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Gold - A Hedge Against Extreme Outcomes (First Eagle)
Posted by: Canadian Value (IP Logged)
Date: February 13, 2014 03:24PM
At First Eagle, gold serves as a potential hedge against unforeseen events. Throughout the 1990s and this decade, we grew concerned with the Federal Reserve’s (the Fed’s) policies during Mr. Greenspan’s tenure as chairman. The Fed’s bias to easy money policies was one of the reasons we started our Gold Fund in the fall of 1993 and maintained a position in gold and gold related equities in all of our other Global Value Team mutual fund portfolios. Since then, the Fed’s monetary experimentation has only become more pronounced, so too the use of fiscal deficits as demand stabilizers.
We look to gold to provide protection against the unintended consequences of government interventions, bank bailouts, long-term trade imbalances and currency crises. There are other potential hedges — TIPS (Treasury Inflation-Protected Securities), oil, other metals, natural resources and real property, but we feel gold enjoys significant advantages over these alternatives.*
Advantages of Gold
First, unlike U.S. Government TIPS and other inflation-protected sovereign bonds, gold has global standing as a store of value. It is not denominated in any particular currency nor dependent on the solvency of any particular government. Second, gold has very limited industrial uses. Its price is determined largely by the existing stock of gold above ground and the demand for that stock. Unlike oil, base metals and real property, it is not tied to the business cycle. In fact, in the depths of the past recession, gold generally held its value relative to declines in commodities and property as the global economy dealt with the unwinding of the credit bubble that was 25 years in the making. Thus, we believe it is prudent to consider holding a small amount of gold, not as an absolute return investment nor as a trading opportunity, but rather as a potential hedge against unsettled economic and monetary conditions.
Store of Value
Gold’s appeal as a monetary instrument can be linked to its many unique characteristics. While its natural beauty first attracted ancient cultures, its malleability led Croesus to make it a medium of exchange in 6th Century B.C. The characteristics that define its value (i.e., purity and weight) are completely measurable and well understood around the globe, and it is fungible. Gold never loses its luster. An ounce of gold mined 4,000 years ago in Egypt looks the same as an ounce of gold mined last year in Quebec. Gold is virtually indestructible. It is one of the densest real assets and its costs of storage are favorable versus alternative commodities. Also, gold cannot be counterfeited — alchemy remains a myth today. Gold is scarce with the above ground stock amounting to less than one ounce per capita based on global population levels.2 These traits are why central banks around the world have maintained gold inventory in their vaults despite the metal’s reduced role in monetary policy after 1971.
When investors look for risk-averse assets they have a choice for “mattress” money. They can hold either cash or gold in a vault but must recognize that the U.S. dollar has lost a significant amount of its value against gold, and approximately 96% of its purchasing power within the United States since 1913 (Chart 1) due to the cumulative effects of increased money supply and inflation. One has had to take risk by lending money in order to earn a compensatory interest rate.
During the commodities boom, gold benefitted from an “all boats will rise” mentality. After the events of September 11, 2001, the price of gold picked up a little. As investors became focused on China, India and emerging market industrialization, the likely effect of these developments on demand meant that base and bulk metal prices soared during the first half of the last decade. The price of gold may have increased during this period, but, on a relative basis, it did not keep pace with commodities like oil and copper. At the same time, with the global economy in full swing for most of this decade, investors ignored the dangerous consequences of cheap credit.
Gold never loses its luster... is virtually indestructible... and cannot be counterfeited.
We at First Eagle took a different view. Since the collapse of Long Term Capital Management, when the Fed demonstrated a willingness to fix problems at any cost, the value of gold as protection against the unanticipated consequences of these interventions had risen sharply.
Throughout its history, gold’s status has flip-flopped between an article of adornment and a monetary instrument. It is when gold is viewed as potential protection against inflation or as a possible substitute currency that its price increases. This flip-flop was evident in the late 1990s when heavy central bank selling depressed the price of gold below the $300-per-ounce level, its marginal cost of mining at the time. In this period, investors focused on jewelry demand and mining supply as the biggest drivers of price. However, jewelry demand growth during the 1990s had very little effect on the price. Rather, gold’s role as an investment vehicle (both through central bank and individual ownership) tends to overwhelm all other supply-and-demand factors. In this period it was central bank selling that dominated prices. A decade later in the wake of the global financial crisis it was private investors precautionary purchases and central bank restocking of reserves that drove gold prices up despite weak jewelry demand. The price of gold is largely determined by how willing owners are to part with the above ground stock. Almost every ounce that has ever been mined is still in existence, so the price of the metal is determined by the above ground float.
