Picture: BLOOMBERG
Picture: BLOOMBERG

While not entirely our base-case scenario, there are arguments to be made for holding gold counters in the current market environment. To understand why, we should look at the history of monetary policy and gold over the past century and be mindful that gold tends to perform well during periods of expansionary monetary policy, a high inflationary environment and equity market corrections.

Initially, all currencies were backed by gold through a form of monetary policy known as the gold standard. However, the demands of the two world wars made it impossible for many European countries to abide by these stringent requirements. To alleviate this burden, the Bretton Woods system was introduced whereby all currencies have adjustable (by government decree) exchange rates with the US dollar, while the dollar was pegged to a $35/oz gold price.

This position of privilege allowed the US to run huge trade and budget deficits. Simultaneously, European economies were depreciating their currencies, making the US uncompetitive and resulting in many countries distrusting the dollar (and by implication the US government) and demanding gold as a currency exchange. This placed strain on the US fiscus, and in 1971 then president Richard Nixon (without consulting friend or foe) announced a 90-day price freeze and no physical exchange of dollar to gold. The age of fiat currencies began, with central banks given more power to manage economic cycles.

This greater power of central banks culminated in the Fed’s reaction to the 2008 global financial crisis, when it embarked on quantitative easing (QE), with the promise of rolling it back once the economy was strong enough. Fast forward to 2020 and Covid-19-induced lockdowns, and the Fed is forced to reverse the trend of reducing liquidity in the financial system and the world is now in uncharted monetary policy territory.

QE principles borrow from modern monetary theory (MMT), a drastic departure from conventional economic theory that proposes that, since governments control their own currencies, they can spend freely as they can always print more money to pay debt. MMT advocates using government spending and taxes, rather than interest rates, to manage inflation and unemployment.

While MMT provides detail on how government finances should be managed, it lacks specifics on how private capital is linked into this system or how government can provide a capitalist economy with an infinite amount of capital. Warning signs have already emerged in the US — since QE started we have witnessed a disturbing rise of US “zombie” companies whose debt-servicing costs are higher than their profits.

We have also seen a trend of capital overallocation to good ideas, the best example being Tesla. While it produces fantastic vehicles and may have great growth prospects, it is difficult to justify Tesla having the biggest market cap of any global vehicle manufacturer, but a global market share below 1%.

Even if a V-shaped economic recovery occurs, companies will have to grow into their valuations, and we will not be surprised by an equity market correction from current stretched valuation levels

Over the past 20 years, inflation has been kept under control remarkably well considering this was during material global GDP growth and unprecedented low interest rates — two factors that, in combination, usually lead to higher inflation. Globalisation has been a key driver of maintaining low inflation since the early 2000s as companies cut costs by manufacturing in cost-effective regions.

However, two events could disrupt this — the rise of Trumponomics has politicised and weaponised once-sacred trade agreements, and trade restrictions during Covid-19 have made numerous corporates reconsider their supply chain decision process. More recently, many management teams have stated that security of supply and political stability may in future supersede manufacturing costs. This mindset shift could result in cost-push inflation. There has been very little evidence of this yet due to extremely suppressed global demand.

The recent global markets rally has many baffled — markets have never felt as disconnected from economic reality and it is difficult to justify current valuations. Even if a V-shaped economic recovery occurs, companies will have to grow into their valuations, and we will not be surprised by an equity market correction from current stretched valuation levels. Gold is a good hedge against such corrections, outperforming the S&P in 11 out of the 14 years that the index posted a negative calendar year.

During market turmoil, gold and the US dollar are viewed as safe-haven investments. As Covid-19 spread globally in March, risk-averse investors pulled their money from risk assets into cash. However, when the Fed lowered rates to 0%, there was less incentive to hold dollar cash, while already low US government bond returns were pushed even lower. This, with ongoing Covid-19 uncertainties, buoyed gold’s safe-haven appeal.

Gold had up to about two weeks ago reached record highs in all major currencies except the US dollar. But, as expected given concerns around the Fed’s current policies and worsening US-China tensions, gold has reached new US dollar highs, breaking through the $1,900/oz level on July 24 and trading above $1,950/oz this week.

While we will always advocate that investors refrain from overtrading and rather hold a longer-term view in quality compounding assets, which neither gold nor gold miners are, we believe that in the current environment there is a real case to be made for a tactical asset allocation to gold.

• Engelbrecht is fund manager at Anchor Capital.

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