My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

"Yellow Dust" (Gold)

Updated: Jul 19, 2020

My last article was on “Texas Tea”, a.k.a. oil, a commodity with very much a life of its own. This article will be about “yellow dust”, or gold. Unlike oil, gold is a precious metal rather than a commodity.  Gold is commonly used in jewellery, dentistry & medical, electronics & computers, medals & other commemorative memorabilia, and china & glassware. Gold is also used by governments and investors as a store of value in times of uncertainty as well as a hedge against unexpected inflation.  The amount of gold is not fixed completely, but net new additions to the global stock of gold are only around 1.5%/annum.  Hence, the price of gold is driven almost exclusively by global demand, meaning that it is immune to the whims of the ever-changing policies of central banks, and it reflects world demand as opposed to the economy of any particular nation making it apolitical.

Gold has been in the news for the last few weeks, because after several years of the price moving sideways, it has increased 35% over the past 12 months as you can see in the graph below.


As an investment, gold is considered a “safe haven” asset that in times of extreme uncertainty is used by investors to preserve value.  The negative of investing in gold is that it generates no income.  Still, gold deserves a place in an investor’s portfolio as a counter cyclical asset class when dark clouds are gathering on the geopolitical or economic front.  Perhaps more pertinent at this particular moment is that gold serves as an inflation hedge.

I am going to talk about gold in this article, starting first with its dynamics and then moving to some specific uses by investors that are particularly pertinent today.

Stock and Supply of Gold

Let’s look first at the amount of gold in the world, who holds it, and how it is held.

According to the World Gold Council, the above-ground stock of gold was around 190,040 tonnes as of 2017, with most of it being in jewellery.


Over the period 2008-2017, an average of 4,306.7 tonnes of gold was added to stock each year, of which roughly two-thirds (2,893.2 tonnes) was mined and one-third (1,413.5 tonnes) was recycled (both figures excluding net producer hedging of 62.7 tonnes/annum). According to my calculations, this means that the gold stock is increasing a mere 1.5%/annum resulting from new stock being added from mining. According to the World Gold Council, there is estimated to be around 54,000 tonnes of “below ground gold reserves” waiting to be mined, or just under one-quarter to the total above-ground stock today. As this data illustrates, gold is limited in its growth and the total stock in the world is believed to be finite.


The world's most prolific gold mining operations for many years were located in South Africa.

At its peak in 1970, South Africa accounted for 995 tonnes of mined gold, which at the time was two-thirds of the world’s total gold production of around 1,475 tonnes. South Africa remained the leading gold mining country until 2006, when its production began to decline and mining in other countries gained steam. The chart below from Wikipedia (core data from World Gold Council) illustrates the top 15 countries by gold production in 2018. Note that this is only mined gold, not recycled gold which – as mentioned in the preceding paragraph – accounts for around one-third of annual gold production.



Demand and Uses of Gold

According to the World Gold Council, an average of 4,282 tonnes of gold was used each year over the 2008-2017 period:

As previously mentioned, this demand was met with roughly one-third recycled gold and two-thirds newly mined gold.

It is interesting also to look at the gold held by countries and their central banks. According to an article from USA Today (with secondary authoritative references), circa 34,700 tonnes (18% of above ground stock) is held by central banks, and the table below shows some of the major nations that hold gold ranked by absolute size of their holdings.

Although the final remnants of the gold standard fell away in 1971, gold remains the de facto third largest foreign currency in the world when compared to fiat currencies, behind only the U.S. Dollar and the Euro. The table below from the IMF shows global foreign currency reserves by currency with gold included as a reference, using gold reserves held by central banks of 34,700 tonnes (as per the table above) and the current price of gold.

Although the final remnants of the gold standard fell away in 1971, gold remains the de facto third largest foreign currency in the world when compared to fiat currencies, behind only the U.S. Dollar and the Euro. The table below from the IMF shows global foreign currency reserves by currency with gold included as a reference, using gold reserves held by central banks of 34,700 tonnes (as per the table above) and the current price of gold.

Gold and certain other precious metals have a long history either as currencies themselves or supporting paper currencies by having a fixed rate of gold / unit of currency.This system evolved over 5,000 years, and you can read all about its interesting history in thislinkto Investopedia.In a nutshell, most countries of the world were on the gold standard by the end of the 19thcentury, meaning that international trade could be settled in gold or in paper backed by gold at a fixed rate/ounce.The Federal Reserve was created by the United States in 1913 to stabilise gold and maintain values.The gold standard lasted until the outbreak of World War I.After World War I, there was more debt (due to war reparations), and as the economy weakened and unemployment increased especially after the 1929 stock market crash and onset of the Great Depression, many countries started to drop their basing of their currencies to gold.The U.S. stopped using the gold standard in 1931, and the U.K stopped in 1933.The private ownership of gold was deemed illegal in the U.S. in 1933 and people were forced to exchange.


