Why Buffett is wrong to dismiss the benefits of gold

Yellow metal provides a useful indication of economic expectations

Paras Anand

Warren Buffett's group reported a staggering cash balance of $122bn Warren Buffett's group reported a staggering cash balance of $122bn © AP

Legendary investor Warren Buffett’s much-quoted dismissal of the investment merits of gold is simple: the metal is “neither of much use nor procreative.” But the Oracle of Omaha has got this wrong. Gold is constantly offering useful insights, if you look closely enough.
Gold as an investment yields nothing and generates no cash flow, so its price is largely determined by the secondary market. In other words, it is only worth what other people are prepared to pay for it. That price has risen by almost a fifth so far this year to about $1,470 per troy ounce.

In that sense, gold is the original profitless unicorn, summoning billions from investors well before tech start-ups arrived on the scene. The obvious difference between tech enthusiasts and goldbugs is that few of the latter get excited about industry-disrupting platforms. On the contrary, they see gold as the ultimate anti-disrupter — an insurance policy against asset price deflation.

Traditionally, gold prices have been given little airtime in discussions of “serious” investment strategy. But even if you have no intention of considering an allocation to gold, there is a value in keeping an eye on the price, as it can be an interesting signal amid the increasing noise of macroeconomic data.

The growth in passive and systematic investment strategies has brought sweeping changes to the structure of financial markets over the past decade. Meanwhile, central bank intervention and a much-changed regulatory landscape have increased the importance of “non-fundamental” investing — investment decisions that are not grounded in an analysis of the value of an asset based on business or economic fundamentals.

The result is that, increasingly, decisions to buy or sell securities are based less on notions of value and more on unrelated functional needs. There is less information in prices today, because there is far less wisdom in the crowds. In response, it is more important than ever that investors employ fundamental analysis, patient capital and wilfully ignore short-term price swings.

Amid all these shifts, the market structure that has arguably changed the least is gold. Given there was never a concept of fundamental value, and it was never bought and sold on that basis, its underlying price drivers have remained consistent. So, could it be that in today’s market, gold is a rare source of wisdom?

If so, it is a contrarian wisdom. Gold’s price action over the past decade has confounded the expectations of even its most devoted fans. In the years immediately after the financial crisis, many goldbugs geared up for a bull market that never arrived.

Given the widespread use of quantitative easing globally and a sovereign crisis in Europe, it would be hard to imagine a more favourable environment for gold as an inflation hedge. Given the fragile financial system, dysfunctional politics and an apparent threat to fiat money, how did gold not catch a bid? Because counter to conventional wisdom at the time, inflation did not pick up with quantitative easing. It collapsed.

Even when it is strengthening, the gold price is surprising. To the extent gold is an alternative store of value to the US dollar, it would be expected to move in the opposite direction to the currency. But recently it has been making material gains despite a strengthening dollar. Signs that the gold price is defying conventional wisdom suggest we should dig a little deeper.

What then is the message that gold prices are sending? There are two very different answers to this question.

The first is that gold’s theoretical value — as an asset that yields nothing — should go up as the amount of negative-yielding assets increases. In this explanation, gold’s rising price is a sign that negative real rates will persist and the recession already priced into many asset classes will be more severe than consensus expectations.

There are weaknesses in the argument. Yes, the amount of negative-yielding assets is at historic levels. But to the extent that these assets have been bought to provide liquidity or meet capital adequacy requirements, their yields arguably say less about future economic prospects than they do about the changes in market structure.

The alternative explanation is equally plausible, but more important. It is that gold prices could signal a pick-up in inflation. This feels less likely, even with looser fiscal policy. But as we pointed out, after the financial crisis gold prices did seem to predict that QE would not lead to the expected increase in inflation.

If gold proves correct this time in signalling higher inflation, investors take note, given the impact this would have on asset prices across markets.

It has always been wise to listen to Mr Buffett. But given the seismic shift in market structure in recent years, gold may yet prove to be an indicator not only of “bandwagon” investor behaviour but broader economic expectations.

