Weekly View: Gold: Investment, Enigma, or Insurance Policy?
Gold’s value is not an enigma in our view, once its history is understood: Gold coins were first struck on the order of King Croesus of Lydia (an area that is now part of Turkey), around 550 B.C. (source: thebalance.com). It has been a treasured store of value that has facilitated commerce ever since. Emperor Augustus, in addition to ordering the census that coincided with the birth of Jesus, established the first formal value for gold when he decreed that a pound of gold could be made into 45 coins around 30 B.C. From 30 B.C. until A.D. 1971 gold was the basis of most global currency transactions, often through the ability to convert government issued notes into gold at a fixed rate. It is therefore no wonder that gold has a very special place in the history of finance. Since gold no longer is the backing for currencies, what is its role today?
From a long-term return perspective, gold has consistently held its value relative to inflation and has risen considerably more than inflation over the last 50 years. However, in successfully managed economies, investing in the shares of growing businesses has generally been much more rewarding, in our view. Institutionally, the role of gold in a 21st century investment portfolio has all but disappeared and it rarely, if ever, features in a strategic benchmark. This is probably because gold pays no stream of income, it is hard to determine what it is worth and, as our chart on page 2 shows, as measured by the MSCI US Stocks Total Return Index (MSCI USA), stocks have ultimately risen more than gold since 1971.
GOLD SINCE 1971 – Gold Beats Inflation, but US Stocks Beat Gold
In 1971 the US formally abandoned the ‘gold standard’ – whereby notes and coins were redeemable for gold bullion at a fixed rate. Today, all major currencies are fiat currencies. ‘Fiat’ is a Latin word for an order or decree and is translated into English as “let it be done”. Thus, a fiat currency is simply one that is declared legal tender by a government but has no intrinsic or fixed value and is not backed by any tangible asset. All paper currencies are only as valuable as the belief or faith in the issuer. The difference between paper money and gold is that there is no physical limit on the supply of notes and coins. The US dollar’s value is thus a reflection of peoples’ faith in the US economy and the institutions that control its supply.
We believe gold has significant value to some investors as a perceived insurance policy, either for an investor worried about the long-term debasing of the value of their paper currency, or a potential refuge from economic mismanagement, political upheaval, or civil crisis. Despite its inconsistent price behavior, we believe there are monetary conditions which determine when gold prices tend to rise or fall.
WHEN DOES GOLD TEND TO DO BETTER THAN STOCKS?
Gold has its own unique heartbeat. The chart above shows the price of gold since it was untethered from the dollar in 1971. It might surprise you that $100 invested in gold at that time caught up with the price of the MSCI Total Return US Stock Index in 2011, with both up 40 times their 1971 level. That price inflation, as measured by the Consumer Price Index (CPI) rose six-fold over the 50-year period shows how inflation can erode purchasing power over long periods. We also think the chart shows the benefits of price growth plus compounded dividend reinvestment for the total return of US stocks (as measured by the MSCI index in the chart above), which today have risen over 100 times 1971 levels. Finally, we draw your attention to the way gold is mostly uncorrelated with stocks, can spend years going sideways, moves in big spurts and has often risen during some tough times for stocks.
Since 1971, we believe the history of gold and stocks can be understood in three distinct phases, highlighted in the chart above: Phase 1: Uncontrolled inflation, Phase 2: The Volker/Greenspan era of high real interest rates, central banks sell gold reserves; Phase 3: The end of central banks reducing reserves, strict supply control by gold miners and a prolonged decline in the dollar; and Phase 4: The post-2008 policy of quantitative easing with the Federal Reserve buying financial assets and expanding its balance sheet, which some have descriptively called ‘printing money’. During phase 4, the Fed has deliberately kept short term interest rates below the level of inflation, giving savers no government-assured way to keep up with rising prices. Think about it this way: if a government will pay you more than the rate of inflation to own their currency, then gold becomes a lot less attractive. This was the case throughout phase 2.
Since 2011, we think real interest rates also explain much of gold’s price performance. Our chart to the right shows the price of gold and the yield on Treasury Inflation Protected Securities or TIPS. The green line (darker) is the yield on TIPS but we have reversed it so that it is easier to see that gold goes up when the yield on TIPS is falling and turns negative such as from late 2018 to today. Gold also tends to be considered a ‘safe haven’ during times of political, economic, and now COVID-19 uncertainty.
SHOULD YOU OWN GOLD?
We believe gold is a personal choice, not a strategic asset. Some investors own gold as a diversification strategy at a time when government bond yields are low and potentially offer much less safety. For others it is an insurance policy against an unhappy end to the period of Federal Reserve balance sheet expansion and rapidly rising government debt. Their concern is that easy money and debt might result in unchecked inflation. Warren Buffet’s Berkshire Hathaway recently bought small position in a gold mining company for the first time. Given Buffet’s consistent disdain for gold, it is not surprising that Berkshire bought a mining stock rather than the metal, or that observers of his actions are intrigued.
If you do choose to own gold, do not expect it to perform like stocks or bonds and recognize it may prove to be unnecessary insurance or may not behave like insurance at all; that is RiverFront’s current tactical view. RiverFront has owned gold in the past but to include it in our portfolios again, we would need to be convinced that there is a strong fundamental case for its outperformance over a sustained period against either stocks or bonds. We do not currently believe that is the case. Also beware that for many traders, gold is a speculative asset and thus prone to big swings in price making the timing of buying and selling difficult. What we can probably all agree on is that the fascination with gold is not likely to go away for a long time.