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“He
who has the gold makes the rules.”
Imagine
the surprise of the world’s first circumnavigator, Ferdinand Magellan,
when upon arriving on the sandy shores of the present-day Philippines in
March 1521 after the first- ever Pacific crossing, he was offered a gold bar
and some spices by the native king. Gold – it was a store and show of
wealth, even there, even then – in uncharted, uncivilized territory,
halfway around the world, half a millennium ago.
Perhaps
Magellan shouldn’t have been so surprised. Gold had been
“money” for more than 2000 years prior to his time. The first
gold coins were struck in about 700 B.C. in modern day Greece. Throughout
recorded history, other assets like weapons, spices, art, metals and even
food have had their day as leading stores of wealth, but gold has endured as
the supreme evidence of wealth across all cultures and time.
Little has
changed today. Gold competes with other assets stocks, bonds, real estate,
and paper currency among others as stores of wealth. But in to- day’s
changing and ever more volatile world, the value of these other assets may
fluctuate more than ever. What’s more – paradoxically – in
response to volatility, the policies of governments and central banks, in an
effort to dampen economic downturns and prop up asset prices, may in fact
make gold more valuable relative to these other assets. In our opinion, the
real purchasing power of gold, over the long term, may rise.
Like most
assets, price is deter- mined by demand and supply.
Going forward demand for gold may continue to rise, while supply will remain
con- strained as it has since the beginning of time. With this backdrop,
let’s explore some specific reasons investors may consider buying gold
at today’s prices.
Reason 1: Hedge Against Inflation
There was
a time, until World War I, when gold was money and money was gold, or at
least backed by real, physical gold. Then the need to repay war debts induced
the involved countries to “print” money. Countries became
partially disengaged from the gold standard then, and more disengaged with
the onset of the Great Depression and World War II. But printing money on a
massive scale happened only during these crises.
Today, it
seems that the “crisis” is nearly perpetual, and the virtual
printing presses run all the time. Virtual? Yes, you don’t even have to
print the money any more; it can simply be created
with the stroke of a key- board. And it’s become so easy that trillions
in new paper “fiat” currency will be created – all to chase
the same amount of goods and services. It may be worth keeping in mind that
there is no upper limit to the amount of dollars that can be created, and to
the extent that gold (or anything else for that matter) is priced in dollars,
there is no upper limit to what the price of gold can be. One estimate calls
for $15 trillion to be printed in the next three years worldwide. We are getting
ever further away from the gold standard.
Of course,
that brings the potential for uncontrollable inflation. That is, unless these
central banks can “mop up” the liquidity, withdrawing the cash
from the economy. But in doing so, central banks will slow their economies
– a politically unpalatable scenario. Add to that the crushing public
debt loads, which induce countries to inflate their way out of debt, that is,
to allow their currencies to depreciate and pay with cheaper money later, and
we have a powerful mixture for future inflation. And what happens when there
is inflation – or when people anticipate inflation? The price of gold
may go up.
Comparatively,
the next five reasons are relatively simple:
Reason 2: Store of Wealth
Aside from
governments and central banks, ordinary citizens of developing nations see
gold as the present and future storehouse of wealth. Moreover, they are
buying it in increasing quantities as questions loom about their own
currencies, and now the currencies of others like the Euro and U.S. dollar.
About 50
percent of world gold consumption is for jewelry, while 40 percent is for
investments and 10 percent is for industry. India alone buys some 25 percent
of all gold produced each year. That figure is increasing: in 2010 alone the
amount of gold bought by Indian citizens increased 69 percent from 2009, and
Indian households today control some 11 percent of the total global gold
stock. Although demand in India dropped off somewhat in 2011 due to new import
taxes, demand is growing in China, Russia and other countries for many of the
same reasons.
Reason 3: Central Banks Fill Their Vaults
In part as
an attempt to diversify their holdings and hedge against the inflationary
effects of global money printing, central banks, for the first time since the
mid 1960s, have become net buyers of gold. From
1965 through 2007, they were net sellers of gold. These banks, particularly
in developing countries, want to fill their vaults with something other than
paper currency and the ever- riskier bonds of sovereign nations.