The writer is head of asset management for Asia-Pacific at Fidelity International

Russia’s Oil Conundrum

Revenue from oil exports may be flowing into Russia, but Moscow can’t decide how to spend the money.

By Ekaterina Zolotova

Global oil prices jumped sharply after drone attacks on two Saudi oil facilities last weekend.

The two facilities produce about 5.7 million barrels per day – nearly half of Saudi Arabia’s daily production. With that volume temporarily out of commission, global oil prices rose by between 12 percent and 15 percent.

That should be good news for Russia: Its economy depends on the oil and gas sector, with sector-related activities accounting for roughly half of the federal budget. And indeed, share prices for Russian oil companies as well as the price of Urals crude, which is based on the price of Brent crude, increased, meaning oil sales will be infusing the national budget with cash.

But the Russian state seems incapable of taking advantage of such a windfall, thanks in part to deep structural problems in the economy. Even when oil prices are lower, the government is unable to decide how to invest the money, leaving the Russian budget swollen with untapped funds.

Between January and August 2019, the country had a budget surplus of 2.56 trillion rubles ($39.8 billion), equivalent to 3.7 percent of gross domestic product. The recent increase in oil prices could further bloat both the surplus and Russia’s National Wealth Fund. The government is required to put into the NWF profits from oil if the price per barrel of Urals oil exceeds $41.60. Once the NWF’s liquidity equals 7 percent of GDP, the government can start investing the money.

With higher oil prices, the NWF could exceed the 7 percent threshold earlier than expected.

And while spending the excess funds is not required by law, it’s in Russia’s interest to invest the funds in things like government programs and infrastructure since the economy has been sluggish and there’s been growing public unrest.

And yet the structural problems – including lack of domestic demand, poverty, rising inflation and a poor investment climate – are preventing the state from reaching a consensus on how the money should be spent. Investing in the national economy, namely through national projects, has drawbacks. For one thing, using the NWF can affect inflation in the medium term.

This would place the Russian population’s real income, which has been declining for six years, under pressure once again. (In the first half of 2019, the real disposable cash income of Russians decreased by 1.3 percent.) Against the backdrop of falling incomes, consumer demand is stagnant and, accordingly, not a viable source of economic growth.

The government would therefore be risking growing dissatisfaction among its constituents over worsening living standards and its failure to follow through on promises to achieve economic growth rates above the global average.

Short-term public investment in the economy doesn’t seem to be a viable option, either. It won’t generate the kind of national projects needed, since these require private investment too, and investors aren’t particularly eager to fund such projects. Neither will investing the additional funds abroad be helpful in stabilizing the Russian economy. Particularly with the fall in President Vladimir Putin’s approval ratings, the government won’t dare to pursue such avenues.

In any case, spending this money would only put more pressure on the budget and increase oil dependence. And using additional funds from the NWF, even with stable or rising oil prices, will make the ruble ever more vulnerable to oil price fluctuations. At present, the NWF investment rule somewhat reduces the ruble’s vulnerability to changes in oil prices; if oil prices jump by 10 percent, the ruble changes by only 1 percent. (In the latest round of oil price increases, the ruble did react, but its fluctuation was, in the end, rather insignificant.)

Moreover, even as Russian oil companies benefit from rising prices, there’s little they can do to change their positions in the world market. Russian oil exports are still limited by an OPEC+ agreement on production cuts, which stipulates that Russia reduce its oil production by 228,000 bpd, down to its October 2018 level of 11.4 million bpd.

In addition, its natural gas exports are governed by long-term contracts that can’t be changed quickly.

Usually, high oil prices mean higher revenue for Russia, increasing the amount of money that could be used to improve the country’s economic well-being. But the Russian state seems paralyzed when it comes to actually spending those funds. What’s more, spending revenue from oil sales can undo any attempts to reduce the Russian economy’s dependence on the oil and gas sector. Structural economic problems are becoming ever clearer – and even a sharp rise in oil prices is not enough to kickstart the Russian economy.

Are Negative Interest Rates on the Way in the U.S.?

