Why gold has the Midas touch

Despite negative forecasts, gold has managed to retain its value during turbulent market conditions. Dominic McCormick explains why this metal remains the one to watch.

On 24 March gold reached a record high of $US1,446 per ounce. If gold ends 2011 positive it will be the 11th consecutive yearly rise.

Yet there was little media coverage about this new record or heightened discussion of what has been the most consistent bull market of the 21st century.

To the extent that views on gold are highlighted, they are more likely to be suggesting that gold is in a bubble about to bust.

At the recent PortfolioConstruction Markets Summit ‘Bubble Bubble toil and trouble’ a panellist, in summing up the day, suggested that of all the asset classes discussed, gold was the only one likely to be in a bubble.

Surely I am not the only one that finds this situation surprising.

How can such a prominent financial variable which has been in a bull market for more than a decade, rising over five times through that period, still be either largely ignored or quickly labelled a bubble about to bust by the vast majority of the mainstream investing industry?

It’s not as if most of those calling it a bubble now were actively recommending/investing in gold at much lower prices in the early 2000s and are now telling their investors to exit. No, back then most of those sceptics were totally disinterested and uniformed about gold.

Today, while interested in jumping on the ‘gold is a bubble’ bandwagon they remain just as uninformed regarding what is driving this bull market.

Is gold a bubble?

The reality of any true major asset bubble is that it eventually sucks in a large proportion of the investing population and the broader consensus and media doesn’t recognise it as a bubble until well after it bursts. That is not happening here, at least not yet.

Gold will almost certainly end as a bubble (and we are likely closer to the end of the bull market than the beginning), but the current investor participation levels, market dynamics and sentiment don’t seem to indicate a bubble about to bust.

While the gold exchange-traded funds have attracted significant support in recent years they still represent a small fraction of the money invested globally in money market funds, often earning close to zero interest.

Gold equity funds are not attracting massive inflows nor growing rapidly in number. It is true that gold shares and funds that invest in them have lagged recently (and at other various times in the bull market) but they have still been one of the best sectors of the share market over the last decade.

Most of the gold sceptics just don’t get gold because they keep looking at the wrong thing. They keep staring at a pile of rare, shiny metal and wonder why people are willing to pay more than $US1,400 an ounce for it.

They really should be looking at the massive volume of paper dollars that the US central bank can effectively print out of nothing; the various central banks’ manipulation of short-term (and long-term) interest rates, towards or below the level of growing inflation; and the dismal fiscal and debt situations of many western governments, driven partly by the unwillingness of flawed political systems to say ‘enough is enough’.

Gold is a barometer of the level of confidence in central bankers and governments, and that confidence remains at low and declining levels, especially in the key US economy.

And it seems unlikely that this confidence will be resurrected in the near term. Indeed, only a series of crises are likely to spur actions to solve these issues.

Ironically, it is many of the commentators dismissing gold who continue to pay reverence to the unstable and flawed global monetary system around the US dollar and the false ‘safe haven’ of US treasuries that are helping to delay the very crisis the US needs to force appropriate change.

All this is not saying gold will definitely keep going up from here. But have investors and their advisers globally adequately challenged themselves about the possible economic/investment scenarios in coming years and whether they should have gold exposure?

If there was a 1 per cent chance of hyperinflation in the US how would investors protect themselves? What if that risk were 5 per cent, or 10 per cent?

Maybe this is less of an issue in Australia, where the Federal Government has been more responsible. The Reserve Bank of Australia is not hell-bent on debasing our currency to be ‘competitive’, and interest rates are close to normal.

However, it is not as if Australia would be immune from a crisis of confidence in the US or paper currencies generally.

Has the horse bolted?

‘It’s too late’ is a common argument against investing in gold now. “Gold was a GFC [global financial crisis] play only – there is no need for gold now,” one of the fund manager panellists at the PortfolioConstruction Markets Summit said.

But why has gold risen almost 40 per cent since March 2009, when many believe the GFC bottomed? Clearly there is more to it than that. Part of the answer may be that the GFC hasn’t finished yet, as ongoing sovereign debt issues illustrate.

I think a big part of it is that many just lump gold in with other commodities and feel they probably are already getting enough commodity exposure through shares and other investments.

