If you don’t own gold, you know neither history nor economics.
-Ray Dalio
I haven’t written anything in a little while because, well, there hasn’t been a whole lot going on to write about. We have had the usual Fed go full-panic-dove-mode, we’ve reportedly made progress on a trade deal with China about 28 times now (but still seem to be where we started), and a Brexit deal has been shot down like 6 times by their parliament. Volatility in currencies and bonds is pressing multi-year lows, and stocks are in the lull before quarterly earnings. But gold is starting to perk up and this is definitely something you want to keep an eye on.
In my personal opinion, gold should be in every single portfolio right now. It doesn’t matter if you are extremely aggressive-growth focused or at the complete opposite end of the spectrum. There are trends occurring which make gold the ideal hedge against risk. I think it is going to outperform stocks (growth) and hedge currency devaluation risk (bonds). In fact, if I could only own one asset class in my portfolio for the next decade, it would be real assets.
I think we are seeing a structural transition from deflation to a sustained period of inflation. This likely won’t pick up for a few more years but markets have a way of sniffing things out early so I’m keeping a close eye on gold prices.
A Few Comments on Gold
Gold is one of the most polarizing assets. People tend to either love it or hate it. For me, it’s just another available tool in the toolbox. If the job calls for it, I’m going to own it. It’s that simple. Here’s an excerpt from my letter to clients back in July 2018:
Gold actually is not an investment; it’s a permanent form of savings with no counterparty risk that holds its value over time as it is not eroded by inflation (i.e. the falling value of your currency). What I mean by this is that gold is not a productive asset that works to make you money, which is why some investors seem to hate it, but a way to preserve your savings. It’s like holding cash but is better than cash over the long-term.
An ounce of gold today is the exact same thing that an ounce of gold 100 years ago was. What changes over time is the value of the US dollar relative to one ounce of gold. This is the same for any commodity but the difference with precious metals (e.g. gold) is that they do not wrought, rust, corrode or disintegrate, which is why people have used them as a form of money for literally a few thousand years. So if someone asks “will gold go up this year?,” what they are actually asking is whether the value of the dollar will fall relative to gold. This might sound silly but it is an important distinction to understand because, being that the world needs the US dollar to depreciate, it explains why we own gold right now.
I would much rather prefer to have your savings invested in a productive asset like the equity of a high-quality company but the dynamics of the current market say that gold is currently attractive to hold while we wait for better opportunities. Relative to the monetary base, gold has only been this cheap three times in the last 100 years: the early 1930s, 1970 and 2000. All three of these were periods in time that we saw significant drops in the value the dollar relative to gold (i.e. the price of gold went up a lot).
Structural Shift to Inflationary Dynamics
We are at the end of a very long-term debt cycle which, historically, tend to occur about every 80 years. By that time, everyone that lived through the last one is dead and we humans tend to make the same mistakes all over again.
As debt loads grow, the marginal effectiveness of each additional dollar of debt contributes less to growth. So governments just continue to endlessly pile on more until the whole system eventually needs reset. Certain trends over the last 6 months tell me we are much closer to that point than most people assume and I’ll walk through what this ultimately means.
There are basically two ways that money is created, either 1) the government just prints it to increase the supply, or 2) someone or some entity takes out debt (i.e. a mortgage, business loan, government debt, etc.). Governments try to avoid #1 because history is littered with periods of uncontrollable inflation which can end disastrously with hyper-inflation. #2 is the primary way that the economy functions and is the primary way that central banks view things. Their recipe for economic growth is to encourage more credit creation (more borrowing, more debt/credit, etc.).
Debt essentially pulls spending from the future to today. By pulling forward spending, you lift the baseline this year but when this debt needs to be repaid, spending drops off in the following years. This is how debt leads to the cyclical booms and busts in the economy and why most crises are caused from too much debt in the private sector.
Instead of letting the system cleanse itself, the Fed has done everything possible to avoid a downturn by responding to each slowdown going back to the 1980’s with lower interest rates in an effort to reflate the economy and asset markets with even more debt.
But in a credit-based financial system, you eventually hit a limit where there is too much debt and servicing it becomes restrictive. This is how debt acts as a deflationary anchor on the economy. We have basically pulled forward as much demand as we can and we’re now left with massive debt loads that somehow need to be dealt with.
Households got burned during the ’08 financial crisis and don’t have much desire to increase debt loads. They have been deleveraging since 2009.
Corporations have juiced their balance sheets back up to historically high levels. This is actually one my biggest concerns right now for the economy and stocks. Once credit markets tighten, companies shift cash flow away from investment/spending toward debt payments. This means less Capex, less buybacks and dividend growth, and more layoffs. Caveat emptor when buying stocks. You better know what a company’s balance sheet is like and I can promise you, they look a lot worse than 5 years ago.
