Your catastrophe insurance policy

01 Jan 2014

10 years of Vision: The basic investment merits (or otherwise, depending on your point of view) of gold have remained unchanged for thousands of years. Some of the conditions in place recently – widespread policies of quantitative easing and heightened geopolitical tension – should be fertile territory for a strong performance yet inflation hasn’t taken off as many feared and financial markets generally seem remarkably sanguine about geopolitics. In dollar terms gold has been flat over the past four years.

Vision 2014 explored why gold gained its status in the investment world. But, given its limitations, what is it really good for?

For a substance that constitutes just 1% of global portfolio assets, gold commands a disproportionate amount of column inches and heated debate. In the blue corner, resolute sceptics like Warren Buffett, who dismiss gold as a “barbarous relic”; in the red, “gold bugs”, who tend towards an apocalyptic view of the future.
Between these extremes are managers who judge gold on its merits relative to other assets and ascribe it a role within a portfolio, mainly as an insurance policy against extreme economic outcomes. Gold is the only real asset that has the ability to protect against both severe inflation and deflation, at least in the circumstances outlined below.
How did gold gain its status? Spandau Ballet hit the nail on the head, describing it as “indestructible”; neither does it tarnish, although it’s not unknown for people to eat it. In pre-currency days, at least one asset in a transaction might have been perishable, so being able to take delivery of a durable substitute constituted progress.
Also the Earth gives up her stores of gold in a miserly fashion: 250 tonnes of dirt yield just one gram of gold. Thus there was, especially before mechanisation, little prospect of a supply glut.
Over millennia gold has tended to hold its value against tradable goods. 
In fact, the biggest glut in history probably occurred when Spanish galleons returned to Europe from Central and South America with centuries’ worth of accumulated production, which unleashed a period of inflation – yes, gold was probably the root cause as much as insurance against it! Other problems with gold include the fact that it bears no interest (you might even have to pay someone to guard it), it has limited utility, and a gold weapon would be too heavy to wield.
The first recorded use of gold as coin was by the Lydians in the sixth century BC. Gold and other commodities remained the prime form of hard currency until promissory notes and letters of guarantee, the precursors of today’s paper money, appeared in Europe in the late Middle Ages. Paper money could not rely for its value on trust alone, and was validated by the promise of convertibility into a fixed amount of precious metal.
Even then, if the paper issuance exceeded the assets of the issuer, a collapse of confidence and a rush for conversion could lead to the bank’s failure and losses for the creditors. Ultimately, the issuance of currency became the role of central banks, and in what is regarded by many as the apotheosis of monetary rectitude, this issuance was backed by holdings of gold.
The key to this being successful was the fact that gold had “history”. Over millennia it had tended to hold its value against tradable goods. One can argue about how much of this is down to just blind faith, but it’s a strong testament. Various “Gold Standards” have existed across the world, but none of them have survived.
The keenest adherent was the US during the 1920s and ‘30s, and many (not least departing Federal Reserve (Fed) chairman Bernanke [who left his post in February 2014]) consider this to have been a major factor in exacerbating the Great Depression, ruling out monetary stimulus. Britain conveniently abandoned the Gold Standard in 1931, opting for a classic devaluation policy to stimulate growth. Even the US finally blinked in 1935, devaluing the dollar relative to gold from $20 to $35 per ounce.
We emphatically view gold as an investment option, not a speculative instrument.
The next major iteration of a Gold Standard evolved under the Bretton Woods Agreements in 1944. Several major countries pegged their currencies to the US dollar and those dollars were convertible into gold at $35 per ounce. Two decades of relative stability followed, but it became apparent during the 1960s that the US was living beyond its means.
France demanded conversion of its dollar reserves into physical gold, and by 1971 President Nixon was forced to end the convertibility of dollars into gold. Theoretically a temporary measure, it became permanent, and the world has lived with pure fiat currencies ever since, in that even though central banks do hold gold in their reserves, there is no fixed convertibility, which allows them to grow their balance sheets at will.
That sets the scene for today, and for what our options are vis-a-vis gold within a balanced portfolio. We emphatically view gold as an investment option, not a speculative instrument. We are not interested in predicting short-term price moves, more in evaluating its utility as an insurance policy. What might it insure against? Threats include monetary debasement, inflation, deflation, credit risk, counterparty risk, foreign exchange and political risk.
Heading most people’s list of worries is the extreme expansion of central bank balance sheets that has vastly multiplied the amount of currency in issue. In the US, the UK and Japan, this expansion has supported the purchase of government debt, which, in turn, has been used to fund bank bailouts and fiscal stimulus. Switzerland has been “printing money” to maintain currency competitiveness against the Euro.
Historically, rapid expansion of the money supply has been associated with higher inflation, and this was very much the fear expressed in gold’s rise to its record high in 2011; yet the inflation dog failed to bark as monetary velocity collapsed when the private sector set about repairing its balance sheet. This has probably been the main factor in the fall of the gold price from its peak.
But history tells us that the postponement of an outcome does not mean that it has been cancelled, and if money begins to circulate more quickly through the economy as confidence recovers, central banks will be faced with the task of rapidly reversing the increase in money supply.