Towards the end of War World II in 1944, the western powers agreed to set up a currency system in which many of these countries’ currencies were to be pegged to the US Dollar, which in turn was convertible to gold at $35/oz. This agreement, known as the Bretton Woods Agreement (in reference to where the agreement was made in New Hampshire), served as the framework for the global currency market until 1971. 44 nations participated in the Bretton Woods Agreement. Even though a de facto gold standard has not existed now for nearly 50 years, two very important institutions – the IMF and the World Bank – were created because of the agreement and play prominent roles in the world today.

Linking a country’s currency to gold and providing convertibility for the paper currency into gold at a fixed rate effectively reduces the threat of inflation and deflation in an economy, and certainly neutralises the influence of the central bank. For these reasons, the gold standard was a way to bring confidence to paper currency that otherwise has no intrinsic value and to ensure its stability. However, from the perspective of governments and central banks, the fixed gold link neuters a policy tool that could otherwise be used to provide counter-cyclical monetary policies to an economy that is over-heated (inflationary) or below full employment. In fact, my understanding is that the inflationary environment in the 1960s in the U.S. put the Dollar under pressure, because more and more U.S. Dollars were being printed to fund the Vietnam War and the U.S. social agenda, and this was causing total U.S. Dollars to exceed the amount of gold held by the U.S. As the pressure to devalue the U.S. Dollar increased, several countries approached the U.S. about exchanging their Dollars for gold. Ultimately, the U.S. decided to eliminate this pressure. The government ended the convertibility of U.S. Dollars held as foreign reserves to gold, devalued the U.S. Dollar initially and then ultimately delinked the currency from gold completely, allowing the U.S. Dollar to float. (Currencies with no underlying link to gold or other precious metal to support its value are known as “fiat currencies”.)

Once the U.S. dropped the gold standard, gold appreciated fairly significantly, which de facto meant that the U.S. Dollar was devalued at least vis-à-vis its former price/ounce against the U.S. Dollar. Since one U.S. Dollar was worth less and the U.S. was increasingly importing goods from abroad, this effectively increased Dollar liquidity, ultimately sowing the seeds for inflation in the 1970s which took many years to bring under control.

Why is Gold an Inflation Hedge?

Gold is deemed to be an inflation hedge because its supply is limited. This is very different from the U.S. Dollar, Sterling, the Euro, the Japanese Yen, and every other currency in the world, because the central banks of countries have the ability to increase or decrease their respective money supply. If a central bank increases its money supply too quickly, then more of its fiat currency is needed to buy goods. This is inflationary, effectively devaluing the paper currency. An investor can protect himself against this risk by owning gold, because gold has a finite supply that cannot be manipulated. Think of it this way: if it takes more units of a fiat currency to buy a fixed amount of goods because of inflation, then it will similarly take more units of the fiat currency to buy one ounce of gold. But even if the same amount of goods costs more in terms of fiat currency, the goods should cost the same in gold because the gold stock is fixed (and hence, it has not been devalued). Therefore, gold is deemed to be an effective hedge against inflation, and especially against expansionary monetary policies by central banks as we are currently experiencing in many major economies.

Below is a graph that depicts the price of gold on a relative basis against U.S. CPI starting on January 1, 1975, which would have given gold a few years to settle to a true market price once the gold standard ended in 1971.


This graph shows that during high inflation periods, such as the late 1970s to early 1980s, gold performs particularly well. As inflation was gradually contained by the mid-1980s and remains relatively subdued until the Great Recession, gold generally lagged CPI, as inflation was largely under control during that period. Gold rallied into the Great Recession due to its safe haven status, discussed further below. However, gold continued to rally strongly even after the recession ended because of unconventional monetary policies used by the Federal Reserve in the form of quantitative easing (“QE”), which was viewed by many investors to be inflationary because it flooded the market with U.S. Dollars. Eventually though when investors realised that economic growth would resume without inflationary pressures in the real economy, gold underperformed other asset classes, losing value as CPI was stable in the 2% / annum area throughout the 2012-2019 period. However, things changed in the autumn of 2019 with injections of short-term liquidity from the Federal Reserve into the monetary system, and then the onset of COVID-19 in early 2020.

