Gold rush - Should you invest?

Many investors are rushing to invest in gold in the current market, why all the excitement?

“Civilized countries generally adopt gold or silver or both as money”. Alfred Marshall

An excerpt from a recent newspaper advertisement espousing the benefits of gold pretty much sums up the current mood: “gold is at its highest levels ever and is definitely one of the best investments in today’s times”. The excitement is understandable and typical: the current gold price of $1500 per ounce is up nearly five times over the past decade. Compare this to global equities which have gone nowhere. So what is gold and why all the excitement?

Gold is not really an asset in the traditional sense as it produces no cashflows and is thus difficult to value. This is why many well known investors steer clear of investing in it. Charlie Munger, Warren Buffet’s pithy sidekick, has said of gold: “producing businesses will over time outperform assets that don’t produce anything. Investing in assets that don’t produce anything is not the way to get rich.” On the flip side, a number of hedge fund managers cannot get enough of the shiny metal. John Paulson, who famously bet on sub-prime mortgages defaulting and made a whopping $3.7bn in fees in 2007 – the biggest fee haul ever for an individual - has bought an 11% stake in AngloGold Ashanti, making Paulson & Co the world’s largest non-sovereign gold investor. They have even gone so far as to offer investors a gold-denominated class of their hedge fund.

Gold is not really a commodity either, as little of it is consumed due to its limited industrial use. In fact, industrial demand accounts for only 10-15% of annual production, which in turn amounts to only a fraction of a percent of total gold stores (165,000 tonnes, which surprisingly, is barely enough to fill a room with 20 metre sides). Additional supply - as opposed to recycled supply - therefore has very little influence on the price, making the supply/demand dynamics different to other commodities that are produced and then consumed.     

Gold, rather than being an income generating asset or a useful commodity, behaves more like a currency. Prior to the abolishment of the gold standard in the 1940’s, the value of paper money had been backed by gold or silver for the previous 500 years or so. And prior to that gold was used as money. In fact, gold fits the definition of money perfectly; it is divisible, transportable, impossible to counterfeit and durable.

The final component of the above definition, namely durability, is important in the current environment because it relates not only to physical durability but also institutional durability. The durability of paper money, which is backed only by the promise of governments, is presently being questioned due to the profligate monetary policies of the developed world countries, which are printing vast amounts of money to bail out their already over-indebted economies. The chart below highlights the massive increase in the monetary base of the USA over the past three years – an unprecedented threefold increase.

Source: Federal Reserve, I-net and Nedgroup Investments

Investors naturally have major concerns that the US government will be unable to reverse this sharp increase in the monetary base and that it will filter into the economy and increase money supply (currently this is not happening as the money is being horded by banks). Excess money supply ultimately devalues money, as more money chases the same amount of goods, causing prices to rise. This money devaluation is manifested in price inflation (or a weaker exchange rate). [As an aside, research[1] suggests that based on the current monetary base and gold stores, should the dollar once again revert to being underwritten by gold, the gold price would be in the region of $6000-$8000 per ounce. The likelihood of going back to the gold standard is however low, given its inflexibility and dismal track record].

Importantly, there exists a relationship between price inflation and the gold price. The most well documented instance of this was the strong performance of gold in the 1970’s, a period in which inflation was uncharacteristically high in the US. In reality, it may not be the absolute level of inflation that is one of the drivers of the gold price, but rather, as is currently the case, the fear of runaway/unexpected inflation. The chart below highlights the relationship between the real gold price and inflation volatility, which serves as a proxy for the uncertainty regarding inflation. The current level of uncertainty about the future path of inflation is stimulating demand for gold and driving the price higher. However, predicting future uncertainty is difficult, so this relationship is probably not useful in forecasting the price of gold.

Source: I-net and Nedgroup Investments

Another factor undoubtedly driving the gold price higher is the fact that the current opportunity cost of holding gold is low. This is because interest rates are near zero in the US. In other words, the income you forego by taking your money out of the bank and buying gold is negligible. This, and the uncertain inflation outlook, has investors clamouring to purchase gold. Gold ETF’s, a relatively new development, have received $80bn of inflows in just a few years.

So should you rush out and buy gold? Well, that depends. It can provide a hedge against unexpected inflation down the line. There must be some probability of this, given that the money presses are still printing with apparent impunity. But the gold price has already moved up significantly and it’s impossible to gauge whether it is already discounting this risk. That said, the opportunity cost of holding gold is at an all-time low, so a small allocation to protect your portfolio against high inflation may be sensible.

There are other asset classes that can more reliably protect you from inflation, most notably inflation-linked bonds, but the real yields they offer are currently low, and their inflation beta (sensitivity) is also low, meaning you probably need to hold quite a lot of them in a portfolio to help protect it from inflation. Gold typically has a much higher inflation beta of 6-8 times[2], as do other commodities, which means a little goes a long way in the event of unexpected inflation.

Property and equity can also protect you against inflation over the long term, as they pass on higher rentals to tenants or higher prices to customers. But they may well suffer from a lower rating (earnings multiples) over such periods, as the market will apply a higher discount rate to the cashflows generated. Bonds, with their fixed coupons, are likely to be the poorest investment in an inflationary environment.

Perhaps it is best to think of gold as an insurance policy against unexpected inflation that you hope never pays off, because your other assets may well perform poorly in such an environment.