That brings us to the high-wire balancing act that must be maintained by central bankers. The US has already shown us how easy it might be to fall off. In May 2013 Ben Bernanke floated the possibility of “tapering” the monthly purchases of bonds by the Fed. Bond prices fell immediately, dragging up mortgage rates, and the US housing recovery was in danger of stalling, with negative consequences for the whole economy.
The response was to delay tapering into the unspecified future. In taking this option, the Fed clearly showed that it values economic growth over monetary integrity. Maybe all central banks should now adopt as their motto the words of European Central Bank (ECB) chairman, Mario Draghi, in reference to their efforts to stabilise the system and renew growth: “Whatever It Takes”!
In the same way as your house insurance is never actually needed until it is burgled, gold can sit around doing nothing until it is called upon.
The US has not set an inflation target, concentrating on the more acceptable aim of growth. Japan, though, has explicitly defined its objective to raise inflation to 2%, which might not sound very much, but stands in the context of two decades of disinflation and outright deflation. It is clear that most central bankers view inflation as the lesser of two evils.
Inflation’s devilish alter ego is deflation. While prudent debt-free individuals might like the idea of paying less every year for their purchases, deflation threatens far greater instability to nations of debtors. As Japan has learnt, if the cost of servicing one’s debt exceeds the nominal growth rate of the economy, the debt can never be repaid.
The situation is exacerbated by the assumption of new liabilities, and ageing populations with increasing welfare needs guarantee that outcome. This is where the spectre of default enters.
As we saw in the cases of Greece and Cyprus (and almost in Italy, Spain and Portugal), there comes a tipping point when investors decide that debts will never be repaid in the contracted form, which can lead to plunging bond prices (in anticipation of restructuring) and collapsing currencies (outside a fixed exchange rate system).
In the same way as your house insurance is never actually needed until it is burgled (or, even worse, burns down), gold can sit around doing nothing until it is called upon. Indians have a long and faithful relationship with gold, and during the emerging market wobble of mid-2013 (another result of Bernanke’s taper threat), the rupee fell over 20% against the dollar. During that period the price of gold in rupees rose close to an all-time high.
Viewed in those terms, one might think that investing in gold is simple, but there are complicating factors – aren’t there always? Given that the financial system almost fell apart in 2008, one might have expected the gold price to soar then. However, its peak-to-trough fall between March and November was 30% (although it rose 4.8% during 2008 as a whole, doing its job admirably).
The problem was that one of gold’s assets – its liquidity – can turn out to be a liability during a period of wholesale financial liquidation. Sometimes managers have to sell things as credit is withdrawn or investors redeem funds; gold is one of the financial assets that is easily realised into cash. In 2008 many hedge funds had identified gold as an insurance policy, but when their prime brokers called in loans in response to their own balance sheet problems, many gold bulls found themselves forced to sell.
One might think that investing in gold is simple, but there are complicating factors.
Liquidity driven moves tend to revert to fundamentals, and once the shake-out ended, gold’s recovery set the tone for a further doubling in price over the next three years. It’s possible that liquidity, this time as investors piled into gold, helped to push the price too high in the short term. Buyers included central banks, previously net sellers, but who now wanted to demonstrate their virtue.
Private investors also jumped on the bandwagon, and holdings within Exchange Traded Funds (ETF) rose from 900 to 2,800 tonnes between 2008 and 2012 – a meaningful amount relative to annual production of nearly 3,000 tonnes, especially when two-thirds of that production becomes jewellery. There has been a sharp reversal in the last year, with 700 tonnes being redeemed.
Gold overvalued as an inflation hedge graph for Investec Vision 2018
No good story is complete without a conspiracy theory, and many believe there was a concerted effort to launch a “bear raid” on gold in April 2013. Conditions were ripe: charts were bearish, ETF holdings were falling, and investors were more confident holding “risky” assets such as equities.
The stage was set for gold to fall 15% in a couple of trading days, and any hope of recovery was dashed with the subsequent taper talk. One of gold’s greatest enemies is a positive and rising real interest rate, as the opportunity cost of holding gold also rises.
So what is our investment case? Forgive us for not making specific price predictions; hopefully the preceding narrative illustrates the difficulties of attempting that. Still, one can suggest some ranges. If one indexes gold in dollars to the US Consumer Price Index from the moment Nixon abandoned the Gold Standard, you get a current price of $243.
What if we went back to 1920? The same calculation still only throws out $250. What if we created a new theoretical Gold Standard? The Federal Reserve Act of 1914 decreed a minimum gold backing of 40%. Today, given the Fed’s holdings, steady since 1980, 40% backing would equate to about $5,000. The cover from 1945 to 1971 was only required to be 25%, which gets us to $3,100. The average since 1973 has been 33%, leading us to a gold price of $4,100.
You can see from this that gold is already to some extent discounting the risks associated with monetary expansion, or, more precisely, the risk of not being able to reverse it. At the same time it is entwined in a complex web of influences that makes exact forecasts perilous.
Our view is that a small amount of gold within a portfolio will likely act as a slight drag if central banks steer a fi ne course between the obstacles ahead, but that overall returns will benefit from economic recovery and receding risks. In the event that the rocks are hit, gold offers upside potential as a counterweight to falling risk assets.
Gold should also offer sterling based investors protection against possible currency devaluation, although given that all the major currency blocks face much the same difficulties, the more likely outcome is that all fiat currencies ultimately devalue relative to gold.
If teh gold standard came back graph for Investec Vision 2018

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