Tag Archives: inflation hedge

Has gold peaked or is the bull run still underway?

16 Apr

Commentators love simplicity.  Most news sources blame gold’s precipitous fall on the expectation that the Fed will tighten monetary policy soon. If that’s the case, why have bond yields been so muted?

It doesn’t add up.

QE has been supporting numerous assets, the main one being government bonds which have been the main beneficiaries of the newly created dollars. If there was any real risk that the Fed really would stop printing, government bonds would have felt the impact immediately with yields rising sharply.

Given that 10 year Treasury yields actually fell by 4 basis points yesterday to 1.68% there is very little evidence that QE is going away any time soon.

There are a number of reasons for this. The economy continues to stall and unemployment remains persistently high. Until key economic indicators start to improve meaningfully, the Fed has little reason to stop. Ironically, the drop in food and energy prices actually takes pressure off the Fed to end QE soon.

So why has gold fallen so steeply, so fast? Data points to the closing of speculative longs rather than any significant change in demand for gold use in jewellery, which accounts for approx. 45% of gold demand.

Will it continue to fall? The risks appear to point to the upside:

QE is not going away soon (Japan has vowed to double its monetary base over the next two years) and the cost of capital remains at historically depressed levels.
At the current price, producers fail to make a profit on gold mining which should lead to a fall in production.
Central bankers continue to buy (with the possible exception of Cyprus in the short term).
Demand for jewellery in Asia and other emerging markets continues to rise.
Global currency debasement will ultimately lead to inflation.

Gold is a volatile asset but its long term fundamentals remain intact. The canary in the coalmine must be government bonds, so worth keeping yields in check.

Whatever the reason, gold is no Bitcoin!

What is inflation?

4 Mar

For those of you wanting a fantastic overview on inflation and what effects it can have on society, you must read Culture and Inflation in Weimar Germany.

Here is a short summary what inflation means:

In economic terms, inflation is a measure of the change of prices for goods and services over a period of time.

Different measures of inflation track different goods and services to give consumers and producers an idea of how the overall price of goods and services they use changes over time.

The three most frequently used measures of inflation are:

  1. The Consumer Prices Index (CPI)
  2. The Retail Prices Index (RPI)
  3. Producer Price Index (PPI)

The objective of all these measures is similar but each will vary slightly and, in different countries, their calculation might also vary a little.

CPI, for example, typically takes into account cheaper alternatives if a specific product get too expensive whereas the RPI does not, hence why CPI is usually lower. In the US CPI includes certain housing costs such as rent whereas in the UK, while RPI takes into account mortgage interest payments and council tax, CPI does not.

In the UK the measures of inflation are calculated by the Office for National Statistics and in the US by the Bureau of Labor Statistics.

Is inflation bad?

It depends who is asking.

Simply put, inflation will erode the purchasing power of your money over time. For example in 1970 $10 would have bought you over 16 Big Macs whereas today it barely buys you 2.

In more general terms, $100 in 1970 had the same buying power as almost $600 today. The Bureau of Labor statistics has an entertaining CPI Calculator to measure how much purchasing power the dollar has lost over time.

So is inflation bad?

As a saver, unless you are able to achieve a level of return equal to the level of inflation, your purchasing power will be eroded over time. Typically, interest rates will be higher than inflation meaning that investors are able to achieve a real return on their cash – i.e. a return, net of inflation, that is positive.

However, in today’s zero interest rate environment, with inflation running at approximately 2%, cash savers will get a negative real return of 2% – i.e. their purchasing power will decrease by 2% a year.

Savers are therefore forced into seeking real returns into real assets that entail risks (such as equities, property etc.) if they are to stand any chance of achieving a positive real return. Not great. But this is exactly what the Federal Reserve is trying to get people to do. By keep real interest rates negative, they force savers into investments that, they hope, will kickstart the economy once again. A risky strategy, but more on that later.

Is inflation good?

As a borrower inflation can have its advantages so long as it does not impact your ability to repay your loan.

For example, let’s assume you get a 30-year $100,000 mortgage to buy a house today. For every year that inflation erodes the value of the dollar, the size of your debt – in real terms – falls. Just like the example above, we can assume that if the next 30 years experience similar levels of inflation to the past 30, the real value of your debt will have fallen by approximately 60%.

Mortgages are usually structured to be paid monthly rather than at the end of the term, so the average fall would be closer to 30%, but the example illustrates very clearly that inflation can aid those who borrow in nominal terms.

I wonder why the Fed would want to spur inflation at this moment in time..? I’m sure it’s got nothing to do with the $16.5 trillion in nominal debt owed by the US government…

Gold as an inflation hedge

30 Jan

gold bars

Gold bullion as a hedge against inflation

The Central banks of the world’s biggest economies are all in a ‘battle’ to devalue their currencies. By ‘printing’ enormous quantities of currency through quantitative easing, central banks are aiming to debase the value of their currency and therefore increase the competitiveness of their industry overseas. This should drive (a little – they hope) inflation which should motivate consumers to spend and invest. That is the theory.

In practice, however, this is a very risky attempt to manipulate the value of fiat currencies, which could lead to a severe currency and inflationary crisis and consumers lose faith in the value of paper money. In this environment gold could prove to be the ultimate hedge.

