Should I Invest in Gold?
This month’s newsletter will be more in-depth relative to previous newsletters given the nature of this question. Below is an opinion piece I sent to clients of Caligiuri Financial.
Enhancing Diversification Through Precious Metals
Prominent investors such as Ray Dalio (the founder and manager of one of the largest hedge funds in the World, Bridgewater Associates) have expressed their beliefs that the current environment is one in which precious metals may perform very well relative to other asset classes. In an article written by Foreign Exchange and Commodity analyst Craig Cohen of J.P. Morgan Private Bank, Cohen writes,
“We believe the dollar could lose its status as the world’s dominant currency (which could see it depreciate over the medium term) due to structural reasons as well as cyclical impediments.”
On July 31, 2019, the United States’ Central Bank (also known as the Federal Reserve) changed course and reduced the Federal Funds interest rate (FFR) by 0.25%, which is the first time the Federal Reserve has reduced the FFR since December 2008 in response to the last recession. Since this July 31st reduction in the FFR, the S&P 500 has decreased 4.5% and Gold (as measured by the largest Gold exchange traded fund in the World, State Street Global Advisors Gold Shares ‘GLD’) has increased 7.9%. It is my belief that this divergence could continue and widen significantly.
Below are three major reasons why the US dollar could lose its status as the World’s reserve currency:
Continued Federal Funds interest rate (FFR) reduction and quantitative easing (QE)
The Federal Reserve’s intended course of action following the lowering of the FFR and QE (i.e. increasing the money supply) that took place after the 2008 recession was to eventually raise the FFR back to normal levels and reverse QE by shrinking the Federal Reserve balance sheet (i.e. reducing the money supply). All else being equal, increasing the money supply and lowering interest rates would result in the devaluation of a currency (in this case the US dollar). One reason the US dollar has not fallen (devalued) following the 2008 lowering of the FFR and QE is that many expected the Federal Reserve not to reverse its intended course of action.
Given that the Federal Reserve reduced the FFR this past July, is not ruling out further FFR reductions, and has expressed a willingness to indefinitely suspend a reduction of its balance sheet, the market may continue to push up the price of gold and decrease the value of the dollar. In addition, it is possible the Federal Reserve implements another round of quantitative easing, which all else being equal, would further devalue the dollar.
Insurmountable United States government debt levels and ongoing budget and trade deficits
As many people are aware, the US government is over $22.5 trillion dollars in debt, and the annual budget deficit is projected to be ~$1 trillion per year going forward. The budget deficit is defined by the amount of revenues the US government brings in subtracted by its expenses.
US Citizens have not felt as much of a negative impact from these large debt levels as they otherwise would have because foreign countries like China, Mexico, Germany, Japan, and Canada have continued to loan the US government money by purchasing US Treasury securities. The reason the US has a trade deficit with these countries is because the US government, US companies, and US citizens send their US dollars to purchase goods and services internationally, and the foreign countries/companies/citizens who receive these US dollars simply send these dollars back to the US in the form of loans by buying US Treasury securities. Put more simply, we send foreigners US dollars, and foreigners purchase United States Treasury securities. The fact that the foreigners are not actually buying US goods and services from the US (on net) creates the trade deficit.
It is a real possibility that these foreign countries significantly reduce their willingness to accept US dollars in exchange for real goods and services because of their belief (based on the current US government debt and deficit levels) that the US will never have the ability to pay them back from true savings. If other countries started demanding to be repaid for their US Treasury holdings and refused to continue purchasing US Treasuries (countries such as China have already started to significantly reduce their purchases of US Treasuries), the US government could either be forced to default on its debt or print dollars to pay off their debts. Many people believe the US government would refuse to default and instead choose to print money. Decreased demand for the dollar from foreign countries and the Federal Reserve printing large amounts of money so the US government can avoid default could lead to devaluation of the dollar and price inflation.
