One of the more misleading statements made by investment pundits is that gold is in a bubble. They argue that this must the case simply because the ‘barbarous relic’ offers no yield. Therefore, a rising price, based purely upon a rising price, can be nothing but a bubble.
This is wrong.
When thinking about gold, the frame of reference is entirely different to that used for other investment classes. Gold is not an asset you can assess in terms of yield. Its “dividend” derives from something else entirely. It is a pure currency hedge. And not against just any old peso, rial or dong. Gold is the undollar, the US dollar’s shadow, and on that basis it is not in a bubble at all.
Consider, the current gold bull market did not begin with the Global Financial Crisis (GFC). It began in 2001 after the NASDAQ tech crash. Why then? Because that was the moment the the US dollar became unstable enough for all and sundry to see it:
The period leading up to the US tech crash was marked by a booming US economy undergoing dramatic innovation and productivity gains. It was also the first time in decades that the US budget reached surplus and interest rates were held at reasonable levels. It short, the US dollar was underpinned by excellent fundamentals. It was strong. Of course, as often happens with any asset price, stronger perceptions of underlying fundamentals turned into a bubble.
Thus, after the tech crash, some of the US’s fiscal and monetary strength was revealed as temporary. Moreover, as the economy struggled out of the post-crash recession, it became clear that a new force was at work as millions of manufacturing jobs bled offshore to emerging economies. The Bush regime also engaged in ill-conceived and uber-expensive military adventurism. Monetary policy fell to unprecedented levels. Prudent fiscal policy was blown to bits.
And so, the dollar dived and gold began its bull market.
The rest, as they say, is history. The next phase of US growth was now famously the result of a housing bubble. The fallout from its inevitable demise was always going to be more fiscal and monetary profligacy. And so gold continued on its merry march, pausing only when panic struck and all and sundry raced back to the perceived safety of the US dollar.
So, if we want to understand what the fundaments for gold are today and in the future, the question we must ask is this: is there any end in sight for US fiscal and monetary profligacy? The short answer is no. But there are a few risks.
First, a shift in Washington towards genuinely addressing its fiscal problems would hurt the gold price. If the Republicans were to win office, the fiscal conservatism of the Tea Party and the leap off the fiscal cliff may cause markets to conclude the US was serious about budget repair and, most likely as well, was headed into recession. That is two reasons to buy the US dollar in a panic.
Second, if the US housing recovery and manufacturing onshoring were to gather real momentum then we might see the prospect of no more quantitative easing, and even rising interest rates. In the near term, that seems to me even less likely than a Republican win in the election.
Third, a serious outbreak of global inflation might also – counter intuitively – be a problem for gold, compounded again if it caused a rise in US interest rates. But it would likely also bring with it a blow-off in the gold price first. So, not something to really worry about.
The fourth possibly is the spontaneous outbreak of global peace. Here’s hoping.
So, accounting for the risks, the gold price retains solid fundamentals.
There may well come a time when gold enters a bubble. For instance, when folks are buying it only because it’s going up and beneath that behavioural driving force, the fundamentals of the US dollar were actually improving. But that is not now. Estimates suggest that less than 2% of investors currently hold gold.
For Australians, there is an additional attraction to the shiny metal. As the commodities boom ends, the Australian dollar is going to fall (as our own monetary and fiscal conditions fray). The price of gold in Australian dollars is already close to record highs and if it breaks through $1800 per ounce, may run handsomely:
Conversely, if the Australian dollar does not fall, it can only be because the US dollar is so weak. Therefore, gold will rise anyway and likely faster than the local dollar. It is a natural hedge for the transition ahead.
Gold is not a bubble. Not yet, anyway. It is a prudent position for any Australian investor.
David Llewellyn-Smith is the editor of Macro Investor, Australia’s independent investment newsletter covering stocks, trades, fixed interest and property. The current edition of Macro Investor includes a range of ideas for hedging with, and profiting from, gold. A free 21-day trial is available at the site. This is an op-ed run in the Fairfax press. It contains general investment advice only (under AFSL 313768).