While gold struggles to attain converts, the broader commodity story is attracting strong demand even from institutional investors through various index and enhanced index products.

The key problem with this approach is that gold is very different to commodities generally.

Gold is a monetary asset, and has been for thousands of years – even though this is not always officially recognised as such. Nearly all of the production through history still exists, and only a small proportion of gold is used in the manufacture of goods.

Most is held as investment or store of value either by private investors or central banks. Many see these attributes as negatives, but the key point is that gold is a monetary asset.

Most other commodities are perishable, get consumed or made into other things that are consumed; and while these attributes are put forward as their advantage over gold as an investment, it is this ongoing need for commodities that has encouraged humans to become much more efficient in producing and consuming them though history.

Humans have been remarkably successful in becoming more efficient in producing commodities (eg, more grain from less land, fatter cows, etc).

As a result, commodity prices generally tend to fall in real terms over the long term. Gold, in contrast, has managed to retain its real value over long periods of history.

Wise words

The arguments were well summed up in a recent piece by Dylan Grice of Société Générale entitled Why this commodity-sceptic value investor likes gold.

Humans have devoted their ingenuity to producing and consuming commodities more efficiently.

So while commodities can have very strong rises over a period of years or even decades in history, simply buying most commodities forever as an investment doesn’t make a lot of sense.

This is especially the case when the very act of many investing in commodities in recent years has changed the market structure of commodity futures and reduced the ‘roll yield’ (one of the key components of commodity returns historically).

Grice highlights the key difference in the dynamics of the key drivers to gold versus commodities generally:

“For our ability to pass knowledge down through the generations applies only to the physical sciences. In the realms of social decision-making, where humility and realism are so often the dupe of hubris and self-delusion, each generation is always condemned to relearn the mistakes of generations past. It is the systematic tendency towards precedented folly which is such a fascinating feature of our financial heritage.”

Gold derives its demand from the level of confidence in other money alternatives and the stability of financial systems generally.

Our ingenuity may make us more efficient producing and consuming commodities, but it has done nothing to prevent financial crises, which continue to occur regularly through history and are arguably becoming larger and more destructive.

The inability of the key people at central banks and governments to predict or even be aware of the increasing risks of crises highlights this. Indeed, there is no point looking to the central banks for guidance about whether buying gold is a good idea.

Many western central banks sold gold all the way down to the $US250 bottom and it is only recently that central banks as a whole have turned into net buyers. If history is any guide, they are likely to be aggressive buyers when the market tops.

Central banks’ warped thinking on gold was recently highlighted by the Dutch central bank’s decision to order a local pension fund there to sell its entire 13 per cent allocation to gold on the basis that such a large allocation to a volatile commodity was “inconsistent with the interests of the funds participants”.

Would it be more consistent to instead put it into ‘safe’ government bonds of its Euro partners like those of Ireland, Spain, Portugal or Greece?

Clearly even some central bankers don’t understand gold’s monetary value. If we accepted central banker’s recommendations on where to invest, US housing would have been a sound investment in recent years and the GFC wouldn’t have happened.

The way things stand

It is true that gold will be a very poor asset to hold at some point in the future.

But this will most likely be when we have both central bankers and politicians committed to preserving the value of their currencies rather than debasing them, and only when the western political system moves away from the notion that more debt and inflation is always the easy way out.

The end of the second round of quantitative easing in the US (QEII) and the pressure on the country to rein in its monetary experiment of recent years is likely to significantly increase volatility in the gold market, as participants weigh judgment about whether the central bank and US government really can move towards ‘normality’ without significantly higher inflation or a fiscal crisis.

We hope that they can get it right, in which case gold will be one of our poorer performing investments.

But we would be going against the lessons of history if we didn’t continue holding some gold-related exposures as a hedge against humanity’s consistent ability to make a mess of things.

Grice sums it up this way:

“Shorting mankind’s ingenuity isn’t a smart thing to do. But ingenuity isn’t wisdom. And shorting mankind’s ability to absorb wisdom … well, aren’t you silly if you don’t? With less of the technological risk you’re taking when you buy any other part of the commodities complex, gold is the oldest, purest and simplest way.”

Dominic McCormick is chief investment officer at Select Asset Management.