Another reason the dollar has not suffered from de-valuation (despite the aforementioned fiscal and monetary situation) is that foreign countries (with different currencies from one another) have respected the “dollar standard” and “settled” in dollars when trading with one another. For example, if a citizen of Canada would like to purchase a good in China, the Canadian citizen would first convert his or her Canadian currency to US dollars because the Chinese company would accept only US dollars as opposed to the Canadian currency. This results in a massive demand for US dollars and has kept the value of the US dollar strong. For specific numbers, 85% of World transactions are settled in US dollars while the US accounts for only 25% of Global GDP. Craig Cohen of J.P. Morgan writes:
“Countries around the world are already developing payment mechanisms that would avoid using the dollar. These systems are small and still developing but this is likely to be a structural story that will extend beyond one particular administration.”
The article written by Craig Cohen is titled, “Is the dollar’s “exorbitant privilege” coming to an end?” I believe this title describes the situation very well. To perhaps oversimplify what is going on, major US companies such as Walmart (which are representative of a large share of the US economy) send dollars to foreign companies in countries like China in return for goods they sell to US consumers. A major reason why the Chinese accept these dollars is they need the dollars to purchase goods and services from other countries.
Why wouldn’t the Chinese (and other countries around the World who have massive trade surpluses with the US) just take the US out of the equation and transact with one another directly? That’s exactly what many countries are trying to do. If they do successfully take the US out of the equation, the costs of many US companies may increase significantly as other countries realize that a significant value of the US dollar was merely as an international settlement mechanism as opposed to a claim for goods and services actually produced in the United States. US companies may not be able to simply “pass on” these increased costs to US consumers as it’s the US companies who are paying the US consumers with the devalued currency in the first place. The end result would be decreased revenues, profits, and a decline in share prices.
Why Precious Metals?
You may be wondering why what is written above should mean precious metals will continue to appreciate in value. There is certainly a logical reason for this aside from the fact that precious metals have already started to appreciate since the last Federal Reserve interest rate reduction. As I was quoted in an Investment News article:
“The inherent value of gold, and the reason why it was the premier currency for thousands of years, is that relative to other commodities, the free market decided gold had the best combination of being rare, valuable, divisible and homogenous.”
A devaluation of the dollar simply means the price of assets, goods, and services (in terms of dollars) increases; therefore, each individual dollar purchases less. This is also known as price inflation. In a situation of significant dollar devaluation/price inflation, which is what may be unfolding as described in the paragraphs above, people would logically want to “get rid” of their dollars as the dollars are continuously losing value via purchasing power. They are looking for something to buy to protect themselves against this price inflation. People want to purchase as much as they can of something they will be able to exchange for other goods and services (e.g. food, water, etc.) they need in the future.
While other foreign currencies around the World may appreciate against the dollar and result in the relative outperformance of foreign stocks and bonds against US stocks and bonds, it’s entirely possible that all major currencies, which are not backed by gold, lose significant value against gold.
Similar to the US Federal Reserve, other central banks around the World such as the European Central Bank (ECB), Bank of Japan (BOJ), and People’s Bank of China (PBOC) seems to be in a “race to the bottom” to see who can lower interest rates further and print the most money to devalue their own currencies. The chart below from goldsilver.com shows how the major currencies around the World have already devalued their currencies relative to gold since 2003.
The characteristics described in my quote above have made gold (and silver to a lesser extent) the primary “safe-havens” from currency devaluation. In general, if something isn’t rare, valuable, divisible, and homogenous, it will not hold its value very well. For example, in the case of price inflation, the amount of money in your bank account will not increase on its own while the price of everything else is increasing. On the other hand, gold should increase significantly in terms of currency not backed by gold (e.g. dollars) and therefore protect one against price inflation.
At Caligiuri Financial, we do not attempt to “time” the markets. What we try to do is diversify client portfolios in a manner that gives them the best chance to succeed. Given the market environment and research from prominent investors, adding a healthy diversification to precious metals can enhance diversification, mitigate risk, and ultimately improve performance. No one knows exactly what will happen in the financial markets, and this is why it is best to remain humble and diversify.
Clients of Caligiuri Financial already have exposure to international equities and international fixed income, which are two asset classes that could be expected to perform well in the case of a dollar devaluation. Adding a position to precious metals adds another layer of diversification. As Ray Dalio said in his article “Risks Are Rising While Low Risks are Discounted:”
“If you don’t have 5-10% of your assets in gold as a hedge, we’d suggest that you relook at this. Don’t let traditional biases, rather than an excellent analysis, stand in the way of you doing this.”
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