And then we have governments. For the last 40 years, people have been worried about the annual deficit and amount of debt our government is carrying. And for the last 40 years it hasn’t mattered… but I believe we are now at the point where it does matter.
Since Nixon ended the gold standard in 1971 and the US setup the petrodollar system, the basic agreement has been: the US consumer buys oil and cheap goods produced overseas and the surplus countries take that money and fund our deficits by purchasing US Treasury bonds. This has the continual effect of pumping US dollars out into the world economy for global growth.
However, starting in 2014, on a net basis the rest of the world stopped buying US Treasury bonds, which means it’s now up the US to fund our deficits internally (by households, insurance companies, pensions, etc.). This creates a “crowding out effect” though because unlike foreign central banks, which have unlimited balance sheets, the US private sector does not. So for every dollar of additional Treasury bonds we have to buy, there’s one less dollar available to spend into the economy, invest, buy stocks, etc. It pulls money from everywhere else which has a negative effect on growth.
But why did the rest of the world stop buying Treasury bonds? Because the writing is on the wall (it has been for decades). With the amount of entitlements promised to the now retiring Baby Boomers, the government will either need to spend less elsewhere (negative for the economy), tax more (negative for the economy), or our deficits will grow exponentially. The more the deficits grow, the larger the crowding out effect on the private sector (negative for the economy). Most estimates have the net present value of all entitlement spending around $100 to $120 trillion. If you think the current $22 trillion of government debt is a lot, you haven’t seen anything yet.
In my opinion, there’s a reason the Fed made a hardcore dovish spin over the last few months. In March, they announced no more interest rate increases in 2019 (the market is now pricing in 2 rate cuts) and they will end the balance sheet runoff (QT) in September. Believe me, QE is the new normal. The Fed knows they will be monetizing our deficits very soon and by a large degree. Monetizing our government deficits is a fancy way of saying that the Fed will be buying our newly issued Treasury bonds so that the private sector doesn’t have to. Since the Fed returns any interest earned to the Treasury, this has the net effect of turning our debt into 0% interest cash, hence the term “monetizing” (i.e. the government is just printing cash).
The problem with QE, to this point, is that it has been stimulus for the investment markets but not the real economy. The Fed purposely inflated asset values in the hope of creating a “wealth effect” and they succeeded all right, just not how they wanted to. Bernanke’s hope was that it would create a virtuous cycle of real economic activity. Instead, the result has been a widening wealth gap and a contribution to the rise in isolationism, populism and strong support for socialist policies.
Have you noticed the increase in politicians and the media discussing Modern Monetary Theory (MMT)? If you haven’t, you’re going to want to do some catching up because you’re going to hear A LOT about it in the upcoming presidential race. Professor Stephanie Kelton is a prime supporter. This video provides one of the best overviews. In short, there’s nothing modern about it. That’s just a fancy name to make it sound like a great new solution. The gist of it is that government deficits don’t matter and the government should run huge deficits as long as there is slack in the economy in order to maximize employment and production.
The tricky part of this debate is that MMT supporters are correct in much of their assessment of the workings of the financial system as a whole. Most people think there is a finite amount of money and in order for the government to spend money somewhere, it first needs to tax it from somewhere else. The government can do this, but this doesn’t have to be the case since the government has the ability to create money (option #1) or borrow (option #2). They can increase the money supply by spending first and then later tax it back out when they need to slow things. They would most likely have the Fed monetize any spending (i.e. print the money) and supporters of MMT admit that the only constraint is inflation if you take things too far. But I’m sure that won’t be an issue. Politicians never spend too much…
Here’s the deal: a purely credit-based financial system is essentially a ponzi scheme. Bear with me on this. Since the financial system is credit-based, you need a continual increase in debt for the economy to grow. But we all know that you can’t just continually increase debt forever. Debt loads become too high, interest rates are held at 0% to keep the system afloat, central banks implement QE to keep asset prices from falling, easy money leads to yield chasing and a deterioration in lending standards which allows zombie firms to survive resulting in too many companies selling too many products/services which is over-supply of everything which suppresses prices (deflationary…), the economy stagnates and people ultimately demand a higher share of profits for labor over capital. And this is where we stand today.
