more from emotion than relevant facts.
Traditionally, most investors see gold as an inflation hedge. But in the contemporary landscape of elevated debt levels, many now view gold as a valuable deflation hedge immune to default. While some traders see gold as an easy-money, risk-on trade, just as many others covet gold as a risk-off, defensive holding. During times of financial stress, some view gold as the default asset to own, while others still favor the safe-harbor status of the U.S. dollar, thereby pressuring the gold price through gold’s longstanding inverse correlation to the U.S. dollar.
One thing is certain, gold ownership is a highly personal investment decision. The choice to own gold must come from within. In most cases, gold investors have migrated to gold because they have developed concerns on some level about the integrity of the financial system in which their capital is deployed. This does not mean Armageddon, Weimar Republic inflation or U.S. dollar collapse. It simply means concern over any one of a number of financial threats such as excessive debt levels or hyperactive central bankers.
Contrary to unflattering profiles popular in financial media, gold investors count among their ranks many of the shrewdest and most disciplined investors on the planet. The fact that some of the world’s greatest investors (Soros, Druckenmiller, Singer) employ gold liberally as they navigate fluid market conditions should logically dispel the superficial depiction of gold as a catastrophe metal or pet rock. What do these investing legends see in gold that escapes common appreciation? To begin with, heavyweight investors value gold’s ability to remove, at a moment’s notice, virtually unlimited amounts of capital from the vagaries of overpriced markets or a shaky financial system.
It is a bit of a mystery that gold’s role as productive portfolio-diversifying asset is still questioned by so many. During the past 16 years, gold has posted the most consistently positive performance of any global asset, yet is still scorned by consensus. What part of gold’s track record is so difficult to understand? The table on page 44 outlines the annual performance of spot gold in the world’s nine prominent fiat currencies since 2000. Despite divergent economic, monetary and financial conditions along the way, gold has risen in every year but three in U.S. dollar terms. Obviously, there must be something going on with gold that is a bit more overarching than the kneejerk investment cues commonly attributed to gold investors.
One way to think about gold’s aggregate performance since 2000 is to envision flows between the total stocks of various competing global assets. It would be fair to say that, at the margin during the past 16 years, a small portion of the global stock of financial assets (now measuring roughly $290 trillion) has chosen to migrate to the comparatively tiny stock of investable gold (roughly $2.6 trillion). On average, perhaps the annual rate of migration has measured one-tenth of 1 percent. In certain years (2007, 2010), the rate of migration accelerated in gold’s favor, and in other years (2013, 2015) the migration rate slowed or even reversed back in the direction of financial assets. Because bullion represents to many investors a safe resting place while global imbalances sort themselves out, the big “payout” from the gold thesis is not about catastrophe, it is simply about owning gold when the annual rate of migration from global financial assets accelerates in gold’s favor to perhaps one-half of 1 percent, because one-half of 1 percent of the global financial asset pile would measure $1.45 trillion, and that amount of capital will not be absorbed into the $2.6 trillion stock of investable gold without significant upward price dislocation.
While gold’s volatility lends itself to short-term analysis, the imbalances on which the gold thesis rests are eminently long-term in scope. The greatest fundamental powering the consistent migration of global wealth toward gold has been growing recognition of the disconnect between productive output in the United States (GDP) and future claims on that output, narrowly defined as U.S. total-credit-
market debt. As shown in the graph on page 43, during the past 100 years the ratio of U.S. debt-to-GDP has rested between 140 percent and 175 percent, except for during two “black swan” periods: the Great Depression and the era of Greenspan/Bernanke/Yellen stewardship of the Federal Reserve. In the first instance, debt remained constant while GDP collapsed 45 percent. In order to preserve the U.S. dollar’s credibility, FDR devalued the dollar versus gold and outlawed private ownership of gold (for reasons other than adornment) for what turned out to be 41 years.
The more recent instance of a skyrocketing debt-to-GDP ratio has been the result of issuance of tens-of-trillions-of-dollars of increasingly dubious debt claims on top of relatively stable GDP. For much of the past 16 years, it has required five units of credit-creation to generate each incremental unit of GDP growth. At year-end 2016, U.S. GDP of $18.8 trillion was dwarfed by $66 trillion in U.S. credit market debt. Because outstanding U.S. debt loads can no longer be effectively serviced by an $18.8 trillion economy, the U.S. requires incremental credit-creation on the order of $2 trillion or so annually, just to service existing debt loads. Whenever the U.S. economy is incapable of generating fresh credit on this scale, the Fed must step in to bridge the gap with liquidity programs of its own (quantitative easing programs QE1, QE2 and QE3).
In essence, the only two options to return the U.S. economy to a more balanced relationship between debt and productive output are default or debasement. Either $20 trillion or so of existing debts are permitted to default (as was starting to occur in 2008), or the Fed must continue to print fresh trillions to debase outstanding debts against underlying productive output. Because gold is a rare asset that can neither default (it is no one’s obligation) nor be debased (global gold supply is highly static and cannot be printed or reproduced), it serves as the ideal resting place for global wealth in times of rampant monetary debasement. Indeed, this is the bottom-line reason gold has outperformed all other investment assets during the past 16 years.
