Investors are queuing up to buy this one asset

Gold, and precious metals in general, are well and truly back in vogue. As a defensive asset class, but more importantly, as an asset to hedge against the impact from the unprecedented central bank stimulus packages, we have witnessed due to COVID-19.

There have been reported queues at refineries, the ones that have remained open, as investors look to source physical in any form they can. Distributors have been working around the clock to fulfil demand in the face of increasingly volatile equity, rates and credit markets. Global market participants are watching Central Banks devalue global fiat currencies (print cash/increase money supply) vs hard assets to mitigate falling asset prices. But at what cost?

The divergence between forward earnings and equity valuations are now very evident, and the question is whether the stimulus is bullish risk assets or just bearish cash?

The only case for buying equities, in the face of unemployment levels not seen since the Great Depression, is that the only thing worse than overpriced assets is a commodity in unlimited supply: cash!

The impact of COVID-19 is going to be felt for generations. It has been reported that Gilead drug is showing effectiveness in treating coronavirus. The social and wellness impact on society, if this is the case, would be tremendous; however the economic implications of the centralised economic response will continue to be felt. Over the last 30 years, we have been building up an increasingly risky debt scenario commonly known as the Greenspan Put.

• In 1991 it was the over-leveraged commercial real estate sector,
• 2000 the leveraged Dotcom bubble,
• 2008 over leverage in property multipliers and
• 2012, leverage again caused the sovereign crisis.

All of these crises were cured by adding excess liquidity, so that deleveraging was orderly and not chaotic. However, we never paid this back. In fact, the corporate sector followed the government on the basis that assets always go up, and we witnessed record share buybacks.

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So why is everyone buying gold?

To tackle this question, we must take a brief look at the history of gold and recognise that until the 1970s US dollars were backed by physical gold. Which meant that the government was restricted in its ability to control the money supply, as they had to have physical gold to offset the paper money supply. Ending the gold standard enabled the US government to begin a process of more effectively utilising both monetary and fiscal levers to smooth economic cycles, and arguably the beginning of the bond market rally. By ending the gold standard, the Federal Reserve had complete control of the USD money supply.

Since the Global Financial Crisis in 2008 and 2012 sovereign crisis, global Central Banks have been attempting to walk borrowing rates higher, after responding to both instances by dropping rates and absorbing the over-leverage in the system. They had been looking for signs of inflation and wage growth, to enable them to reset a key lever that they utilise to manage economic activity, monetary policy, as well as unwind the risk on their balance sheets. However, a technology overhang on inflationary factors throughout this period, enabled a period of muted inflation, skyrocketing asset prices and a widening wealth gap. This environment leads to increased political divides (moving away from the centre) and concerns around how we would manage through the next economic downturn without the ability to stimulate growth through lower borrowing costs.

This was coupled with increasingly dangerous levels of corporate debt, who had been using this period of stable growth, improved banking liquidity levels and low borrowing costs to continue to leverage their balance sheets. The result was if Central Banks did raise rates, the impact on the economy would be significant, given the amount of leverage in the system.

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So why does this all matter for gold? 

A lot of commentators would now argue that Modern Monetary Theory (MMT) is now in play. And that means, at a very high level that any government can continue to print (increase their money supply), if they don't issue debt in a foreign currency, and they tax their citizens in their local currency. This theory throws out the door that the government is an entity like any other corporate or citizen who needs to repay debts. They can just print more money and pay the interest on their debts with this newly minted currency. Japan is cited as a role model of this theory, where the currency and credit rating of the country hasn't dramatically changed despite being in a zero interest rate environment since the 1990s. The fallacy in this argument is trust.

Investors need to be able to trust the government of the currency of issue. They need to know that they have the levers available to them to continue to smooth growth. We have effectively eliminated monetary policy with zero rates and record sovereign and corporate debt levels.

We cannot raise rates without inadvertently impacting the domestic economic conditions as well as the credit ratings of sovereigns. We can utilise fiscal policy and QE; however, we can only fund this via increasing the money supply. In the end, we are in a vicious cycle, where we cannot raise rates (and we continue to encourage over-leverage in the market) as well as leaving our central bankers and policymakers with only one lever – money supply. This is a one-directional trade. Cash is a commodity in unlimited supply.

The only currency which is not centrally controlled and cannot be printed or manipulated is gold. 

It is the original store of value and the asset that backed most currencies until the 1970s. Interestingly enough, central banks have been buying gold since 2009 at record levels with 374 tonnes bought in 2019 alone. And in Q3 of 2019, they ended the Central Bank Gold Agreement (CBGA), which was a coordinated approach to selling down gold reserves, an agreement that had been in place since 1999.

Gold is clearly back in vogue, but not just from retail and institutional investors but central bankers as well. It is the ultimate hard currency in an environment of increasing money supply. 

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