|
As the price of gold has gone up fivefold
over the past 10 years, why would one buy it at today’s prices? For the
same reason an investor would buy any other asset:
if one believed it would be a good investment now, that is if one believed it
may appreciate in value and add portfolio diversification benefits. A key
reason to hold gold today might be to prepare for the crisis tomorrow.
I am no gold bug. But I hold
a substantial portion of my personal assets in the yellow metal. To
understand why, let me give a little bit of background. When I wrote the book
‘Sustainable Wealth: Achieve Financial Security in a
Volatile World of Debt and Consumption’ in early 2009, my
editors wanted me to talk about the financial crisis in the past tense. I
balked, arguing that the crisis will be far from over by the time the book
would be published later that year. The crisis has long been in the making
and may be far from over. Indeed, I started investing in gold back in 2002
and made it part of my family’s “golden college savings
plan” (discussed in the book) in 2003:
“Back in 2003, we
contemplated the hypothetical question: If you had to choose one asset class
over the next 10 or 20 years, which one do you think would perform better
than many others? We picked gold. The trends that we see unfolding these days
were already in the making years ago. It was our view that in the absence of
some miraculous reform of entitlement programs such as Social Security, odds
would be high that policymakers would nominally keep their promises, but
erode the purchasing power of the dollar.” (SustainableWealth
page 217ff)
While anyone can argue that deploying gold
to save for college isn’t particularly diversified – and my plan
should not be considered investment advice for others – it’s the
discipline in pursuing a plan, any plan, that is key
to success. It helps that the price of tuition has been going down every year
since we started the plan – that is, when college tuition is priced in
gold.
Here we are almost 10 years into the plan.
In 2008, we remained focused on our priorities by fully funding the savings
plan. However, the motivation for the plan was not the euro-zone crisis (by
the way, has anyone noticed that, of the major currencies, the euro has had
the highest correlation to the price of gold, not the so-called commodity
currencies?). The motivation was that, and it is worth repeating: in the
absence of some miraculous reform of entitlement programs such as Social
Security, odds would be high that policymakers would nominally keep their
promises, but erode the purchasing power of the dollar.
If there is one good thing to be said
about our policy makers, it is that they are rather predictable. And while we
hope for change whenever we elect a new politician, odds are that business as
usual continues. This isn’t merely an American phenomenon. Just about
anywhere in the world, politicians running for office promise to cut wasteful
spending. The definition of wasteful spending tends to be what “the
other party” spends money on; in turn, when elected, the politician
will redirect resources to more productive projects. Of course, those other
projects are similarly considered wasteful spending by their political
opponents. And as we have seen in the US, those budgets tend to balance only
under rosy scenarios, with spending cuts only projected to take place once
the politicians that imposed the cuts will have retired. In practice, the
cuts rarely ever take place.
The last time the debt ceiling rhetoric
raged in Congress, the one area both Republicans and Democrats agreed on was
to consider changing the definition of the Consumer Price Index (CPI) so
that, nominally, contractual obligations are kept, yet the purchasing power
of such promises is eroded. That change, if implemented, is reported to
reduce the deficit by $220 billion over 10 years.
While the Obama administration has a clear
track record of running record deficits, don’t get your hopes up too
high that the deficit trend will reverse should we get a Romney
administration. The presidential hopeful has already committed to continue
subsidizing student loans and to keep up defense spending. He might have some
miracles up his sleeves, but short of that, we don’t get a warm and
fuzzy feeling about his ability to implement major entitlement reform –
key to making US budgets sustainable. By the way, when politicians refer to
“reducing the deficit”, they typically mean reducing such deficit
as a percentage of Gross Domestic Product (GDP), rather than in absolute
terms.
By now it is no secret anymore that the finances of the US government are
heading towards a fiscal train wreck – a positive step, as at least the
discussion on how to tackle the deficit has started to broaden. Each year,
the Congressional Budget Office (CBO) is warning in ever-clearer terms that
the current path is unsustainable. In its 2012 long-term budget outlook, the CBO is warning
of a 199% debt-to-GDP ratio by 2037 under its “extended alternative
fiscal scenario” that considers “what might be deemed current
policies, as opposed to current laws, implying that lawmakers will extend most
tax cuts and other forms of tax relief currently in place, but set to expire
and that they will prevent automatic spending reductions and certain spending
restraints from occurring.” With regard to the forecast, the CBO
cautions “the projections… understate the severity of the
long-term budget problem… because they do not incorporate the negative
effects that additional federal debt would have on the economy.”
