In our view, a modest portfolio allocation to gold has never been more prudent.
During the past three months, market sentiment has shifted on fundamentals dominating short-term trading in gold markets. Consensus views have gravitated towards further Fed tightening, rising Treasury yields and a strengthening U.S. dollar. In the body of this report, we have outlined our reasoning as to why each of these assumptions may be short-sighted.
In our view, cumulative and immutable imbalances (debt levels, valuations, dollar liquidity) will soon test recent sentiment shifts, we expect decidedly in gold’s favor. While we are not stocking canned goods, oiling muskets, or bottling water, we are suggesting that a modest portfolio allocation to gold has never been more prudent.
A consistent theme at investment conferences during 2016 has been the compression of investment returns. Especially in the pension and endowment world, very few institutions are achieving chartered rates of return. While institutions might have expected historically to achieve real rates of return of 5% on equities and 2 ½% on bonds, the realities of achieved returns during the past several years are tracking (at the high end) roughly half these historical levels.
We believe the root cause for compressed returns is far simpler than much of the sophisticated quantitative analysis we have encountered. The United States has a structural debt problem, and the Fed has employed ZIRP for eight years to forestall rationalization of this untenable debt load. As every student of economics is aware, marginal returns gravitate towards marginal costs.
The longer the U.S. economy operates in a ZIRP environment, the closer to zero will migrate the sum-profit-total of U.S. economic agents. Recognizing this, the Fed has telegraphed for years a desire to normalize rate structures. Consensus has recognized the Fed’s poor track record in achieving rate normalization but, in our view, has failed to grasp the true impediment to higher rates.
It is not popular to suggest U.S. debt levels cannot sustain higher rates, but we believe these are the root facts. During the past decade, global productivity has collapsed to its lowest level in the modern financial era. Optimists shrug off these statistics as outdated and unreflective of vast productivity enhancements enabled by the internet, I-Phones and social media. We cite this example (which we will develop further in our February report) as a metaphor for a broader condition in global asset markets.
Most investors sense that there are looming risks in financial markets and troubling impediments to healthy global growth. Yet, the relentless performance of the S&P 500 Index has reinforced the inclination to ignore these nagging concerns. In the institutional arena, excessive bearishness or even adoption of defensive and hedged strategies can handicap performance and introduce career risk. To us, an allocation to gold is a powerful tool to help insulate portfolios from potential dislocations in a complicated financial world. In essence, a gold allocation can provide a bit of cheap insurance to any ongoing investment program.
We continue to marvel at gold’s lack of sponsorship in the institutional arena. During the past hundred years, even a modest portfolio commitment to gold has been proven to push total portfolio returns further to the right along return frontiers for any reasonable asset mix, generating equal returns with less risk and standard deviation, or superior returns with equivalent risk and standard deviation, versus identical portfolios without a gold investment component (World Gold Council).
During the past 16 years, gold’s non-correlated and market-leading returns have provided invaluable portfolio alpha in an increasingly challenging investment environment. During the next several years, mounting monetary, economic and financial imbalances, which appear to be approaching important tipping points, suggest gold is a portfolio-diversifying asset worthy of serious consideration.
We view corrections in gold markets during the fourth quarter of 2016 as fairly standard retests of early 2016 breakouts from established downtrends. To us, underlying fundamentals suggest significantly higher gold prices during the next several years.
Gold’s Prospects in 2017 and Beyond
Over the long run, we believe the gold investment thesis rests squarely on monetary, economic and financial imbalances which continue to be resolved to the measurable benefit of investors choosing to denominate a portion of their wealth in assets which can neither default nor be debased. Over the short run (one-to-two years), gold’s performance can be impacted by consensus views on a wide array of market variables.
We would highlight five such variables as motivating the lion’s share of trading patterns in gold markets: Fed policy, the U.S. dollar, 10-year Treasury yields, U.S. economic performance and U.S. equity risk premiums. It is unusual for any single event to impart significant impact on all five of these variables simultaneously. The Trump election has certainly proven to be such an event!
Trump’s victory has unleashed one of the strongest expressions of business and financial optimism in history, starkly affecting variables central to gold’s short-term trading patterns. While optimism is never a bad thing, we suspect financial markets are reflecting classic emotional blow-off.
Investors, admittedly parched for a more normalized economic world unfettered by QE and ZIRP, have, in our view, temporarily lost sight of immutable realities such as debt, valuation, debasement and mathematics.
Should our suspicions bear out that reigning euphoria proves short-lived, recent market dislocations will provide excellent entry points for a wide array of investment assets. Given our confidence in underlying fundamentals relevant to precious-metals, we view the Q4 back-up in gold markets as a rare opportunity to achieve a significantly discounted entry point in gold’s unfolding advance.