A New Vocabulary

Before we get into the investment portion of today’s update, let’s familiarize ourselves with some new terms:

The bottom line: the world is changing in ways we could not have imagined a few years ago. Moreover, as the consequences of half a century of unsustainable policies make themselves felt, we will likely see a lot more of the same. Politicians will continue to place all blame on the pandemic, the Ukraine War and climate change, but these are all catalysts, not the systemic root causes.

As I’ve commented in recent months, my updates used to focus primarily on investment policy— something that is becoming increasingly difficult to do as social chaos and geopolitical events affect financial asset markets to a growing degree.

For the moment, the talk is all about high inflation, deeply negative real interest rates and the central banks’ tough talk (coupled with far less severe action). What we don’t know is how the inflation/interest rate dynamic will evolve. What we do know is that lots of things can derail any central bank or political agenda at any moment.

Gold Revisited

My investment advice against this backdrop: stay defensive when it comes to stocks and bonds. We’ve recently added to our positions in insured term deposits such as Canadian Guaranteed Investment Certificates (one-year maturity now yielding 4.25%) and U.S. Certificates of Deposit (one-year rates at 3%), further reducing an already conservative equity allocation. We are also maintaining our solid gold exposure, which is what I’d like to focus on today.

Why gold? Since I wrote my first book on the subject in the late 1970s, I’ve always placed the yellow metal in four different contexts:

• Gold, the asset of last resort
• Gold, the currency
• Gold the commodity
• Gold the portfolio stabilizer

Asset Of Last Resort

Let me start by looking at gold as an asset that is universally recognized, has instant liquidity and is not someone else’s liability, at least when held in physical form. Curiously, the last time I saw these virtues recited as frequently as now was in the 1970s. Not only are there numerous investment articles making reference to the need for an asset which can be privately held and is negotiable outside of centralized systems, I can also tell from client inquiries that such concerns are once again widely shared.

“What can I do to safeguard myself against a systemic collapse?” is the question I hear a lot. Given the recent examples of government overreach on countless fronts, the explosion of money printing and government spending, and the consequent rise in price inflation, that is no surprise. In the 1970s, gold did best once similar dynamics manifested themselves. After an initial climb from $35 to $200, the metal slumped back for a while before taking a second run in 1978. By January 1980, it peaked at just over $850. I think the odds that the decade of the 2020s will see a repeat of that are good.

In short, while the probability of a complete systemic collapse may be small, it makes sense to hold a small amount of your overall portfolio in physical gold in your possession. I am emphasizing the word physical. Many issuers of gold certificates or Exchange Traded Funds claim that their security is backed by gold, yet in numerous cases that means nothing more than that they’ve covered their liability by obtaining a promise of delivery from a third party institution. That, to my mind, constitutes counter- party risk and is far different from a physical holding. A few issuers of certificates or ETFs do back up their liability with a guarantee that the gold held on your behalf is held at a specified location, such as the Royal Canadian Mint. That is reassuring and fulfills the requirement of physicality, but it still complicates matters in that taking delivery of your gold can be cumbersome and expensive. Another drawback of holding “last resort” gold in certificate or ETF form is the risk of government intervention.

Gold As Currency

If you compare gold to other currencies, you’ll immediately want to own it. Consider only these three points and the yellow metal becomes an irresistible place to store liquidity. First, unlike any currency, gold has withstood the test of time: its recognition as a globally recognized, tradable asset spans millennia. Second, unlike its competitors in the realm of fiat currencies, it cannot be created out of thin air. Yes, newly mined gold currently adds approximately 1.8% a year to the total above-ground stock of the metal, yet the float of fiat currencies issued by central banks in the developed world is growing by 12.8% per annum. Third, despite its ups and downs over the past decades and centuries, gold’s climb against any major currency has been relentless. Take a look at the charts on the left, tracing the metal’s progress over the past 50 years against the heavily debased U.S. dollar and the more prudently managed Swiss franc.

There are additional reasons to like gold when looking at it through the currency lens. While the dollar’s dethronement as the world’s reserve currency will progress over a period of years, recent sanctions policies implemented by the U.S. and hastily adopted by the European Union have effectively served notice upon nations around the world that a reliance on dollar and Euro-based mechanisms (from central bank reserves to trade settlements to participation in international payments systems) can be a dangerous thing. Even a gradual unloading of the world’s two key currencies, which both happen to be dangerously debased, should provide additional tailwind for gold.