Wharton's Itay Goldstein and Peter Conti-Brown, along with Lisa Cook of Michigan State University, discuss the possible impact of negative interest rates on the U.S. economy.

negative interest rates

First it was former Federal Reserve Chairman Alan Greenspan saying back in August that he sees “no barrier” for U.S. Treasury yields going negative. Then President Trump called on the Fed this month to drive interest rates negative in order to stimulate the economy. While negative rates have been a distinguishing feature of the Japanese economy and many European economies for some years now, the concept has not been a serious possibility in the U.S. until recently.

The concept basically involves a charge to banks for holding reserves. That cost would be intended to spur them to lend more, which — along with lower rates more generally — would presumably drive economic growth. Negative rates on government securities held by the public are another possible scenario. Greenspan told CNBC on September 4 that investors should watch the yield on the 30-year note to see if negative interest rates are in the offing.

Today, there are some $16 trillion in negative government securities worldwide, and the European Central Bank (ECB) on September 12 cut its interest rate 10 basis points to a record low of -0.5% and also ordered a new round of quantitative easing ($20 billion in bond purchases and other financial assets) in November. Such bond buying drives down yields and cuts borrowing costs. The ECB also recommended some spending stimulus for countries — to boost European Union economies.

But while lower interest rates generally can whittle down government debt, they also subtract from the returns earned by banks and individual savers. And when rates turn negative, it is not clear exactly what the bottom-line effects might be long term across the economy. Some observers say negative rates could lead to a slow-growth environment from which it would be difficult to escape. Others contend the overall effect would be to stimulate the economy.

Behind the Trend

But what is driving this trend, and what might it mean for the U.S. economy?

In addition to long-term trends, the immediate cause for the U.S. is likely trade tensions, which have touched off an investor flight to the perceived safety of U.S. government securities. That has pushed interest rates lower. And that all piles on to a longer-term drift downward for rates, long underway and led by a slowing economy. Japan, for example, has had negative rates since 2016.

The slowing of economic growth is sometimes blamed on “secular stagnation,” said Wharton professor of legal studies and business ethics Peter Conti-Brown during a recent segment of the Knowledge@Wharton radio show on SiriusXM.

Secular stagnation has been defined as “a prolonged period in which satisfactory growth can only be achieved by unsustainable financial conditions.” U.S. economic growth, while steady, has been lackluster at a time when the current expansion since the Great Recession is the longest on record. For reasons not well understood, Conti-Brown added, inflation is low despite very low unemployment.

Part of reason for the low-growth economy is demographics — an aging workforce — said Lisa Cook, a professor of economics and international relations at Michigan State University, who also joined the radio show. In agreeing with Greenspan on that point she added, “We have a population that is not only aging but leaving the workforce,” and that is a drag on the economy.

Given the exodus from the workforce, retirees will depend more on their savings, and thus negative interest rates “will have tremendous implications for them,” Cook added. Similar — even stronger — trends are at play in Europe and Japan.

Downward Pressure from Inflation

Typically, when interest rates remain low for a long period, inflation picks up, but this time that is “really not happening,” noted Wharton finance professor Itay Goldstein, on the radio show. 

It’s time to challenge the “old paradigms” because something structural seems to have changed. 

At the same time, cheaper money has flowed freely into boosting asset prices, from equities to bonds and real estate, he added. “So maybe this is where we see the effect. But we don’t see it in prices of goods. We don’t see it in inflation.”

In any case, the Fed is left today with less power to influence financial markets given that rates are already so low. When rates hit zero, the so-called zero-bound, the Fed’s potential influence is thought to be at the end. Negative rates could change that. Since the Great Recession, lowering rates has not been as effective at stimulating the economy as in the past, and QE has also lost some of its bite. “So, central banks are asking themselves, ‘what can we do?’” Goldstein added. One tool is to cut rates to below zero.

Conti-Brown agreed. He pointed out that Fed chair Jerome Powell admitted that the Fed’s key estimate of “one of the most important indicators — the unemployment rate, that is the so-called ‘natural rate,’ the rate that it should be targeting — has been wrong. And not just wrong, badly wrong.” While unemployment rates kept slipping down, inflation did not budge, unlike what the models predicted. The relationship between inflation and unemployment “seems to be absent without leave.”

