A Few Thoughts on Buying Gold
The price of gold has over the last few months seen some upward pressure and it is thus reasonable to ask whether this minitrend is an aberration or whether it could signal a turning of the tide that investors should carefully heed. I presume that neither of these conclusions can be decisively inferred from what we have been seeing in the last year or so, primarily because I would ascribe the movement in the price of gold to the general volatility which has been the chief characteristic of equity markets for quite some time. Despite the fact that certain relationships that were not long ago considered almost sacrosanct no longer convincingly hold (decreasing oil prices usually exerted a positive influence over equities given the support they offered to consumption, yet that is not what we are observing these days, for a number of reasons I cannot possibly elaborate here), the general inverse relationship between the stock market and gold still seems to work. This makes a lot of sense because investors look for save investments when equities bleed. Now, because this relationship still more or less holds, one might conclude that there is no need to think of buying gold, given that the SP 500 (one of the leading indices of US stocks) is currently growing through the roof.
This would be true if we lived in ordinary times. (Un)fortunately, we do not. There are two major forces which are fatefully omitted from predictions of the future development of gold prices. Yet they could both possibly be felt and they would both send the price of gold much higher than it is today. Specifically, I have in mind the fact that the western economies are still on their monetary doping and China’s continuing ambition to amplify its gold reserves. Let us consider these factors one at a time.
Because policy makers in the West demonstrated considerable ineptness after the Great Recession of 2008/2009, it was the central banks who attempted to save the developed economies. Very low interest rates were coupled with massive injections of liquidity (aka quantitative easing) in hopes of reinvigorating inflation and boost aggregate demand through investment. Despite these great amounts of money that were suddenly available, banks did not seem that eager to lend the money out, businesses delayed investment and inflation stayed stubbornly low. This is a puzzle that is not easily explicable with current monetary theories. I tend to think that it has something to do with the fact that in a situation where investors generally doubt the health of the economy, the business environment, and the long-term fiscal feasibility of the western governments’ budgetary behavior, not even cheap money will convince firms to expand capacity. Another factor could be the West’s ageing population but it is unlikely that this kind of gradual change would become so palpable so suddenly.
Some will suggest that there are also positive stories, such as plunging unemployment in the United States. The problem is that the participation rate in America has dropped considerably and the official unemployment rate does not account for those who have simply given up looking for a job. Many European countries continue to battle the sclerotic nature of their labor markets and given the resistance that for instance French unions have put up against labor market reform demonstrates the degree to which it will be difficult to change the situation. If one thinks about the other sources of fundamental uncertainty that the world is currently facing (slowing growth in China, tensions between the West and Russia, instability in the Middle East, the possibility of electing Donald Trump), the gloomy picture of the world economy takes shape. To be clear, there are still many companies that are doing very well, maintain a healthy cash flow, and continue to innovate. The problem is, if a systemic problem hits, these companies cannot save the entire economy.
Now, a large portion of these sources of instability has been hidden because of central bank activity. As the central banks pumped more and more money into the economy and businesses did not necessarily make use of it, liquidity poured into the one sector where it could be utilized – the stock markets. Indeed, the stock markets have grown, with a few bumps along the road, quite strikingly and the American market is currently hitting new records. The problem is that this growth has not necessarily been driven by a fundamentally healthy economy; it has been greatly enhanced by the central banks’ policy. One can notice the degree to which the markets have become dependent on the central banks’ policy whenever the Fed suggests even a minimal hike in the record-low interest rates. Make no mistake, the markets have always paid close attention to what the central banks are saying but central banks have rarely been the crucial reason behind the markets’ growth.
Clearly, the current situation is unsustainable. Governments need to get their act together. They need to reform, build infrastructure, infuse the labor markets with more dynamism and demonstrate that they can fix their precarious fiscal situation. Chances are that this will not happen overnight, not least because investing in infrastructure and lowering deficits are difficult to achieve at the same time. Chances also are that the current gridlock will continue and that the political elite will in fact not be able to reverse the course, at least not before significant damage takes place. And this damage could start taking place precisely at the time when the equity markets realize that they have been growing on monetary steroids. This would mean that the stock markets would go through a crisis and investors would turn to the one commodity that has proven its value over ages – gold. Naturally, the price of the yellow metal would grow significantly. It is difficult to predict when the aforementioned realization could take place but a figure between two and three years comes to mind.
The other development whose importance is perhaps neglected is China’s growing appetite for gold. China, unlike most western countries, only reports its gold holdings very rarely. What is sure is that China is trying to increase its gold reserves and what is likely is that the figures it occasionally reports are not fully accurate. Arguably, China owns more gold that it is prepared to admit. The reason for China to acquire gold is at least two-fold. First, the country now holds most of its reserves in foreign currencies, most notably the US dollar. This fact exposes the China to external risk because Beijing does not control the printing presses of the US dollar and therefore cannot prevent changes in the dollar’s value. If China were able to convert at least a part of its reserves into gold, this external risk would be reduced. Secondly, all major powers hold considerable gold reserves, which enables them and their currencies to wield noticeable influence in the global financial system. A theory which according to some borders on conspiracy (I am not so sure) claims that China is actually trying to accumulate more gold to surpass the United States and become the country with the world’s largest gold reserves. Following this line of logic, China would at a certain point announce that it has more gold than the United States, which would undermine the US dollar as the world’s reserve currency because Beijing would then be able to back its renmimbi with the yellow metal. This would constitute an almost violent confrontation and I am reluctant to think that China necessarily aims at this kind of upset. Yet the country’s ambition to accumulate more gold is quite expected and natural, whether in order to claim global dominance or to merely assure its status as one of the world’s powers.
What is crucial is that once China reveals how much gold it owns, and it most surely will reveal a number that is higher than is officially claimed, the price of the metal will again have a reason to grow substantially. As with the last development, it is difficult to predict when exactly this announcement might take place but expecting it within the next decade is not unreasonable.
Given the possibility (probability) of the two developments described above, considering enlarging the share of gold in one’s portfolio seems a natural step.