One final comment. During the past three years gold has arguably suffered from competition by crypto- currencies. That dynamic may be in the process of reversing itself. The recent industry-wide crypto selloff has not only decimated the playing field, but also resulted in the loss of tens of billions of dollars, mostly among small investors who won’t be able to redeploy the sums they previously invested. There is also mounting evidence that governments are clamping down on the crypto space, not just targeting undeclared transactions but, more importantly, blockchain validators. In addition, central bankers are on record as opponents of cryptos, as well, fully intent on introducing their own version of digital currencies. This is not to say that some of the truly decentralized platforms that have embedded limits to issuance (like Bitcoin) can’t stage a significant price recovery, but my guess would be that the path forward for the crypto-space as a whole will be more difficult, which should help bring investors back to gold.

Gold As A Commodity

A third way of looking at gold is to consider its virtues as a commodity. When it comes to the metal’s supply-demand profile, things look more promising than gold’s seemingly uninspiring performance in recent weeks. Of course, the disappointment many investors voice has to be seen in the context of the Fed’s interest rate hikes of 0.25% in March, 0.50% in May, and its two adjustments of 0.75% in June and July. The anticipation of such action and its actual implementation resulted in a spectacular rise in the U.S. currency. That, in turn, took its toll on the dollar-price of gold.

The question now is whether the Fed and other central banks will continue their fight against inflation, despite growing evidence of broad economic weakness—or whether, conversely, they will step back and risk a prolonged period of severe inflation. In our opinion, gold’s movements during the coming weeks will reflect how the debate over these two outcomes will evolve. While the components of gold supply and demand are as important as ever, such ‘details’ will likely be overlooked in this narrative-driven environment.

Still, here are some of the basics. In a nutshell, global gold production will grow this year, but is expected to decline starting in 2023. On the demand side, jewelry sales staged a solid recovery last year, after a sharp pandemic- induced decline in 2020, and remain stable so far in 2022. Industrial demand is also improving. In line with weakening bullion prices, investment offtake has softened in recent weeks, but is still ahead by 6% for the year to date. One area in which I continue to see sustained improvement is that of government gold reserves. As I’ve already mentioned, for many less developed economies the incentives to reduce dollar holdings are strong.

Gold As A Portfolio Stabilizer

During my fifty-plus years in the investment business, I’ve had many opportunities to experiment with gold as a permanent portfolio component. Just as a cash reserve can help reduce overall volatility, gold can achieve the same, but with the potential of meaningful appreciation. Let’s look at market performance so far in 2022. Gold has fallen, just as bonds and stocks have, but to a lesser extent (at the time of writing S&P500 -13.7%, Bonds -13%, Gold -1%). Admittedly, my example uses a specific timespan. Things look a bit different if we measure the decline in each asset class from last year’s high to the most recent low (S&P500 -23.3%, Bonds -16.7%, Gold -6.3%). We could also look at specific years or time frames when gold outperformed stocks or bonds, or other periods when it did the opposite. But the bottom-line is constant: gold helps stabilize a portfolio, especially in periods of great volatility.

During my years as a speaker and panelist at investment conferences I was often asked what the right portfolio allocation to gold should be. The conclusion: looking at different contexts and time periods, an allotment of 10% and 15% works best. An added positive effect can be achieved by adding or reducing holdings, when allocation parameters are violated. For example, if a10% gold holding appreciates to the point where it equates 12% of the overall portfolio, cutting it back down to its original 10% weight can further boost results. Conversely, if the metal underperforms and the holding drops to 8%, buying to bring it back to target makes sense.

Technical Parameters

What about gold’s technical position? While I strongly believe in a permanent holding, there are times when additional exposure to the metal itself or gold mining shares, which can offer considerable leverage, can make a lot of sense. Is now such a time?

Consistent with my belief that rapidly changing central bank narratives are likely to dominate for much of the rest of this year, and considering gold’s chart position, I would wait with adding to core positions. A re-test of July’s $1,700 bottom is highly possible. If that level were broken, further weakness could ensue. On the other hand, a move above $1,825 could easily lead to a run at the $2,030 level, which was reached in summer of 2020 and again earlier this year.

Believing that global inflation, a highly explosive geopolitical environment, and a rapidly deteriorating social fabric will all contribute to continued improvement in gold demand, I expect a move to new highs, most likely in 2023.

Best wishes,

Peter Cavelti