Quick Overview

Positives

  • Gold has been a safe store of value in periods of high inflation
  • It has been used as a form of exchange and currency for millennia
  • Gold is easily transported
  • You cannot print it

Negatives

  • Gold does not provide a yield
  • The gold price is volatile and in periods of low or negative inflation it can be subject to severe draw-downs

Let’s take a look at these points in more detail.

1). Gold has been a safe store of value in periods of high inflation

Gold 1970s

There is no denying that gold has fulfilled its role as a store of wealth for the last 2500 years. The gold in an aureus coin of the B.C. Roman Empire would purchase approximately the same quantum of commodities, labour, or fixed property today as it could then. No fiat currency ever introduced, even if all interest paid on it had been re-invested without taxation, has come close to passing that test over any extended period.

In 2011 Warren Buffet gave this – now infamous – view on gold, which has since been adopted as part of the gold bears’ doctrine:

“I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars – that’s probably about a third of the value of all the stocks in the United States. For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven ExxonMobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it
and fondling it occasionally…Call me crazy, but I’ll take the farmland and the ExxonMobils.”

His point is indeed very valid. However, I think Mr. Buffet would struggle to find another asset that, despite decades of inflation (the US dollar has lost 96% of its purchasing power since the creation of the US Federal Reserve in 1913!) could still buy the buy the same, if not more, assets than it could 100 years ago. In other words, gold has fulfilled its role as a secure store of value, as it has done for millennia.

2). It has been used as a form of exchange and currency for millennia

The history of Gold as money in modern coin form spans 2630 years. The earliest known use was in 643 B.C in Lydia (present-day Turkey). Gold was part of a naturally occurring compound known as electrum, which the Lydians used to make coins. By 560 B.C., the Lydians had figured out how to separate the gold from the silver, and so created the first truly gold coin.

Numerous civilizations throughout history have had obsessions with gold. The Roman empire, the Aztecs, the Incas, the Mayas and many others all had a fascination with gold. The Romans were the most successful of these in harnessing its use for trade, but it has always been used for trade or as a powerful display of wealth and social standing.

3). Gold is easily transported

Property and land are real assets that should theoretically retain their purchasing power relatively well over economic cycles. However, one would struggle to carry their property across borders. Due to the heavy nuclei in its atoms which are closely packed, gold is a heavy precious metal and therefore one doesn’t need a huge amount of it to be carrying a very valuable cargo.

The traditional gold bar stored by central banks, weighs 400 troy ounces (438.9 ounces of 12.4kg) and can therefore easily be carried, is worth about $660,000 at today’s gold price.

Moreover, property and land may be seized by governments or creditors should they have debt associated to them, or even taken over by foreign enemies in war. Other real assets such as inflation linked bonds can very quickly have their value eroded by a collapse in the currency of the bond’s denomination.

It is worth noting, however, that governments can make it illegal to ‘hoard’ gold, as happened in the US in 1933. Therefore, storage is a crucial element of owning physical gold bullion. Investors should also note that the safest investment in gold is in physical gold bullion itself as the many forms of derivatives and exchange traded funds that track its price very successfully is normal times, might be ineffective as a form of exchange in extreme events.

4). Gold cannot be printed

Printing dollars vs. Gold Mining
The price of gold is determined by supply and demand. While demand for gold is impossible to predict, one should assume that in times distress, demand for quality assets should rise. Supply of gold, on the other hand, is a little easier to predict given there is a limited quantity of it on our planet and we are restricted by how much we can extract from the earth. It’s supply therefore should remain reasonably constant.

So the theory goes:

Gold is priced in USD
USD supply is increasing substantially through Quantative Easing le while the supply of gold is limited
The USD should therefore fall in value relative to gold. Or in other words, the gold price, in USD, should rise.

Negatives

1). Gold does not provide a yield

While property, stocks and inflation linked bonds can provide a yield through rental income, dividends or interest payments, gold provides no yield.
This is true in most environments, but with today’s ZIRP (zero interest rate policy) world, even yielding assets produce very little income. Some, such as inflation linked bonds, even give a negative yield!

2). The gold price is volatile and in periods of low or negative inflation it can be subject to severe draw-downs

Gold’s 30-day standard deviation over the last 10 years has averaged 10% vs. 12% for global equities. The peak for gold volatility was in October 2008 when it peaked at 56%, although during that period equity volatility peaked at 82%.

The issue with volatile assets is that they can be subject to severe draw-downs and gold is no exception. The worst draw-down ever in gold was between September 1980 and August 1999 when it lost 62%. Had someone bought at the top in 1980 it would have taken them 21 and a half years to recoup their initial nominal investment, see chart below.

Gold recovery period

Most commentators take very extreme views on one specific asset for an all in or out approach. That is definitely the best way to make (or lose!) a lot of money in short periods of time, but for sensible investors the key is to diversify into a number of asset classes and adapt the weighting to these as the economic cycle develops. Gold is not a guarantee for success and will be subject to severe draw-downs again in the future. However, at this juncture in the economic cycle, with uncertainty at every corner and central banks fighting to debase their own currencies, the asymmetry seems to point very much in favour of owning a portion of one’s assets in gold.

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