Capitalism cannot function with artificially low interest rates. It leads to perverse incentives (like companies using debt to buyback stock instead of actually growing their business), a widening wealth gap, kills your banking system and destroys retiree, pension and insurance company reserves. One half of the system desperately needs higher rates to survive (did you know that total unfunded US pensions liabilities is now over $6 trillion?) but raising rates will blow up the other over-indebted half. It’s an endless trap that leads to continual stagnation if you’re unwilling to take any sort of pain by letting the system cleanse itself, write off the bad debts and start fresh. Japan is a good 15 years ahead of us in this process. Despite the lowest interest rates in the world and endless QE for the last 20 years, their economy remains stagnant. Europe is following suit and we’re not far behind. You would think that after 20 years, central bankers would learn that their academic theories were wrong.
The Fed’s policies over the last decade of trying to force investors into riskier assets by removing the supply of high quality assets and suppressing yields has put them in quite the pickle. This is another reason why they turned so dovish after the dip in Q4 last year. Pensions, already facing a shortfall of over $6 trillion, have long-term return assumptions of 7% to 8% baked in. With yields on high quality bonds in the 2% to 4% range, pensions have been forced into illiquid investments, junk bonds and loans, higher allocations to stocks, etc. It reminds me of Minsky’s definition of Ponzi Financing. Hyman Minsky was a professor of economics that outlined the 3 stages the financial cycle typically follows. You have:
- Hedge Financing – where companies are able to service and pay their debts via the cash flows they generate (stable)
- Speculative Financing – where a company’s cash flow can pay interest but they need to issue new debt to pay for existing debt, basically rolling over their debt (less stable – this is what governments do)
- Ponzi Financing – when cash flow isn’t enough to even pay interest and an entity is reliant on an increase in the underlying asset in hopes that it will cover liabilities (very risky – this is where pensions are right now with their reliance on an ever-increasing stock market and zero defaults in junk bonds)
And then you then have Fed presidents coming out making comments like this:
Hey Robert, how do you think corporate debt levels got so high in the first place? I don’t know…maybe because the Fed held rates at 0% for 7 years to encourage it? Just a thought. So higher rates will blow up the over-indebted system but low rates leave us mired in stagnation. Tricky situation… The only way out is a big increase in inflation (they know this) and this is where we’re headed.
What I’m getting at is that there are essentially two different financial worlds. You have the credit driven economy (option #2 in how you create money) which is what paper assets are tied to (i.e. stocks, bonds, REITs, etc.) and you have real assets which tend to hold their value over time against inflation. In the short-term, real assets like commodities are affected by supply and demand dynamics but in the long-term they are driven by the monetary base (option #1 in how you create money). For the last 40 years, the Fed has continually tried to juice the economy by easing borrowing conditions through lower interest rates to spur credit creation and the paper asset markets have experienced their best 35 year run in all of history. Lower rates increase valuations in DCF models and increase asset values of anything purchased with debt (e.g. a home purchased with a mortgage. The lower the rate, the more you can afford).
Once central banks hit 0% interest rates, they had to then start directly injecting money into the system via QE to allow continued increases in debt to keep the system inflated. I’ve used the analogy in the past that the whole system is like one big balloon that needs a continual flow of more air to keep it inflated. If credit stops, or contracts, the whole thing unwinds. Once you’re tapped out, the government has 3 choices:
- You can go through a very long (30+ years) process of stagnation as you slowly bring debt levels back to manageable levels. This is kind of what Japan has been dealing with since their markets peaked in 1989…
- You can go through a very severe but much quicker depression where bad debts are written off and asset values revert back to “normal” levels. This would involve mass unemployment like the Great Depression.
- You devalue the currency (i.e. inflation)
For the past 2000+ years governments have always chosen number 3. It’s political suicide to not. And if the natural cycles of the market force either #1 or #2 on them, they short-circuit it by jumping to #3. Ever wonder why the central banks all have this arbitrary 2% inflation rate that they target? Here’s the ridiculous story of where that came from but the short answer is that 2% is the amount they can slowly steal from you each year without you really noticing it.
The pickle that most Western central banks have been in since 2008 is that they haven’t been able to sustain that 2% inflation target which means the growth in debt levels continue to far exceed the growth of the economy (debt as a percentage of GDP continues to rise). Historically, if governments haven’t been able to gradually devalue the currency, they revert to more drastic measures of outright devaluations overnight. We’re not at that point but if things get dicey in the years ahead don’t be surprised to see it happen again. It’s how they ended the Great Depression. Before that point, we’ll see 0% interest rates (again), possibly negative rates (because it’s clearly working so well for the European banking system…) and a lot more QE! If you think I’m crazy,
-Here are the minutes from the Fed’s July 31st/August 1st meeting where they start the meeting with staff members presenting an analysis of what to do during the next recession (hint: they talk about the limits of how low they can take interest rates and the effect of expanding QE). They’re going to bust out the same playbook they’ve been using since Greenspan started this mess in the 80’s.
