The bullion argument

Why revisiting gold as an investment makes sense even as its price rises

PREPARING YOUR portfolio for a large market dislocation has long been a solid component of any investing strategy, but I don’t think anyone thought that we would experience a global pandemic along with the accompanying government response of lockdowns.

What’s occurred since March has decimated the service, retail and travel industries, and many small and medium-sized enterprises have been negatively affected. The result: an increase in unemployment that we had not seen since the 1930s. Global financial markets crashed in unison. In unprecedented fashion, governments and central banks provided plenty of monetary and financial stimulus to financial markets as well as individuals and companies. Stock markets rocketed back, leaving many investors shaken by the volatility.

The government stimulus numbers are staggering. Canada by the end of August had increased its money supply by 500% in just five months. By comparison, the money supply only increased by 100% during the Great Depression and Second World War (1935 to 1945) periods. Federal debt has concurrently exploded, and will be an anticipated $1.2 trillion in fiscal 2001/21, from $692 billion in February.

The question now becomes: how will governments deal with the challenges created by the significant amounts of new debt added to their balance sheets? Examining previous long-term debt cycles, when these types of imbalances occurred, governments will likely monetize their way out: that is, they’ll pay creditors back with depreciated currency. Historically, it’s been the most politically palatable way to deal with excessive government debt levels. This is a form of default, since the debtholders do not receive the full purchasing value of what was lent to the government.

This has a few consequences for investors. First, the traditional 60/40 portfolio of stocks and bonds has significant risks and headwinds. Traditionally, bonds were held to provide income, and, because they tended to move in the opposite direction to equities, they lowered a portfolio’s volatility. But with interest rates near zero, this benefit has been lost. If interest rates were to increase, then the market values would fall. As for equities, they may go higher given the additional money printing, but they are considered expensive by most valuations, even relative to the current zero interest rate environment.

The desire of governments to create inflation by further stimulus via Modern Monetary Theory (MMT) combined with increasing government debt-to-GDP ratios achieved through artificially low interest rates has put us at an inflection point. Going forward, the western world is likely to experience a drag on growth and consumption, albeit with rising prices. For those not old enough to remember the 1970s, this is called stagflation.

The last time we experienced economic stagflation was when the United States went off the gold standard on Aug. 15, 1971. Then-president Richard Nixon “shut the gold window” in order to monetize debts that were incurred for the Vietnam war. Up until that time, there was direct convertibility of the U.S. dollar to gold at US$35 an ounce. The bull market that ensued pushed gold to a peak of US$850 an ounce in 1980, when interest rates almost went to 20% to fight inflation.

Recently, gold has hit new highs after a long bear market that began in 2011, which followed a decade of outperformance in the millennium’s first decade. Is this relic of an age gone by still relevant and valuable? Much of gold’s value is not because of rarity, but its stockto-flow ratio: Gold is highly valued because new production is small relative to all the gold ever mined. In other words, the inflation rate of gold is low, with a growth rate of approximately 1.6%.

Adding gold as an asset class to a traditional 60/40 portfolio makes sense for investors who are concerned about the historic money printing by central banks and record levels of growing government debt, and still wish to improve the diversification and return potential of their portfolio. In most cases, bond exposure would be reduced to make way for the addition of gold.

Gold is easily bought at banks and through financial securities such as exchange-traded funds and mutual fund trusts, thus allowing exposure in regular taxable investment accounts, but also retirement savings plans, Retirement Income Funds and tax-free savings accounts. A good characteristic to look for in a gold fund is the allowance of physical delivery in addition to redemption for cash.

Investors such as Warren Buffett never used to think that gold was a promising investment, but he has now bought shares in Canadian gold miner Barrick Gold Corp. for Berkshire Hathaway Inc. Even the Oracle of Omaha thinks the outlook for gold is bright.

Arthur Salzer is CEO and chief investment officer at Northland Wealth Management.

Gold has recently hit new highs after a long bear market that began in 2011