Some observers argue that there is an explanation for inflation’s disappearing act, and that is an overall lack of demand that keeps the economy below its full potential productive capacity. 

Fiscal stimulus is called for, they contend. The problem with that is ideological and political. 

With budgets deep in the red, and a prevailing mood against adding to debt, more spending would appear to be a non-starter for now.

Conti-Brown explained that one way to think about negative rates is to ask if they would have made any difference during the Great Recession. Had the Fed at the time cut nominal interest rates into “deep negative territory,” he added, “is it conceivable that the recovery would have been much, much faster? Yes, it is. This could be a very potent tool.”

Nevertheless, Conti-Brown added that there remains the question of whether or not the Fed has the legal right to move rates below zero and whether or not institutionally the Fed is capable at the moment of taking what could be viewed by some as such a drastic step. What’s more, political resistance would be strong and the panelists agreed that politics is increasingly important in influencing the Fed’s interest rate policies.

Ample Uncertainty

On top of that, there is a lot of uncertainty about the effect of negative rates. “How will individuals and firms react?” asked Cook. “Will they continue to wait for further rate cuts, will they continue to wait for lower mortgage rates or lower interest rates on their loans…? We don’t know. This is completely new territory.”

Regarding consumers, Cook noted that if banks can’t “make money the traditional way, they’re going to try to make money by [charging] more fees. … This will certainly raise some safety and regulatory issues related to consumers.”

Conti-Brown agreed that it is very difficult to predict all of the results that negative rates would produce. “We simply don’t know how markets in the world’s largest economy would respond to this new world.” Would it lead to “explosive economic growth” or “high inflation that we never expected or … something new that might just be coming our way that we didn’t anticipate?”

Another consideration: the effect negative rates might have on the financial system. Banks are used to positive interest rates. “This is how they make their spread. They might face difficulties making money and generating profits in a new world like this,” Goldstein said. If they are charged for putting money with the Fed, and “they can’t necessarily transfer the negative rates to their depositors, that might cause big difficulties for banks.”

Patrick Harker, president of the Federal Reserve Bank of Philadelphia, in a recent Knowledge@Wharton interview, made a related point: “We don’t have a lot of room to move rates.… Moving rates 50 basis points is not going to have a demonstrable effect. Then, it also creates other risks, because there’s a third component of the Fed, not in our dual mandate, but very important — financial stability. There is ample evidence that rates being this low for this long, start to create situations of financial instability….”

Nevertheless, the three panelists agreed that at this point, we are more likely to see negative rates than not.

Could Ultra-Low Interest Rates Be Contractionary?

Although low interest rates have traditionally been viewed as positive for economic growth because they encourage businesses to invest in enhancing productivity, this may not be the case. Instead, extremely low rates may lead to slower growth by increasing market concentration and thus weakening firms' incentive to boost productivity.

Ernest Liu , Atif Mian, Amir Sufi

sufi2_getty Images_graph

CHICAGO – The real (inflation-adjusted) yield on ten-year US treasuries is currently zero, and has been extremely low for most of the past eight years. Outside of the United States, meanwhile, 40% of investment-grade bonds have negative nominal yields. And most recently, the European Central Bank further reduced its deposit rate to -0.5% as part of a new package of economic stimulus measures for the eurozone.

Low interest rates have traditionally been viewed as positive for economic growth. But our recent research suggests that this may not be the case. Instead, extremely low interest rates may lead to slower growth by increasing market concentration. If this argument is correct, it implies that reducing interest rates further will not save the global economy from stagnation.

The traditional view holds that when long-term rates fall, the net present value of future cash flows increases, making it more attractive for firms to invest in productivity-enhancing technologies. Low interest rates therefore have an expansionary effect on the economy through stronger productivity growth.