Importantly, gold is not necessarily a permanent portfolio asset for all investors. There are decades in which robust financial conditions reduce gold’s potential investment utility and other decades in which chaotic financial conditions make gold a mandatory portfolio asset. During the 1980s, when GDP was strong, savings rates were robust and debt levels were modest, there were ample opportunities for true capital formation in the U.S. economy and gold’s comparative allure was limited. In the current investment landscape, by contrast, GDP is weak, savings rates are negligible and debt levels are off the charts. In this type of environment, gold becomes a mandatory portfolio-diversifying asset to protect wealth from both the inevitable rationalization of overvalued financial assets, as well as from the relentless debasement inherent in global central bank liquidity programs.
A powerful litmus test for gold’s ongoing relevance is whether the U.S. financial system could endure even moderate normalization of interest rate structures. Should the Fed raise fed funds to 3 percent or 4 percent, or should 10-year Treasury yields trade back to 6 percent to 8 percent, without inflicting significant damage on the U.S. financial system, constructive progress may have been achieved in rebalancing U.S. financial markets. Because probabilities for either of these developments are still low, gold remains a mandatory portfolio asset.
Gold will remain a productive portfolio-diversifying asset until an inevitable process of U.S. debt rationalization is permitted to occur. Since 2000, the Fed has now interceded to forestall this rebalancing process on at least three prominent occasions. Eventual normalization of the relationship between claims on future output and output itself will return ratios such as debt-to-GDP and household-net-worth-to-GDP to historically sustainable levels, say below 200 percent and 350 percent, respectively. Because these ratios at prevailing GDP levels would imply (respectively) $20 trillion and $30 trillion in debt defaults combined with depreciation in financial-asset prices, the Fed will certainly do everything in its power to postpone this rebalancing. Given implications for declining intrinsic values of U.S. financial assets, as well as ongoing Fed efforts to debase outstanding debt obligations, gold remains a mandatory portfolio asset.
Finally, should the U.S. economy ever be able to resume GDP growth between 3 percent to 4 percent, with a net national savings rate in the 8 percent to 10 percent range, the necessity for $2 trillion in annual nonfinancial credit growth (or Fed liquidity programs) to stabilize the U.S. debt pyramid would be ameliorated. In this type of healthy growth environment, U.S. security markets would be replete with prospects for true capital formation and gold would hold limited investment utility.
In the meantime, even the “prudent man rule” would seem to favor a portfolio allocation to gold. In constructing a well-rounded gold allocation, individual investors should consider two basic components: physical bullion and gold equities. Bars and coins are the most tangible way to hold physical precious metals. Coins offer the invaluable benefits of accessibility, portability and instant liquidity around the globe. Government-minted coins, such as the American Gold Eagle, offer the additional guarantee of verifiable purity. Because coins can become cumbersome in large quantities, institutional investors generally favor bank-sponsored programs for vaulted bullion ownership.
Over the past decade, the liquidity and flexibility of exchange-traded bullion vehicles have increased their popularity as the default vehicle for institutional precious-metal exposure. There is, however, a wide range of publicly traded bullion vehicles employing vastly divergent methods of gold exposure. Investors placing high value on the attributes of physical ownership must differentiate between vehicles guaranteeing exposure to fully allocated physical metal and those permitted to hold paper gold and other forms of unallocated metal, which do not command direct title of ownership. While most bullion ETFs are constructed largely of allocated metal, many have the latitude to maintain a portion of their invested capital in an “unallocated metal” subcategory, designed to facilitate easier creation and redemption of shares. In addition, bullion ETFs commonly employ the custodial services of investment banks, which can raise counterparty risk in the event of bankruptcy or insolvency. Other differentiating features of bullion ETFs worthy of investor consideration include venue of bullion storage, capacity for investors to redeem their shares directly for underlying bullion, and eligibility for capital-gain tax treatment.
A second component of a portfolio allocation to gold should logically be an investment in gold equities. Because gold equities are a highly specialized and complex asset class, they present a high hurdle for productive investment by individual investors. Preferred vehicles for investment in gold equities are actively managed strategies or passively managed ETFs (which can either be market-cap weighted or employ factor-screens to select and weight securities). An important phenomenon to consider when investing in individual gold miners is the “negative survivorship bias” displayed by many of the larger market-cap industry participants. In short, being big does not necessarily provide the same safety in gold mining as in other industries. The largest gold miners face significant challenges in replacing their mined reserves and therefore run the risk of being priced more like depleting assets in the marketplace. On the smaller end of the spectrum, the gold mining industry is replete with wannabe operators facing long odds to profitability. The sweet spot for gold-mining equities probably rests somewhere in the middle, where an emerging producer has proven its pedigree and stands to be acquired by a senior producer looking to replace mined reserves.
All in all, a commitment to gold and gold equities seems an awfully prudent portfolio decision until global imbalances of excessive debt and rampant monetary debasement have had the chance to sort themselves out. While no one knows for sure in what manner these challenges ultimately will be resolved, in the meantime, gold offers an attractive and comparatively safe resting place for accumulated wealth.
Trey Reik is senior portfolio manager at Sprott Asset Management USA.