Going For Gold

There is more nonsense written about gold than any other asset class, says Simon Smith

I say that with real conviction because I’ve read a lot of it and experienced it first-hand.

Like the time, for example, I was on TV during a time of crisis, and another guest told me to stick everything in gold! I question their logic and there is generally none, apart from something about governments devaluing fiat money and gold being the only safe asset in town.

I remember being at a talk in 2013 where a very experienced investment bank analyst was explaining about how he had put nearly all his pension into gold and silver.

As a result, he’s had to add several more years to his working life, with gold falling nearly 25% in the following 2.5 years and missing out on equity and bond returns to boot. But how can it be that, to me at least, people lose all sense of reality and logic when talking about gold?

You can throw any argument at them, but nothing will change their mind

The first reason is that gold has no yield. Property has rent, shares have dividends, bonds have coupon (interest) payments and cash yields interest, albeit not a lot at the moment. Gold yields nothing.

Indeed, there is generally a cost to holding gold, given that you have to store it somewhere, whether directly or indirectly (i.e. if you invest in a fund that stores on behalf of investors). It’s the yield on assets that plays a large part in determining their value so, without it, value is determined purely by capital appreciation (minus storage costs).

The second reason derives from gold’s historic use for backing the value of money. Long story short, long ago gold was used as money. Gold was exchanged for something of perceived equal value. All well and good, but carrying gold around naturally turned out to be rather cumbersome. Hence the switch to paper money, which used to say something along the lines of ‘this entitles you to such and such amount of gold which I have held at some designated place’.

Eventually, there was not enough gold, but we did have gold standard to back currencies, so each currency was pegged to be worth a certain amount of gold. That, in turn, fell to pieces in the early 1970s, so we are left with pieces of paper which everyone believes are worth what they say – so called ‘fiat money’.

There are some who are inherently uncomfortable with this whole concept and that underpins their belief that gold is ultimately more valuable than any form of paper currency. You can throw any argument at them, but nothing will change their mind. It’s a bit like a cult.

Now overlay the above two arguments with the fact that the price of gold rose for twelve consecutive years between 2001 and 2012. The price of gold, in other words, rose before, during and after the global financial crisis. This made gold the most indestructible asset class in their eyes. That’s when the ‘gold bugs’, as they are known for some strange reason, were at their most fervent. And there was no reasoning with them, although I did try.

Gold did well as central banks cut interest rates towards zero and undertook quantitative easing. Some feared this would eventually stoke inflation, hence the desire to hold gold to hedge against that.

Add to this the opportunity cost of holding gold when the yield on other assets (principally money and government bonds) was near zero (or sometimes negative). You wouldn’t be giving up much interest on other assets to receive no interest on gold.

But inflation never took off in the way that the gold aficionados expected. The US central bank’s preferred measure of inflation fell dramatically in 2012 and into the mid part of 2013, falling further in 2015. Central bank money printing did not lead to the currency debasement many had warned of.

As a result, the price of gold fell 45% in dollar terms over the space of four and a half years, with most of that fall occurring between 2011 and 2013, or, in other words, when inflation was falling the most in the US.

Still, this should have served as a valuable lesson that the old adage ‘nothing lasts forever’ remains alive and well. No asset, even with the questionable approaches to valuation that gold has, can rise forever.

Since the lows seen late last year, the price of gold has meandered higher and investors, according to statistics from Bloomberg, have tentatively been adding to holdings via ETFs (Exchange-Traded Funds), even if the price has been waning a little in the second half of the year. This suggests a growing confidence on the part of investors that the worst is behind us.

 

WHERE DOES THIS LEAVE US?

As an investor, could you take a view of gold and use it in your portfolio or self-invested pension? My own view is that you can, but as you can guess, you have to be rational about it and leave aside some of the crazier reasons for holding gold. Which brings me to my take on how to look at gold through non-rose tinted or gold tinted glasses.

Firstly, I look closely at real interest rates. By that I mean what investors are earning over and above inflation. Getting 2% a year interest is great, but if inflation is 3%, your real interest rate is -1%. In other words, the real value of your money is declining as it buys less good and services through time.

To look at this (and this is the slightly geeky bit) I created a measure of global real interest rates. This is based on inflation protected securities, so it’s a measure of expected real rates over the next 10 years. Geeky bit over.

So if investors are pricing for positive real interest rates over the long-term, then the opportunity cost of sticking money in a non-yielding asset such as gold is higher.

Conversely, if real rates are negative, you are more prepared to take the risk of sticking money into zero yielding gold and hoping for a bit of capital appreciation.

So, having been quite a bear on gold over the past several years, I am more constructively bullish

As the chart above shows, this approach is far from perfect, but there is some sort of a relationship. That said, global real interest rates have been falling for most of the year (chart shows this as rising as the scale is inverted), creating a gap between this measure and the gold price.

Of course, this gap may not close and global real rates may reverse the move seen during most of this year, but I don’t see that happening in the current environment. This can get complicated again, but if investors start to buy protection against rising inflation, then this will generally push down real interest rates.

So, having been quite a bear on gold over the past several years, I’m more constructively bullish. But you have to remember that there is an added risk to gold as an asset, so gold should always be viewed as a minority holding in your portfolio. And don’t get emotional about it. Save that for gold jewellery.