Estimates
call for central banks to buy some 10 percent of the new supply of gold each
year. Countries like Russia and Mexico will actively buy bullion in the world
market as well as directly from their domestic producers, keeping that new
supply off of the world market.
Reason 4: Protecting Your Purchasing Power
If you
look at a long-term chart of the price of gold versus the price of oil,
you’ll notice that over time, and given some up and down volatility,
gold and oil move pretty much in tandem. Put another way, an ounce of gold
buys about 14 barrels of oil, plus or minus – would do so today, and
has done so for over 50 years. In the early 1960s, gold was $35 an ounce, and Saudi oil could be had for less than $3 a
barrel.
If you,
like most of us, need to purchase energy, college education, or health care
over time – items that can’t be artificially deflated in price
by, say, offshoring to China, investing in gold may allow your purchasing
power to keep up with the price of these key goods and services. More people
are figuring that out – which only adds to the demand for gold.
Reason 5: They Ain't
Making More of It
Gold is a
commodity. The biggest bugaboo in commodity investing is that demand
eventually begets supply. That is, when the price of corn or soy- beans or
copper rises, what happens? Farmers plant more corn and soybeans, and miners
mine more copper, and more copper is recycled – you get the idea. The
supply adjustment may take a year or two to unfold, but for most commodities,
more supply is around the corner when demand increases. As the saying goes:
‘the cure for high prices is high prices’, in part because those
higher prices attract greater supply from the market.
For gold,
not so much. Even with the increased worldwide demand for gold as a store of
value and an inflation hedge, production has remained relatively flat.
Production did double from the 1970s to about 2000 to ex- ceed
80 million ounces per year, but then fell back well below the 80 mil- lion
mark in the mid 2000s. Only recently in 2011, did
production slightly exceed the 2001 peak. Supply growth continues at a 5
percent rate in our assessment – modest in light of some of the demand
figures already discussed.
Reason 6: It Pays to Cover the Field
An
allocation to gold provides potential portfolio diversification benefits. The
more asset classes you invest in, the less chance all of your holdings will
fluctuate in tandem.
When
considering any investment, you should not only consider the potential
positive and negative scenarios for that investment over time, but also the
impact on your overall portfolio performance. It is about not putting all of
your eggs in one basket, as well as picking the right baskets.
It goes
without saying that an investment with a positive expected return is
preferred over one with a negative return. With gold, the outlook appears
favorable for a number of reasons as outlined above. Equally important should
be how the investment works with the rest of your portfolio; the way the
expected return of this asset moves relative to your existing portfolio. This
relationship is called correlation. Adding assets whose price movements have
a low correlation, or a negative correlation, to your existing assets may
help improve your overall portfolio’s performance.
Think back
to before the recent financial crisis had taken hold: it was great if you
held assets that moved lockstep with one another on the way up. But, when the
market capitulated in 2008, all those assets likely fell together as well,
causing some investors to lose a great deal of value in their portfolios. The
gold price has historically exhibited a low correlation with other asset
classes. This fact makes gold a good source of diversification for a
portfolio, and gold may help you protect yourself against downside risks. In
2008, when the S&P 500 lost 37% of its value, gold was up nearly 6%.
Holding a
variety of assets, including gold, the price movements of which are
uncorrelated with one another, may smooth out your portfolio returns over
time and help protect against catastrophic losses.
The final
word: even though the price of gold, in the past ten years, has “woken
up” to these trends, and has quadrupled since the late 1990s, factors
suggesting a strong future are there. No asset should comprise the majority
of your portfolio, but it may be hard to argue against owning at least some
of the precious metal going forward.
Turns out,
Magellan’s Pacific Island friends knew what they were doing.
Axel Merk
Call Out Box: Be alerted as we explore the world of
gold! Sign up for Merk Insights at : www.merkinvestments.com/newsletter
About the Author:
Axel Merk is the President
and CIO of Merk Investments, manager of the Merk Funds. Axel Merk is a
sought after speaker and author on topics ranging from the economy, gold and
currencies to sustainable wealth and personal finance, as well as a regular
guest and contributor to the business media around the world.
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