The Bowles-Simpson budget plan released in late 2010
suggested a way to bring the long-term deficit under control, but the
committee was unable to move the blueprint forward. It is certainly possible
to bring the long-term deficit under control, but as we have seen in Europe,
austerity is not a popular policy. Indeed, I am even optimistic that we will
eventually find a way to manage our deficits. However, the time may only come
once the bond market forces policy makers to do so. From the European
experience, it should be clear that the bond market is the only language
policy makers listen to. Different from the euro zone, however, the US has a
substantial current account deficit. In our analysis,
currencies of countries with a current account deficit are more vulnerable,
because such countries are dependent on inflows from foreigners to finance
the current account. While the debt crisis weighs heavily on the borrowing
costs in the euro zone, the euro itself has held on remarkably well; we have
our doubts that the US dollar would has benign a ride should investors shun
US bonds.
Yet looking at the bond market, all is quiet on the Western front (for
those not familiar with the pun, it relates to a 1929 novel covering the last days of WWI. The main
character is killed in October 1918, on an extraordinarily quiet day).
Remember the tech stocks that would always rise in the 1990s? Remember the
housing market that could not possibly crash? Remember bonds that appear to
be going nowhere but up? Former Federal Reserve (Fed) Chairman Alan Greenspan
warned of irrational exuberance in 1996; yet the Nasdaq
Composite index didn’t peak until March 2000. As the saying goes,
markets can stay irrational longer than you can stay solvent.
As such, we don’t predict the bond market will crash tomorrow; nor
do we even think the pending “fiscal cliff” will be
insurmountable. But we simply cannot ignore the risks that come with keeping
money in US dollars. The question is not whether negative fallout on the US
dollar due to US fiscal and monetary policy will happen, but whether there is
a risk that it will happen. And if one acknowledges that risk, how does one
prepare for that risk? For asset managers with fiduciary duties, how do you
take the scenarios outlined above into account? Throughout my investment
career, I have assigned probabilities to different scenarios; when I see a
non-negligible risk for a scenario, I try to take it into account. Granted,
this is no easy task in a world where there may not be such a thing as a risk
free asset anymore. However, there is no reason not to engage in even classic
portfolio optimization while throwing out the so-called risk-free asset, but
adding in alternatives including gold and currencies.
And we have not even touched much on monetary policy. The Fed has helped
finance deficits. Not just now, where Fed Chair Bernanke claims the Fed
policies are not aimed at helping finance deficits, although they have done
so in practice, but also in the late 1940s and early 1950s, where it was a
stated policy to help the government to lower its borrowing costs. Compared
to other major central banks, the Fed has one of the better printing presses
and has been willing to deploy it. I don’t even question the intent of
policy makers – conspiracy theories suggest that kicking out “the
bad guy” will fix the problem. But how can the Fed conduct sound
monetary policy when it has taken away its own gauges? Specifically, the Fed
would typically look at the yield curve (the relationship between short-term
and long-term interest rates) to gauge the health of the economy; but by
micro-managing the entire yield curve, the Fed looks itself in the mirror
when assessing the impact of its policies. Similarly, by artificially
depressing long-term yields, potential warning signs are taken away from
Congress, allowing them to continue their fiscal largesse longer than might
otherwise be the case.
While we have had a substantial rally in gold, we have not had the sort
of blowout that occurred in 1980. At this stage, I am not particularly
hopeful that a successor to Bernanke would “crush” inflation
should it flare up in indicators the Fed cares about. We have simply too much
leverage in the system for another (former Fed Chair) Volcker to come along
and raise rates to 20%. Spain says it can’t even sustain 7% on its
10-year debt. But even Volcker, the hero that rooted out inflation, did not
bring the price level back down; he merely tamed future rises in inflation.
By all means, the price of gold is rather volatile. As such, investors
must consider whether they can stomach the volatility of gold. It’s a
key reason why we historically advocate diversified baskets of currencies
including gold to manage volatility. The trends outlined almost a decade ago
remain in place. I have no reason to change our family’s college
savings plan; in our family of four, our youngest is scheduled to graduate
from college in 16 years, so we still have a way to go…
|
|