The recent COVID-19 global economic downturn has led to a series of aggressive countercyclical policies by the world’s largest countries, including - once again - unprecedented amounts of fiscal and monetary stimulus. Monetary stimulus has come in the more conventional form of lower short-term interest rates (which are in fact negative in the Eurozone and Japan), but also in the reintroduction and / or expansion of unconventional monetary policy via quantitative easing. QE refers to the purchase by central banks of government securities to influence the level of long-term interest rates. (Recently, the scope of QE has been expanded in some countries to include corporate bonds and asset-backed securities, and even equities in Japan.) This has very quickly increased the supply of money in the system, facilitating liquidity and boosting asset prices. As of yet, it is not proving to be inflationary because global demand is so week.

Recent history has also shown that even with the Federal Reserve, the Bank of England, the ECB and the Bank of Japan priming their economies by printing money and flooding their economies with liquidity since 2008+ to see off the effects of the Great Recession, inflation never really materialised in the real economy. However, it did manifest itself in an increase in asset prices, causing distortions that are not the subject of this article. In fact, the fear in both the Eurozone and Japan was – and remains - more around deflation than inflation. This is not a paper on monetary policy but on gold, so let’s leave this here for now by concluding that the inevitable end game for an oversupply of liquidity in the system will, at some point, likely surface in the real economy in the form of price inflation. For this reason, the price of gold increased recently, not only because the massive injection of excess liquidity lifts all asset prices (including gold), but more because investors fear inflation. With its fixed stock, holding gold provides ready protection against ill-advised policies of central banks should they swing too far in the accommodative direction.

Why is Gold considered a “safe haven” asset?

Gold is considered one of the world’s safe haven assets, in good company with the U.S. Dollar, the Japanese Yen, the Swiss Franc, and U.S. Treasuries. This means that when uncertainty increases in the world, investors prefer to move out of “risk assets” like equities and real estate, and into assets that they deem to be the safest. In spite of the discussion in the preceding section regarding unconventional monetary policies, the U.S. Dollar, the Yen and the Swiss Franc all typically strengthen (against other currencies or a basket) when times become challenging. Similarly, U.S. Treasury bonds are deemed risk-free because of the size and diversity of the U.S. economy, and because there is a democratic government and political stability in the U.S. Gold is rather unique in that it transcends borders and is not influenced at all by ill-advised economic policies or political uncertainty because of its scarcity and fixed stock. As you might expect, gold tends to move inversely with the outlook for the economy and the stock market, as illustrated in the graph below.

I went back further in this graph to April 1968, although keep in mind that at the time gold was fixed to the US Dollar then (and remained so through 1971). Had you owned and kept gold in the 1960s, its performance (ex-dividends) would have been better than the stock market since then! Although the early years of this graph is arguably artificial, it does show fairly clearly that there is an inverse correlation between the S&P 500 (“risk on”) and gold (“risk off”). You can see this during the late 1970s/early 1980s (oil shock/recession), and during or just after the onset of both the dot.com bust and the Great Recession. Gold flattened out during the 2013-2019 period and stocks performed strongly, but CV19 has again changed the outlook, as safe haven asset gold allied as investors sought safety and capital preservation.


If we look at a more recent period, starting in 1985, the outcome is slightly different although the trends are the same. This graph makes the case clearly that stocks have outperformed gold rather significantly over the life of this chart (since 1985), but that stocks are also more volatile and subject to wider variations whilst gold is a stabilising force. Regardless, holding gold makes sense because of its inverse correlation.


Should an investor own gold, and if so, how and how much?

Investors can but physical gold, known as bullion, via coins or bars, but of course need to be particularly careful storing it. Investors can also buy ETFs that have interests in physical gold that is stored safely, usually issued via grantor trusts to protect the buyer from the bankruptcy of the sponsoring company. Several gold ETF’s are in this article from Investopedia, published February 18th 2020. It lists three low cost and well-structured physical ETFs: GraniteShares (BAR, 17.5bps running expenses), Aberdeen Standard Physical Swiss Gold Shares (SGOL, 17 bps running expenses) and iShares Gold Trust (IAU, 25 bps running expenses). As far as the percentage of one’s portfolio that should be allocated to gold, firstly note that gold is a liquid asset class not dis-similar to the U.S. Dollar or other major fiat currencies. This means that there will always be a market to buy or sell gold. Gold provides inflation protection and appreciation potential, but it pays no current return. Gold can decline in value when we are in a “risk on” environment, generally at times when there is economic and / or political stability. During these times, investors prefer a combination of upside and current return better achieved in the stock or bond market. However, gold will likely increase in price when instability lies ahead or if investors are concerned about future inflation, which can be especially detrimental to fixed income assets like bonds. As a result, I believe that gold should probably be 2%-5% of one’s portfolio, noting that this is not a recommendation but rather a suggestion.

Conclusion

Gold is a fascinating story with a long history. As an asset class, gold has redeeming attributes that means that it belongs in a portfolio, true at the moment perhaps more than in a very long time.

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