Wall Street's Best Minds
FRIDAY, NOVEMBER 22, 2013
A Caution Flag for Gold
By DAVID KELLY
The potential of rising interest rates and stronger economic growth make the metal a questionable investment now, argues a JPMorgan pro.
Given its historical role in the global monetary system, gold has consistently exhibited a negative correlation to the U.S. dollar, offering protection against losses in purchasing power and suggesting the precious metal can still serve as a global hedge against instability in the fiat currency system.
While U.S. Treasuries are universally accepted as the world's "safe haven" asset, gold has proven to be a valid hedge against extreme tail risks. However, given its inflated price and vulnerability, the potential for higher interest rates and stronger economic growth make gold an expensive form of insurance with limited coverage against future crises.
Despite a "lost decade" for equities in the 2000s, it is worth noting that investors benefited from being invested in one asset class over that time period: gold. While gold's meteoric rise has led to an almost cultish following, it is important for long-term investors to remain cognizant of the facts. Gold does not have a fundamental intrinsic value, and does not provide any cash flow, a right to future earnings or a promise of repayment at a later date. Furthermore, it has little economic use and is not tied to global consumption.
However, given its rarity, gold does have a perceived value and has played an important role in the global monetary system over the last century. Additionally, while short- run catalysts are few, the precious metal is still tied to long run drivers of price appreciation, including limited supply and robust demand from the emerging world.
Below we discuss some of the truths, and half truths, surrounding the value of this precious metal.
Supply & demand: Why gold is not an inflation hedge As is the case in any market, gold prices are determined by supply and demand. Regarding supply, while commodities in general are scarce, gold is the epitome of a rare good, with 39% of annual supply, on average, derived from recycling new and old scrap metal. This inherent rarity has given gold its reputation as a global medium of exchange and notable hedge against fiat currency inflation. Gold production is relatively stable from year to year, differing greatly from money creation. We will touch upon this in greater detail later in the bulletin.
Given that the supply of gold is relatively stable, changes in aggregate demand have a disproportionate effect on the price. The majority of gold consumption is jewelry purchases.
However, given the illiquid nature of jewelry, financial investments (primarily through liquid exchange traded funds) are a core driver of intra-day gold prices, representing 36% of gold demand on average, investors poured into the asset, as a flight to safety, during the recession.
Not surprisingly, as an improving economy has begun to deflate many "safe haven" assets, gold has suffered year-to-date, falling 23%. Nevertheless, with jewelry manufacturing and investors together representing more than 85% of demand, gold prices remain independent of many economic variables, most importantly inflation.
Most inflation hedges are related directly to consumption or industrial use. This makes perfect sense – if investors expect the price of final goods to increase, why not invest in either the final goods themselves or the inputs used to produce those goods? However this argument does not hold in the case of gold.
Gold's industrial and technological uses remain very limited, as jewelry represents the majority of demand. Additionally, absent of a pass-through mechanism for prices, gold has shown a limited ability to act as a traditional inflation hedge, with a negative correlation to consumer prices of approximately -34% over the past 30 years.
The world's oldest currency The changing link between gold and inflation stems from the pivotal role it has played in currency valuation during the past century. Until the early 1970s, the U.S. dollar was pegged to gold at a rate of $35 per troy ounce and was the basis of the Bretton Woods international monetary system.
However by the late 1960s and 1970s a burgeoning US trade deficit and rising inflation caused a fundamental disequilibrium in the pegged value of the dollar and gold, leading to capital outflows of the precious metal.
In response, President Nixon unpegged the U.S. dollar in 1971, allowing both the price of gold and the U.S. dollar exchange rate to float based on market determined levels).
While commodities in general can help hedge against domestic inflation, the price of gold has generally maintained a very low, if not negative, correlation to consumer prices. However, the link between inflation and gold prices has been observed through another indirect channel: the U.S. dollar.
Not surprisingly, the correlation between gold and the U.S. dollar has been consistently negative since the two were delinked in 1971, supporting the long-time argument that since gold is primarily traded in dollars, a weakening U.S. dollar should lead to higher gold prices.
However, a careful understanding of the underlying data may provide a more sufficient answer, as only relative inflation pushes an exchange rate lower with a country losing purchasing power versus its trading partners. This provides the missing component: while the correlation between gold and domestic inflation may be insignificant, the metal can still be used as a hedge against higher inflation on a relative basis given its consistently negative correlation to the tradeweighted exchange rate. The relationship implies that as the dollar depreciates, international currencies and gold should simultaneously appreciate, indicating gold trades in a similar manner to a global currency, rather than a traditional commodity.
Although fiat currencies can be expanded at will, thereby destroying consumer purchasing power, gold production is limited and stable, providing a store of value in the face of a depreciating exchange rate.
An unsafe safe haven The consistently negative correlation between the U.S. dollar and gold makes fundamental sense given the metal's historic role in the international monetary system. However, further proof supporting gold's role as a global currency can be seen when the current model of fiat money comes into question during periods of economic stress.
Traditionally, the U.S. dollar is viewed as the world's safe haven currency, which is confirmed when individuals purchase U.S. Treasuries during crises. However, with one exception, gold has exhibited similar tail risk properties during some of the worst market sell-offs since it was delinked from the U.S. dollar.
Although it has normally displayed a highly volatile and unpredictable correlation with equity markets (with average correlations near 0%), gold has done well during periods of market turmoil. Nevertheless, investors should be aware of purchasing this expensive form of insurance, especially given a still healing global economy and no obvious or recognizable economic crises on the horizon.
Where to now?
Few assets are more prone to changes in investor sentiment than gold. With no direct tie to global growth, the intrinsic value of gold is based on negative investor sentiment, as it has historically served as a hedge against depreciation of the U.S. dollar.
However, with the potential for stronger economic growth and tapering of Federal Reserve asset purchases in 2014, U.S. interest rates, and therefore the U.S. dollar, will most likely become increasingly volatile. Consequently, the still fear-inflated price leaves gold vulnerable over the coming quarters, and with limited and unpredictable links to global demand as well as sentiment-driven prices, investors need to remain aware that gold resembles an expensive insurance policy against catastrophe, while only providing limited coverage.
• Despite gold traditionally serving as a safe haven asset, investors should be wary of fear-inflated investments given the potential for improving global growth.
• While central bank actions suggest risks of future inflation, other real assets such as consumption-driven commodities may provide a better store of value.
• In the context of a diversified portfolio, gold has provided a consistent hedge against losses in the value of the U.S. dollar as well as low correlations to other assets.