A few words from the real world

I have just secured the mortgage on my new home.  In the end, I opted for a loan which tracks 3-month EURIBOR but with the caveat that, for the next five years, the rate of interest cannot exceed 1%.  I tell you this little tale, as it is a reflection of my expectations.  If I were seriously concerned that the current bout of inflation could bring back the interest regime of the late 1970s, where I paid 19% on my first mortgage, I would have aimed for a 30-year fixed rate mortgage.  That was indeed one of the options I had – at the annual cost of about 4% in interest – but I chose the other option, as I don’t think the 3-month EURIBOR rate will be meaningfully higher than 1% five years from now.

I may obviously come to regret this for the rest of my life, but I am quite convinced that the inflation bout anno 2022 is quite different from the one we experienced some 40 years ago.  The risk is that my analysis is proven wrong, and that we go from bad to worse as far as inflation is concerned.  Therefore, in last month’s Absolute Return Letter, I asked the rhetorical question: are public deficits out of control?  I even went one step further and asked: is gold the answer?  However, I never provided a proper answer, as I ran out of space, so here we go again.

It is a fact that millions of investors all over the world have a significant share of their wealth, either directly or through their pension savings, tied up in government bonds.  Many pension funds are forced by the regulator to invest in high grade bonds, even if the outlook is somewhat suspect, as it is at present.

Investing in high grade bonds normally serves two purposes – they provide some income (well, they used to), and they bring stability to the portfolio in stormy weather.  The latter part – stability – can also be provided by for example gold.  I therefore ask the question again: could gold possibly provide a good alternative to government bonds for all those investors looking for a hedge against challenging times in equities?

Recent performance of gold

So far, 2022 has been a year of high drama.  More often than not, the sorts of conditions we have experienced this year bodes well for the gold price.  The year-to-date performance of gold hasn’t been too shabby, but neither has it been stellar (Exhibit 1).  It is therefore only fair to ask why gold’s reaction to war and sharply rising inflation has been so muted?  My first inclination was to blame it on anticipated versus unanticipated inflation.  As I have pointed out many times in the past, historically, gold has proven a much better hedge against unanticipated inflation, and the current bout of inflation wasn’t a major surprise, even if the war in Ukraine made what was already bad a bit worse.

Then, one my colleagues pointed to the fact that some of the biggest drawdowns in gold in early 2022 have coincided with big down-days on Wall Street. i.e. he suspects that gold has been used to raise capital to meet margin calls in leveraged accounts (of which there are many).

I then stumbled over an argument presented by Goldman Sachs, which I will share with you in a moment.  However, before I do so, let me share another data point provided by World Gold Council (WGC), which makes it all a bit puzzling.  According to WGC, inflows into gold ETFs totalled about $2.5Bn in the month of April, equivalent to about 39 tonnes of physical gold, which is only 2% away from the all-time high.  In other words, it is not exactly investor demand that is weak, so what is going on?

Before I try to answer that question, let me share with you how gold has performed this year so far (Exhibit 2).  As you can see, the price peaked a week into March, following which it has fallen most days.  It is now down almost exactly 10% from this year’s high despite the war in Ukraine and despite inflation surprising on the upside.

Goldman Sachs' argument

According to Goldman Sachs (GS), there are three key drivers of gold demand – central bank demand, investor demand and consumer demand.  Industrial demand is negligible.  All three show signs of strength at present, which should drive the gold price higher, as we move further into 2022.  The last time all three key drivers kicked in at the same time was in 2010-11, when gold appreciated no less than 70%.

The research team at GS argue that the reason gold has only delivered modest returns so far this year is because of poor liquidity in the gold futures market, which has overwhelmed strong physical demand – at least so far.  They further argue that, provided physical demand remains robust, the gold price has to rise eventually.  This is an important point.  Allow me to quote GS:

When gold investment demand is strong [as it is], the price has to rise to make consumers postpone their purchases and make room for investors.  The longer such a positive investment demand momentum continues, the higher prices have to go to keep consumer demand depressed.  Therefore, over the medium term, gold tends to be highly correlated to the overall cumulative level of ETF holdings.

The Russian twist

The arguments so far have had little to do with Russia but, once you include that element, the storyline gets even more convincing.  Gold production in Russia has been rising steadily since the Global Financial Crisis and is now hovering around 350 tonnes a year.  More importantly, as you can see in Exhibit 3 below, most of the output from Russia has been exported the last couple of years, but the outlook for 2022 is dramatically different.  It is now widely expected that the Russian central bank will buy up most gold mined in Russia this year.  The same is happening in Kazakhstan, and it is all about the sanction programme to do with the war in Ukraine.  The implication is that a significant supplier of gold in the international marketplace will soon disappear – at least for as long as the sanction programme runs.

Is silver an alternative?

Silver is also a precious metal, although it cannot be directly compared to gold.  It offers less of an inflation hedge and is used far more frequently in industry.  In fact, it is a very important metal in the green transition – something that gold doesn’t benefit from.  Silver is down significantly from its recent highs – off about 25% since early August 2020 when the price peaked.  I am intrigued by silver, not because it will protect you against inflation (it probably won’t), but because it is part of the green transition, and because it is only modestly correlated to the S&P 500 – about 0.30.

With the ongoing sanction programme in mind, Europe must make itself independent of Russian gas as quickly as possible, which means even more investments going into the green transition.  That can only be good for the silver price.  If you, on top of that, add the lowly correlated nature of silver, and you think global equities could fall further, then silver is not a bad choice at all.

Final few words

From an inflation hedge point-of-view, gold has to rank higher than silver but, otherwise, silver looks very attractive at current prices.  To me, it is therefore not a question of either or, but whether I could find room for them both in my portfolio.

Timing-wise, I would establish a meaningful position in gold as soon as possible.  Although I don’t expect a repeat of the late 1970s, I think the next couple of years will offer more bad than good news on inflation.  Consequently, interest rates are destined to rise further, before they begin to fall again.  And, should that scenario unfold as expected, gold will most likely prove a safe haven.

Establishing a position in silver is less urgent, and that is particularly the case, should the global economy run into recessionary conditions.  Recently, I raised the probability of a forthcoming recession in both Europe and the US to levels well above 50%, i.e. that is now my core outlook.  I would therefore tiptoe my way into silver by taking advantage of significant weakness to build such a position.

Niels C. Jensen

7 June 2022