Market Musings 031222 Part 2:
Gold

Gold is glittering again.

Commodities - a long-shunned asset class

Commodities have been neglected by investors for over a decade now, and for the large part for good reason. As an asset class, commodities have been very poor performers since 2009, falling 75% from peak in that year to a pandemic low in 2020.

CRB Commodities index very poor since 2009 peak

Source: tradingview.com

In fact, the best thing an investor in a diversified portfolio with a diversified portfolio could have done as regards commodities was to ignore them from 2009 at least until 2020.

But remember the economic context. We had pretty much zero (or even negative) interest rates on the back of ultra-low inflation. In fact, I remember a number of commentators published articles and even books declaring that inflation was dead. How wrong could they have been?

On top of that, you had moderate economic growth. So this sort of a “goldilocks” economy (i.e. not too hot, not too cold) of moderate economic growth with no obvious signs of inflation, made the life of central bankers and the job of central bankers very easy indeed.

At the same time you had an abundance of liquidity and abundance of production of a variety of commodities, notably energy, metals and other. But today that has changed.

We have become very acutely aware following the Ukrainian war, of shortages in energy, oil, natural gas, and therefore electricity. On top of that, we have tight supply in a number of base metals. Particularly with the energy transition in view, we are going to run up against shortages of copper, nickel, tin and other base metals which are related to battery construction.

Consider Precious Metals too

There is a third category that's probably the most interesting to me right now and still neglected, which is that of precious metals, principally gold.

Did you know that since the beginning of 2000 that gold as an asset class, despite its lack of income yield, has outperformed other major asset losses by quite a distance, whether that be global stocks, global bonds, global corporate credit, or even real estate.

Since 2000, Gold has far outstripped US Equities and Bonds

Source: tradingview.com

Admittedly, this performance tends to come in short bursts of strong, very strong performance (e.g. late 2008 - mid 2011; and late 2018 - mid 2020), followed by longer periods where not very much happens.

So the moral of this story is, when investing in commodities, and in particular in precious metals, you need to be in at the right time. As it's difficult to tell what the right time is, it means you need to be a long term, patient investor, because there will be periods when you're invested in precious metals where nothing happens and the price drifts sideways or even drifts down. That's been the case recently for over 2 years now.

But then you can see periods of sharp, explosive performance where you really make your money over the long term. And if you're not in at the beginning of these periods, you will tend to miss most of that sharp, explosive performance.

I believe we may be at the beginning of one of these periods of strong performance right now. Why do I think that? Well, let's take the example of gold.

Gold as a non-paper currency and store of value

Gold is primarily what we call a financial commodity. While of course it is used for jewellery these days, its principal uses are as an alternative currency and a long-term store of value. It is the financial value of gold that is important here, and people hold gold bars, gold coins or funds which own physical gold such as exchange-traded funds (ETFs).

The key drivers of the gold price are threefold:

1. Geopolitical instability. Well guess what, uncertainty in the world is good for safe haven assets. Gold is a safe haven store of value, so that's typically a good thing. We have plenty of instability geopolitically today, what with the war in Ukraine and also with the tensions between the US and China.
2. Long-term interest rates, what we call bond yields, particularly the real yield. This is the long-term bond yield, then subtracting long-term expected inflation. What is left is what we call the real underlying yield. When that rises, as it has done over the last twelve months, this is bad for gold because it provides a safe haven alternative which has a higher yield, whereas as we said, gold has no yield, no income.
   
   So what's going to happen to the real yield? It's been going up. My feeling is going to continue to drift lower now after a surge upwards, I don't think it'll get back to where it was before which was in negative territory. We had negative reels for quite a period of time following 2009. That being said, the real yields, the long term real deals can decline, I think meaningfully from here.
3. US dollar. If you look at the performance of gold over this year to the end of November, gold has actually been a respectable performer. In a year when stocks have delivered on average a double digit negative return to the end of November, as have bonds, both government bonds and corporate bonds, and when real estate clearly is coming under pressure from the weakness in the economy and the sharp rise in financing rates.
   
   Gold has held up well in currencies other than the dollar. If you look in euro terms over the year to date you would have gained 6%, which is a lot better than negative performance than these other asset classes, in sterling 8%.
   
   But for investors in dollars, gold can be thought of as an alternative currency. So when the dollar is strong, gold tends to be weaker, at least when expressed in dollar terms. The good news is that I expect the US dollar to weaken further. It has already started to weaken because US inflation is coming down. The US Federal Reserve, the central bank can therefore calm down the speed at which it raises interest rates and I think the Fed will even stop raising its Fed Funds benchmark interest rate as of January, which removes a key support for the dollar

Central banks have been buying gold

Another point that I have neglected to mention, which is very important, is the underlying demand for gold has been strong on the investment side from a new source, which is central banks themselves. Central banks around the world, led by China, Russia and India, have been buying up gold in greater quantities than ever before. And this is a very important argument for gold going forward, that as a result of the geopolitical tensions between the US and the rest of the world.

Source: World Gold Council

These nations want to diversify their central bank reserves out of dollars. Remember, central banks have to hold money in other currencies. And the key reserve currency for most central banks is of course, the US dollar because it's the most transacted in the world by far. It is the currency that underpi's most international transactions, notably commodity transactions. That's why oil, as an example, is typically priced in dollars, not any other currency.

But as a result of the sanctions particularly levered by the US against Russia, central banks around the world are reacting to this so-called weaponization of the US dollar as a political weapon by the US government. They are reacting to that by diversifying their central bank reserves out of the dollar into other alternatives.

Now, in terms of currencies, that I guess means yen sterling or the euro. However, what it means more than anything else is greater demand for gold, because central banks, we define gold as an alternative currency in greater and greater numbers.

Think too about Silver, Platinum

I think. In addition, we can think not just about gold, but also by extension about other precious metals which will also do well, led by gold. Gold is clearly the most important and most liquid of the precious metals, but we should also consider exposure to silver and platinum. Other precious metals which, remember, are not just financial commodities, but also have key industrial uses, for instance in electronics, solar panels, and even in hydrogen power to give some examples.

Investment Conclusion

So I think now actually is a very good time to be looking at investments in gold and other precious metals for the long term.

I do think it's a true diversifying asset, which can be questioned in the case of bonds, because as I said, in 2022 bonds and stocks went down equally together. There was no diversification. You suffered whether you were in stocks or in bonds.

However, if you had been in gold, for investors based in currencies other than the dollar, you would have been far better diversified then. I think this diversifying quality is underestimated by investors at present in their portfolios. So for those of you who are very heavily invested in stocks and bonds, consider an exposure to gold and other precious metals as well for diversification.

Remember that the performance over the very long term, over the last 22 years has been strong, stronger than for these other asset classes in fact. And there's a good opportunity, I think here to see that repeated over the next few years.

How to invest in precious metals? Well, you can invest in funds and ETFs that invest in the physical metals that literally buy and store gold, silver and platinum. Those exist. They're readily available in UCITS fund and ETF format, such as the PHPP Wisdomtree Physical Precious Metals ETC

What I find more attractive from a financial viewpoint is to buy exposure to the producers of these precious metals. i.e. the gold, silver and platinum miners, which you can buy in diversified funds and investment trusts and ETFs of global miners such as the GIGB Van Eck Global Mining UCITS ETF, or of gold miners specifically e..g the AUCP L&G Gold Mining UCITS ETF.

In the investment trust universe you have funds such as the BRWM BlackRock World Mining Fund or the CYN CQS Natural Resources Fund. These funds have a high exposure to producers of these precious metals, companies typically listed in the US, Canada, South Africa or the UK.