2023-05-08 21:23:56 ET
Summary
- Gold's value will ultimately be determined by the US government's fiscal health, and there is little appetite to address ballooning debt, suggesting gold will outperform cash over the long term.
- However, gold is likely to face serious headwinds over the coming quarters as markets already appear priced for significantly lower rates and higher inflation.
- In this article I present four key questions for bulls to consider.
Based on the comments and emails I have received on my previous gold article (' Gold Hits New All Time Highs, Don't Expect Them To Last '), gold bulls appear to be all-in on the metal as the fundamental long-term outlook is positive. I fully agree that gold will continue its track record of outperforming cash over the next decade and beyond. Gold's value will ultimately be determined by the fiscal health of the US government, and there is little appetite on either side of the aisle to do anything to arrest the exponentially rising debt load. This, together with weak real GDP growth will necessitate continued currency debasement, undermining demand for the dollar as a store of value at home and abroad, and in particular among emerging market central banks.
However, I expect to see a 25% decline in the metal before a sustainable rally ensues. While this view will change as the fundamentals change, right now they are decidedly negative. It should be a concern to bulls that gold failed to hold its new all-time highs on Friday, and remains unable to break above its 2020 highs, despite the widespread bullish sentiment surrounding the metal. There are four key questions that gold bulls should be asking right now.
On What Basis Is Gold Undervalued?
Bulls often argue that gold is cheap because it remains 40% below its 1980 peak in inflation-adjusted terms, and more than 80% below its 1980 peak when measured against M2 money supply. Comparing the value of an asset against its bubble peak is not a good way to get an objective idea of an asset’s valuation. While there is no way to accurately value gold as it does not typically generate any cash flow, we can look at how the metal has performed since President Nixon severed the dollar’s link to gold in August 1971 ushering in the fiat era. Since then, gold prices have risen by 7.8% annually, while M2 has risen by 6.9% annually.
Furthermore, when we take into account the stable but relentless rise in the above-ground gold stock, which has averaged 1.5% over this period, the market capitalization of the gold market has risen by 9.3% annually, 2.4pp faster than M2, leaving it 3.5 times larger as a share of US money stock than it was in 1971.
There is no evidence to suggest that gold is undervalued when measured relative to US money supply, while there is strong evidence to suggest it is extremely overvalued on the basis of real interest rate expectations. Gold bulls like to point to trailing CPI as evidence that real interest rates are deeply negative, but as with any asset, prices are driven by expectations of future fundamentals not current ones. 10-year inflation-linked bond yields have been particularly closely correlated with gold prices over the past two decades, with lower real yields coinciding with higher gold prices and vice versa. This can be seen in the chart below, which shows the fair value inflation-adjusted gold price based on their relationship with 10-year TIP yields. Based on data going back to 2003 with an r-squared of 0.65, gold is currently a record 50% above its fair value, which is almost 3 standard deviations above its mean.
Is The Decline In Money Supply Growth Not A Concern?
The main pillar of the bullish argument in favor of gold is that the US money supply will continue to rise faster than the pace of gold supply. This has indeed been the case in the past, but according to the World Gold Council, global gold supply increased by 2.3% in 2022, while the supply of M2 in the US is currently contracting 4.1% y/y. This is the largest decline in money supply since the Great Depression and there is no sign of it ending. High real interest rates and tightening credit conditions suggest credit growth will continue to slow over the coming quarters, while the Fed is set to continue contracting its balance sheet. With the market capitalization of gold having risen faster than the money supply since 1971, why should we expect prices to continue rising in a deflationary monetary environment?
Can We Dismiss The Bond Market's View That Inflation Will Fall Back To 2%?
The current yield of 1.3% on the US 10-year inflation-linked bond reflects the 10-year nominal yield of 3.5% less the average expected inflation rate of 2.2%. I personally think this is on the low side due to the fiscal problems explained above. Bond investors completely failed to anticipate the surge inflation seen over recent years, which I predicted in several articles as early as 2020 (see ' RINF: Bull Market In Inflation Just Getting Started ').
However, we should not fully dismiss current low breakeven rates. In 2013 10-year breakeven expectations stood at 2.6%, which is exactly the average rate the CPI has risen since then. As for the risk of the government underreporting inflation as has been argued by many gold bulls, I find it highly unlikely that inflation has been unreported to any meaningful degree. The strongest evidence against this view is that industrial metals, energy, and agricultural prices remain lower today than they were 15 years ago and are between 40-60% below their 2008 peaks when adjusted for official CPI. Anyone who believes that inflation has been underreported by several percentage points for decades must acknowledge that in real terms almost everything is at multi-decade lows, including the real size of the global economy.
Since When Have Central Banks Been Ahead Of The Curve?
A key bullish argument for gold is the diversification away from the US dollar, predominantly by emerging market central banks, which hold trillions of US dollar assets and are shifting increasingly in favor of gold. On the surface, this seems highly positive, but despite seeing the largest net gold buying on record by central banks in 2022, this demand amounted to just 0.5% of the total above ground gold stock, and less than a quarter of the new supply that came onto the market. In 2020 the Fed bought over 10% of the entire stock of government debt, yet bond prices still fell.
Central bank gold buying should be considered a contrarian indicator. Central banks are not forward-looking investment gurus, but a committee of backward-looking politicians and academics who react, belatedly, to market developments. Central banks sold gold throughout the entire bull market of the 2000s, before becoming net buyers in 2011 just in time to see the bull market peak. As is the case today, investors in 2011 and 2012 widely expected central bank buying to drive up prices , but the market has other ideas, sending gold prices down 46% over the next four years.
Summary
The long-term bullish arguments for gold are abundantly clear but are already reflected in the lofty price of the metal. Despite the surge in money supply growth over past decades, gold's market cap has risen even faster than M2 since the US ended the dollar’s link with gold in 1971. Monetary conditions are now the tightest we have seen in decades and inflation expectations are low and falling under the weight of high real bond yields. Central banks appear to be once again making an ill-timed shift in their policies as they chase the market higher. The widespread bullishness across retail, institutional, and central bank investors is not the kind of environment from which sustainable gold price rallies emerge.
For further details see:
4 Key Questions Gold Bulls Should Be Asking Right Now