-Yellen says Fed purchases of stocks, corporate bonds could help in a downturn
-BlackRock’s Reider says ECB should start buying stocks
It’s unfortunate because I believe the evidence is clear, all of these actions are actually deflationary and will not succeed. History shows that the most inflationary action of governments is central bank financed (i.e. monetized) fiscal spending. So yeah, there’s a very good chance we see MMT in the years ahead. MMT is essentially QE for the people instead of QE for the investment markets. They try to disguise it as a one giant shell game but it’s effectively money printing (option #1). If we get some form of central bank monetized fiscal spending in the years ahead (MMT, universal basic income, massive infrastructure programs, etc.), that’s when inflation starts and the whole process of managing an investment portfolio flips. Until that point, the old rules apply and long-term Treasury bonds act as your best portfolio hedge. But after, gold will become the new hedge and long-term bonds are one of the worse things you can own.
Many, many countries have gone through periods like this. In the US, we had similar dynamics through the 30’s and again in the 40’s and 50’s to bring down debt levels following World War II. Stocks crushed long-term bonds in real terms because inflation rates were higher (gold was still pegged then). And also again in the 70’s after Nixon ended the gold standard. Stocks beat long-term bonds in real terms but gold crushed stocks.
I have been patiently waiting for gold to start showing signs of a breakout. I’m writing all this now because my long-term trend system recently kicked on and I’ve been increasing our exposure. It has largely been consolidating for the last five years and this turn could be another fake-out (I can very easily see gold remain under pressure for another couple of years) but given my long-term outlook the reward-to-risk ratio is well worth taking.
All of my clients hold a core position in gold because it provides the best hedge against the risks we currently face in the global financial system but I also will add or subtract based on tactical signals if gold is trending higher. I believe it should be in every type of portfolio right now, regardless of risk tolerance or investment goals. If you’re a very aggressive investor looking for high growth, it’s likely going to outperform stocks by a wide margin. If you’re a conservative bond-heavy investor, it provides the best hedge against the large fiat currency devaluations coming down the pike (all a bond is is a currency that pays interest).
Gold – 10 years, weekly
I’m not advocating one type of policy or another. The truth of the matter is that we’re so deep into a system that is unsustainable in real terms that I believe it’s inevitable we get a lot of money printing to honor all of the promises made. I do not think that it’s the best way to run a system but at this point, if you’re unwilling to take your medicine and suffer through some short-term pain, it becomes inevitable. The policy maker’s response to the 2008 financial crisis made it very clear that they are unwilling to take any pain and let the system cleanse itself. So the best remaining option is to inject money into the economy (QE for the people), not into the investment markets.
All of this is connected and is leading to a rise in populism. You can only rip off the masses for so long before they revolt and start electing politicians that seem extreme. We’re at the point where the person who promises the most wins the election. It doesn’t matter if the next president is from the right or the left. There’s a change in fiscal policy coming our way that is going to flip things and start to act with an inflationary dynamic. Be ready for it, I know I am.
So why gold over other real assets? Because that’s what the rest of the world is choosing to use as a means of bypassing the US dollar-centric global financial system:
-In 2018, central banks bought the most gold since 1967
-Ken Rogoff of Harvard, recommending foreign central banks to diversify and buy more gold
-China doubles down on gold in shift away from US dollar
-China’s gold imports jump to 15 month high
-Russia becomes world’s fifth biggest gold holder after sanctions
-Russia is dumping US dollars to hoard gold
-Germany repatriates $31 billion in gold from Paris and New York
-Italy’s Populists Covet Central Bank and its Gold
Real assets in general do well though – commodities, real estate, certain types of stocks. And if you’re younger and more aggressive, I would even have some crypto currencies.
I still think we have one last deflationary pull lower from the dynamics we’re seeing of a strong US dollar where bonds rally, rates collapse, stocks and real estate could come under pressure, etc. which causes a panic response from central banks and potentially action from congress for increased fiscal spending. That would be the ideal point to start making a major transition away from bonds and into real assets. Let’s hope we get that opportunity.
One last thing – be careful about how you buy gold in your portfolio. The most common gold ETF’s, like GLD and IAU, say they own gold but their net asset value is only backed by physical gold at roughly 40% or so. They use futures contracts for exposure to make up the rest and paper gold is not real gold. Asia has been draining the physical gold from these products for years. It’s a low probability, but in the event that the paper markets break down from a run on physical claims, these ETF’s might not accurately track gold.
Thanks for following!
-Nick