But if low interest rates also have an opposite strategic effect, they reduce the incentive for firms to invest in boosting productivity. Moreover, as long-term real rates approach zero, this strategic contractionary effect dominates. So, in today’s low-interest-rate environment, a further decline in rates will most probably slow the economy by reducing productivity growth.

This strategic effect works through industry competition. Although lower interest rates encourage all firms in a sector to invest more, the incentive to do so is greater for market leaders than for followers. As a result, industries become more monopolistic over time as long-term rates fall.

Our research indicates that an industry leader and follower interact strategically in the sense that each carefully considers the other’s investment policy when deciding on its own. In particular, because industry leaders respond more strongly to a decline in the interest rate, followers become discouraged and stop investing as leaders get too far ahead. And because leaders then face no serious competitive threat, they too ultimately stop investing and become “lazy monopolists.”

Perhaps the best analogy is with two runners engaged in a perpetual race around a track. The runner who finishes each lap in the lead earns a prize. And it is the present discounted value of these potential prizes that encourages the runners to improve their position.

Now, suppose that sometime during the race, the interest rate used to discount future prizes falls. Both runners would then want to run faster because future prizes are worth more today. This is the traditional economic effect. But the incentive to run faster is greater for the runner in the lead, because she is closer to the prizes and hence more likely to get them.

The lead runner therefore increases her pace by more than the follower, who becomes discouraged because she is now less likely to catch up. If the discouragement effect is large enough, then the follower simply gives up. Once that happens, the leader also slows down, as she no longer faces a competitive threat. And our research suggests that this strategic discouragement effect will dominate as the interest rate used to discount the value of the prizes approaches zero.

In a real-world economy, the strategic effect is likely to be even stronger, because industry leaders and followers do not face the same interest rate in practice. Followers typically pay a spread over the interest rate paid by market leaders – and this spread tends to persist as interest rates fall. A cost-of-funding advantage like this for industry leaders would further strengthen the strategic contractionary impact of low interest rates.

This contractionary effect helps to explain a number of important global economic patterns. First, the decline in interest rates that began in the early 1980s has been associated with growing market concentration, rising corporate profits, weaker business dynamism, and declining productivity growth. All are consistent with our model. Moreover, the timing of the aggregate trends also matches the model: the data show an increase in market concentration and profitability from the 1980s through 2000, followed by a slowdown in productivity growth starting in 2005.

Second, the model makes some unique empirical predictions that we test against the data. For example, a stock portfolio that is long on industry leaders and short on industry followers generates positive returns when interest rates fall. More important, this effect becomes even stronger when the rate is low to begin with. This, too, is consistent with what the model predicts.

The contractionary effect of ultra-low interest rates has important implications for the global economy. Our analysis suggests that with interest rates already extremely low, a further decline will have a negative economic impact via increased market concentration and lower productivity growth. So, far from saving the global economy, lower interest rates may cause it more pain.

Ernest Liu is a professor at the Bendheim Center for Finance at Princeton University.

Atif Mian is Professor of Economics, Public Policy, and Finance at Princeton University, Director of the Julis-Rabinowitz Center for Public Policy and Finance at the Woodrow Wilson School, and co-author of House of Debt.

Amir Sufi, Professor of Economics and Public Policy at the University of Chicago Booth School of Business, is the co-author of House of Debt.

British Airways risks doing permanent damage to its reputation

The airline delivers profits, but its handling of the pilots’ strike has been lamentable

Camilla Cavendish

Artwork for FTWeekend Comment - issue dated 14.09.19
© Jonathan McHugh 2019

“We’ve been trying to reach you,” claims the email from British Airways. Maybe they sent a carrier pigeon. I’ve received several of these messages in the past year, when the airline has wanted to make late changes to my flight. Yet there are no missed calls. There is something about the insouciant tone of this message, the cynical contempt it expresses, that goes to the heart of this week’s pilot strikes.

The grounding of 1,700 flights on Monday and Tuesday was catastrophic for BA, financially and in terms of reputation. The planned walkouts caused untold misery to passengers. Yet BA’s management seem to be on autopilot. Their response of digging in, stripping pilots of their generous travel perks, has failed to head off the next planned strike on September 27 and seems unlikely to rescue the brand. The company may be delivering healthy profits, but it looks set to become a business school case study of reputational damage.