The tendency of sovereigns to print money to solve financial problems means that private investors ultimately tend to bid the price of gold above its value as jewelry —especially during times of uncertainty. However, the fact that sovereigns don’t possess the discipline to buy sufficient reserves of gold to back their currencies means that gold has historically traded at a discount to where it would need to were it publicly accepted legal tender. As such, gold trades as nature’s monetary alternative, vacillating between its depressed jewelry value when systemic confidence is high and approaching its elevated monetary value when confidence is low.
We do not forecast the gold price at First Eagle. Since we view it as a potential hedge, we evaluate the cost on a spot basis versus alternatives. Its value ebbs and flows inversely in relation to confidence in and the quality of sovereign money. We like to own gold bullion because it is free and clear of the risks associated with mining. We realize, however, that bullion is not always the cheapest way for us to gain our exposure to gold. Therefore, when making a decision to buy or to add to our gold allocation, we evaluate the price of bullion versus gold mining stocks.
When evaluating gold mining stocks, we apply the same discipline we would apply to any stock in any of our portfolios — we want what we feel is resilient and embodies a margin of safety in price. Therefore, we tend to focus on miners with proven and probable reserves operating in regions where mining is widely accepted. When comparing gold mining stocks to bullion, we tend to think of ownership as a call option on the ounces in the ground. Gold mining stocks have leverage to the gold price and has historically moved at least twice the price of bullion. This relationship, however, tends to work on both the upside and the downside. Therefore, we have tended to keep a greater percentage of bullion in our non-gold funds versus gold stocks because we want some stability from our potential hedge and we recognize that the gold mining stocks’ performance is inextricably levered to the price of gold. However, in the past year, we have increased the proportion of the gold we own via equities given the dramatic underperformance of stocks versus bullion.
We recognize that the price of our potential hedge may be more costly when the price of gold increases relative to incomes, but such times often parallel reduced multiples and increased uncertainty in the broader equity market. Just as the cost of your homeowners insurance may increase if a hurricane were to devastate your neighborhood, the volatility in the financial markets during times of distress may increase the price of certain “safe haven” investments like gold. This indeed happened in the summer of 2011 when investors feared a Euro meltdown and S&P downgraded U.S. government debt. During this environment, we modestly trimmed our gold to avoid our potential hedge positions becoming outsized.
When asset bubbles burst, investors face forced liquidations and panic selling, typically leading to an accumulation of cash, at least in the short run. Even in times of panic, gold has historically been able to be converted into other assets and has held up well relative to equities and economically sensitive commodities and property. In future economic or market crises, rather than reflexively trying to build U.S. dollar cash balances, we believe investors may seek to diversify their U.S. dollar holdings particularly if worries shift from ordinary business cycle pressures to systemic concerns over deflation and sovereign solvency. The Fed is using the full might of its balance sheet to try to solve the vulnerability of excessive debt levels. With an accommodative monetary policy and the Fed’s long-held desire to avoid a Japanese-type deflationary environment, we think owning a potential hedge against the possibility of inflation or at least sustained financial repression to combat deflationary forces makes sense.
Of late, as faith in the monetary architecture has improved — as evidenced by declining bank and sovereign credit spreads, increases in long term real rates and expectations of declining budget deficits — gold has weakened versus equities and global incomes. Investors are shunning gold because its price has gone down but as a potential hedge it has behaved as one would expect and now we are getting the gold cheaper.
We value that potential hedge. We are a long way from sovereign debt, real interest rates, household savings and balance sheets being fully normalized while valuation levels for risk assets are also a long way from trough levels.
One can see that for the last forty years, gold broadly moved in the opposite direction to equities relative to world incomes (Chart 3). If one has the majority of a portfolio in equities, is it not prudent to own some gold as a potential hedge?
As former Federal Reserve Chairman Greenspan once said, “Fiat money in extremis is accepted by nobody. Gold is always accepted.”3 While we hope we don’t enter an environment where the U.S. dollar has collapsed along with other major global currencies, we certainly sleep better at night knowing we are somewhat hedged with our gold holdings. When financial markets are stable, the Keynesian view that gold is a “barbaric relic” takes hold, whereas in times of uncertainty, gold once again emerges as nature’s alternative to other monetary instruments. We think the prudent investor should always think about the downside when looking at an investment and we believe gold offers the potential downside protection for those events which we have no ability to forecast.
Stocks Discussed: GLD,