As countries across the world print money in response to the COVID crisis the resulting inlfation leads to investors looking for investable asstes to protect against inflation. History shows that these protective assets are gold, silver and oil. Let’s take a deeper look.
Macro investing is differrent from stock picking. In the latter one looks at differentiating factors between individual securities like companies, stocks or ETFs to identify good opportunities for investment. In Macro investing, however, one looks at secular (aka long term) economic trends that could last decades such as demographic changes, inflation, business cycles and trends in debt levels. These ‘secular’ trends informs us not on what stocks to pick per se but which asset classes to invest in. Example of asset classes are commodities (corn, oil, oranges) , equities (Google, FB) or metals (Copper ,Gold) and Treasuries (soverign debt).
Increasing Debt and Inflation
When countries around the world increase their money supply by printing money and injecting that money into the economy either through purchases of assets in capital market or through transfer programs and these actions result in inflation, or increases in the price of the assets.
It should be mentioned here that by inflation I mean broader asset inflation as compared to popular measures of inflation, such as CPI (Consumer Price Index), that just look at a small segment of assets.
Let’s illustrate asset inflation through a thought experiment. If for some reason you suddenly told everyone in the United States that a one dollar bill is worth two dollars, a 10 dollar bill is worth 20 dollars and so forth and that they can go to a bank and exchange the old notes for new notes. What will happen, as you can imagine, is that the prices of all assets (houses, food, alcohol, stocks etc) would almost double and not just the prices of a small basket of consumer goods included in the CPI. What we have today is just another version of the thought experiment described. Governments are printing money out of thin air and increasing the amount of money that exists on this planet, hence increasing the money supply which inturn will increase the prices of all assets as money that needs to buy something.
IMF reports that as of mid-June 2020 governments have spent $11 Trillion in loans, equity injections and guarantees to counter COVID and sustain economic activity. In addition they estimate tha an increase in borrowing by governments globally could rise from 3.7% of global gross domestic product (GDP) in 2019 to 9.9% in 2020, as indicated in Figure 1.
The 7% estimate in world government fiscal debt, for a $90 trillion dollar world economy, equates to about $6.3 trillion (some estimates point to more) increase in debt that is injected into the economy. You can think of this strategy as taking a loan worth 7% of your salary, during a tough time, to try an make up for your paycut, like holders any loan, the governments will have to pay it back at some time in the future. And an important point to note here, that 7% is the new debt added on in 2020, the total government debt of the US is about 106% of GDP. So as a country we owe about as much as we earn annually.
The strategy of taking on additional debt may work out just fine if we take that 7% debt, make a good investment and pay back the 7% with ease while making a profit. It doesn’t work if the investments made aren’t good investments. Unfortunately during a pandemic the investments are liquidity provisions and don’t necessarily improve the solvency of the world’s economy (read Liquidity vs Solvency). Another way to pay back the debt is to inflate it away, meaning, by printing more and more money you increase the money in the world to pay back old debts. Going back to the thought experiment, if all of a sudden you increase the value of every dollar held in cash and savings to two dollars, debtors will immediately be able to pay back debt much faster hence reducing the debt in the world. The problem arises for the lenders, the people who lent the money and now only get the debt paid back at the $1 equivalent price at a time when the price of all assets in the world have gone up by 100%.
The thought experiment is meant just to illustrate inflationary environments caused rising debt. While we are not doubling the money supply the world is seeing about a 7% rise in debt in relation to its earnings the previos year. So we are seeing a rapid increase in the level of debt in the world at a time when the economies across the world are faltering, forecasting reduced GDP or income.
As you look at major stock market indices the prices of assets which seem to be increasing are, just that, increases in prices and not value, the prices are going up because there is more money in the system (read price v value). During these times of price inflation and value loss, investors generally flock toward safer assets. Derek Horstmeyer, a professor at George Meyer, looked back at history to look at how different asset classes performed during periods of inflation, this is what he found. The following is an excerpt from his medium post.
Which investments offer the best protection against rising prices?
The best way to figure that out is to look at the correlation between an asset’s returns and the rate of inflation. It’s simple: The more closely an asset’s returns track the course of inflation, the better the asset serves as a hedge. In concrete terms, the closer an asset’s correlation coefficient with inflation is to 1, the better protection it offers. At the other end of the spectrum, a coefficient between 0 and minus 1 means the asset’s returns tend to move in the opposite direction of inflation.
Exploring the returns of a variety of assets over the past 50 years and examining their correlation with the inflation rate over the same period reveals that the assets that correlate best with inflation are metals, real estate and materials — so-called hard, or tangible, assets. Gold and oil have the highest correlation coefficient, at 0.35, with silver and real estate next at 0.25.
While it is clear that some assets(such as Gold, Silver and Oil) do better than others during inflation, it should also be noted that they are not long term hedges againt inflation and hence timing of entering and exiting these markets are key and is what Millenial Gold emphasises as part of a good Gold investment thesis.
As another more direct illustration is the relation between the monetary base of the US (amount of money in the US) and gold (a safe asset). Between September 2008 and September 2014 ( a period of declining economic activity) when the US Monetary base saw a sharp increase from $909 billion dollars to $4,049 billion dollars and we saw gold increase from Gold $941 per troy ounce to to $1,241.33 per troy ounce
Since March 2020 we have seen an increase in Monetary base from 3,454 billion dollars to 5,000 billion dollars and are beginning to see the corresponding rally in the Gold.
The Search for Yield:
The price of assets goes up and down based on how much money flows in and out of this particular asset class(buying v sellin). As seen from history, as the world economy goes into a recession, investors no longer find stocks as a good investment and hence put money into ‘safer’ assets such as US Treasury bonds (backed by the US Goverment) and gold, this flock of investors toward toward safer assets, inturn results in the appreication of the safe asset’s price, which makes the safe heaven a pretty good investment. However, it should be noted that this relation works in reverse too, that as the economy goes out of recession, investors will find stocks that they want to invest in and will hence take their money out of safe assets which drop in price.
In todays world, the traditional safe assets government bonds or treasury’s accross the world are offerring their lowest rate of return in recent history. Below is a chart of the 10 yr treasury yield of major world economies. The Treasury yield is the interest rate that the government pays to borrow money for different lengths of time.
Most safe nations offer just 0-1% interest rate for investing in their treasuries, some of the developing nations such as India and Brazil offer more, but are also considered less ‘safe’.
With treasury yields so low investors are searching for investments with higher yields, aka better returns. Equities have long been this outlet for better returns, but as the world economy slows due to covid and companies earnings decrease or become negative it is rational to believe that investors will be looking for other safer asset classes such as Gold, hence further increasing its price.
In the next part of the gold investment thesis, we will look at previous gold bull runs to get a sense of what price appreciation an investor can potentially see and discuss why equities in gold mining companies are poised for great returns as of June 2020.