Even the stranglehold BA’s parent company IAG has on 55 per cent of slots at Heathrow may not be enough to retain customers who have endured tired planes, penny-pinching and call centres so unresponsive that one American passenger has suggested setting up a support group for Executive Club members trapped in mindless waits. Personally, if I have to listen once more to BA’s soothing “Flower Duet” theme tune, I fear I may spontaneously combust, leaving nothing but a smoking heap of Avios air miles.

The dispute would have been resolved by now had it been just about money. BA has offered an 11.9 per cent pay rise over three years, which it said would take some pilots to more than £200,000 a year. The problem is that staff feel as unappreciated as customers.

This is a far cry from 2009 when pilots helped the airline out by taking a pay cut, and BA’s boss Willie Walsh committed to work a month without pay. But that spirit of solidarity has evaporated since BA returned to profit, Mr Walsh has ascended the ranks of IAG, and Alex Cruz was appointed BA chief executive to keep on cost-cutting.

We customers know that airliners are cattle trucks, disguised to distract us from the essential madness of flying in a tin can far above the world. But precisely for that reason, we need the experience to be good. We don’t want to worry that the guy flying the plane might be tired and ratty because his employer has downgraded his layover hotel. We resent feeling simultaneously annoyed by having to pay for coffee that used to be free and sorry for the crew member who is having to apologise for it.

On a BA flight to Boston last year, a kind steward regularly nudged the seat of the snoring passenger in front of me, which kept over-reclining into my face. He was wonderful; but he was embarrassed by the poor service on the national carrier he used to feel proud of.

Airlines become dehumanised at their peril. At Heathrow recently, I couldn’t get the BA check-in machine to accept my e-ticket. Looking around the shiny wastes, there was no human being in sight. Eventually I found a rather senior official who checked me in, and even found me a nicer seat. “Thank goodness you were here,” I said gratefully. “I shouldn’t be,” he responded wryly. “I’m not supposed to come down here. They’d like to get rid of all of us.”

I know that Ferrovial, the owner of Heathrow, is more interested in bombarding me with luxury handbags than in helping me catch my plane. But the airline itself ought to care.

Of course, BA faces challenges in a fiercely competitive industry. While the pension deficit is no longer the defining issue it was before BA merged with Iberia, it is still a burden. There is also a gulf between newer staff who don’t have defined benefit pensions and whose pay and perks are substantially lower and their older counterparts. Plus there’s the flag carrier factor, which means that even one lost bag out of a million can make headlines. But the strategy of running the business for cash to boost shareholder returns may ultimately prove self-defeating.

The complacency is staggering. Until now, the company has been able to rely on the inertia of corporates booking transatlantic business class, which account for the bulk of profits. But charging frequent flyers to change seats is a strange way to reward loyalty, and cramming more seats into business creates a level of intimacy you might not want even if your neighbour was George Clooney. Since admitting last year that the data of 380,000 customers had been hacked, BA has never provided reassurance that it won’t happen again — or made me think that it minded.

Far from being “the world’s favourite airline”, BA shot down the Skytrax rankings of customer satisfaction between 2012 and 2018. Unless it starts to bother about people, its promised £6.5bn investment into new planes and lounges may come too late.

The most bewildering aspect of this whole saga is the company’s repeated refusal to consider the union’s demands for profit sharing. In cyclical industries, such arrangements can be a very positive way to align staff and shareholder interests. It has been a significant feature of labour settlements by US airlines in the past few years. It lets staff share in the good times, while acting as what HSBC analyst Andrew Lobbenberg calls a “shock absorber” in the bad.

All companies go through turbulence — the question is how they handle it. Right now, BA seems to be accelerating into crisis. I admire the professionalism of the pilots and like the cabin crew. But I no longer trust the company to look after them, or me.

The writer, a former head of the Downing Street policy unit, is a Harvard senior fellow