Q: Lockdowns are easing worldwide but the economic outlook remains deeply uncertain. How should investors behave against this backdrop?
A: As we look at markets today, we see a very bifurcated picture. On the one hand, bond markets globally are showing a very poor outlook for growth. On the other hand, equity markets are buoyant, particularly in the US. This divergence partly reflects central bank behaviour over recent months. Rate cuts and quantitative easing have provided significant liquidity and equity markets have responded positively to this trend. But our fund tends to take a lead from bond markets rather than equities so we believe that investors should be cautious right now. Most corporates are still reluctant to provide any guidance about future earnings, the employment picture is clouded and it is hard to gauge underlying supply and demand trends in the real economy. Overall, therefore, we are not optimistic about global growth.
Q: What are your principal concerns in the current environment?
A: Heading into 2020, the stock of government, corporate and household debt was already at record levels. But the coronavirus pandemic has pushed this considerably higher, as governments have run up very large deficits to try and ease the pressure on their economies.
High levels of debt usually constrict consumption, which can result in a period of deflation. Our sense is that governments will respond to this by trying to stimulate demand and thereby sowing the seeds for a period of inflation. As a result, we expect to see deflation followed by inflation over the next five years or so.
But most asset managers have positioned their portfolios in response to mild disinflation. While that approach worked pretty well in recent years, the next decade is likely to be very different. Anticipating that transition and being able to profit from it is the key investment question today.
Q: So what should asset managers do?
A: Obviously, different funds have different mandates. Our mandate is for defensive growth, so our priority is to preserve the purchasing power of our investors. That can be tough, if markets are suffering from deflation and inflation either sequentially or possibly even simultaneously in different parts of the economy.
In such conditions, we believe that gold has an increasingly important role to play. Gold tends to respond positively to negative real interest rates, especially at the long end of the yield curve and right now, 30-year US real rates are very low. At the same time, most economies are in recession and governments have either embarked on significant fiscal intervention or seem about to do so. These trends are also positive for gold. In short, gold can react well in a deflationary environment – and in fact it has done very well lately - but it can also outperform, as we transition from a deflationary to an inflationary period.
Q: Why are you so concerned about inflation?
A: Central banks are printing money so the stock of money within the system is increasing. At the same time, growing government intervention is likely to accelerate the velocity of money, that is, the speed with which money is turned over in the real economy. There is also talk about the Federal Reserve restarting yield curve control to keep long-term interest rates at low levels. A combination of increased monetary supply, increased velocity of money and extremely low interest rates creates the perfect backdrop for inflation. It is also, incidentally, the perfect combination for gold to outperform.
This occurred in the late 1970s, for instance, and gold went up fourfold. We are not at that stage yet but we are moving in that direction.
Q: Why do you hold gold in your portfolio? What function does it perform for you?
A: Investing in gold is an extremely efficient way of preserving purchasing power over time. If we go right back to 1933, before the Gold Reserve Act, one ounce of gold cost $20.67. Today, gold is over $1800 an ounce. If an investor had put their capital into gold over that near 90-year period, their purchasing power would have been fully preserved.
Today, however, there is the potential both to preserve wealth and deliver outperformance by investing in gold.
In recent decades, gold has been regarded as a peripheral asset within the institutional investment community. But we believe that markets are embarking on a period of change, which could provoke a fundamental shift in asset allocation. This reattribution of value is exciting for investors and it is an opportunity to generate significant returns.
If quantitative easing and other factors encourage investors to treat gold as money, the potential for price outperformance over the next five to ten years is extremely high. So here is an asset that can preserve wealth and deliver price outperformance in an uncorrelated way and that makes it extremely attractive.
Some people suggest that gold could account for up to 10% of an investment portfolio. On average it is nearer 0.5%. Of course, fund mandates differ but I do believe gold has the potential to become a mainstream asset. With extensive and prolonged central bank intervention and governments running massive deficits, gold may well replace US Treasuries as the de facto reserve asset. This may take time but change is already afoot and for us, gold is a bulwark in our portfolio.
Q: You’ve mentioned that gold is under-owned in the investment community. Why do you think that is the case?
A: Before the Bretton Woods agreement was suspended, gold was widely viewed as money. For most people, today, gold is most closely associated with jewellery. That’s not a pejorative statement. The price of gold is driven very heavily by retail purchases, particularly in countries such as India and China, and that type of demand is critical to gold’s long-term price performance. But it has also perpetuated a view among some investors that gold is a peripheral financial asset.
In addition, most investment portfolios have followed the 60:40 ratio, for at least the last ten to 20 years, with 60% of their assets in equities and 40% in bonds. That strategy has delivered reasonable returns because bonds and equities tend to be negatively correlated over the course of a normal economic cycle.
In a period of rising inflation, however, bonds and equities tend to be positively correlated, which can spell disaster for a typical 60:40 portfolio.
That’s why gold is an interesting addition to an investment portfolio - because it provides an alternative. For us, that is the key message for gold ownership at the moment
Q: Could you envisage a time when you wouldn’t need to hold gold in a portfolio?
A: If real interest rates were to rise dramatically, allocations to gold would go down. But the bond market especially the US Treasury market is saying the opposite and that suggests one’s gold allocation should be rising.
Q: Some investors say they are reluctant to invest in gold because they find it hard to source accurate information on gold as an asset class. How do you source the data that you need?
A: We use a number of different sources. We monitor ETF flows, which are an increasingly popular way of owning gold, especially among retail investors. We look at gold futures, using data from Comex. And we use the World Gold Council for information on trends in the retail sector and the central bank community, as both of these have a significant role to play in the global gold market.
Retail demand, particularly in emerging markets, tends to rise when the economy is doing well and that can have a significant effect on price performance.
Central bank activity is worth watching too. For many years, the proportion of gold within central bank reserves was in decline but that started to reverse a few years ago – which clearly says something about central bank attitudes towards the global financial system.
We find the World Gold Council’s flow data extremely useful but they also have some highly skilled analysts, whose models allow investors to assess the fair value of gold and its contribution to a portfolio. This is a difficult topic because gold has multiple uses - as jewellery, a store of value, a safe haven and as money. Each of these may be valued differently and values can change over time but the World Gold Council’s models clearly show that there is an investment case for gold as a mainstream asset and it’s based on analysis not just gut feel.
It's also important to bear in mind gold’s role as a form of money. That involves monitoring currency markets, particularly the dollar, as the world’s de facto reserve currency. We look at money supply within the US and we analyse flows in the Eurodollar market as well. Of course, gold and the dollar tend to be negatively correlated but at times of crisis, both may rise in sync. As a long-term store of value, a currency and an asset against which there is no other liability, gold is usually in demand when the stability of the financial system is being called into question. And that, of course, often encourages a flight into the dollar and US Treasuries too.