2023-04-21 16:52:52 ET
Summary
- Demand from central banks is growing and creating a new powerful source of demand for gold, and thus iShares® Gold Trust Micro ETF.
- I believe we are witnessing the emerging of a new monetary order in which gold could become a reserve asset of last resort to settle trades outside the dollar system.
- Structural inflation combined with negative real interest rates represent another secular tailwind for gold.
- At the same time, calls for de-dollarization appear premature and gold may be overextended for the time being.
Why gold, why now
Cries for the demise of the dollar have recently intensified, as the Federal Reserve appears close to peak tightening and the US Dollar Index (DXY) has consequently fallen by almost 10% over the last 6 months. Conversely, gold has risen almost 20% over the same period and is hovering near its all-time highs. Undoubtedly, recent events are challenging the dollar's status as the world's reserve currency, as evidenced by remarks by Brazil's president Lula and increased acceptance by commodity exporters to settle trades in local currencies outside the dollar system. It is, therefore, not surprising that some geopolitical commentators are calling for the death of the dollar and pointing out gold as a major beneficiary in the new regime.
Such claims appear to be premature. It is my belief that de-dollarization is an almost inevitability, but at the same time, it will take longer than expected to fully play out. In other words, current dollar weakness is not a good reason to be bullish on gold in the short term, but de-dollarization is in the long term.
Why do I believe that the dollar might still be far from peak strength? First of all, in the short term, the dollar appears to be oversold. The most important component of the US Dollar Index is by far the euro (accounting for 57.6% of the index). As headline inflation remains stubbornly higher in the Eurozone than in the U.S., the ECB is striking a more hawkish tone than the Fed (after falling dramatically behind the curve last year, in probably its greatest policy mistake ever). Therefore, interest rate expectations have caused the euro to strengthen against the dollar over the last six months. However, looking beyond these relatively short-term factors, on longer timescales, more structural factors come into play, based on which the dollar may still turn out to be the best performing fiat over the coming decade.
To start with, the U.S. is in better shape financially than many other developed Western nations. While the U.S. has a fairly high government debt to GDP ratio (129%), the U.S. private sector has managed to deleverage significantly over the last decade, which means that the U.S. has a total debt to GDP ratio of roughly 350%, below countries like Japan (500%), and Canada or France (400%). Therefore, the U.S. is able to sustain higher interest rates for longer. In addition, the status of the U.S. dollar as the world's reserve currency (almost 2 out of 3 international transactions are still carried out in U.S. dollars) creates an important source of demand for dollars that other currencies simply cannot rely on.
It should be noted that emerging markets (with the notable exception of China) have far lower debt-to-GDP ratios. Therefore, it is only Western countries that are between a rock and a hard place in the fight against inflation. To crush inflation, central banks should be aggressively hiking rates above inflation but, unfortunately, their economies are too highly leveraged for that. Brazil provides a counterexample. After inflation peaked at 12% in April 2022, the Central Bank of Brazil quickly brought rates to 13%, with the result that inflation is now below 5% and heading to its 3% target. This was made possible by the fact that Brazil has a relatively low total debt-to-GDP ratio.
A similar approach could not (and in fact has not) been chosen by Western central banks. The reason is that, when taking into account the amount of debt in the system, the average maturity of that debt, and the need to refinance it at higher rates, most Western countries simply cannot sustain rates above 10% (and, in fact, probably much lower than that) for any prolonged period of time. It is above the pay grade of your correspondent to guess what will be the terminal rate for this cycle, but we are likely close to it. Market-implied expectations for the 3M average Federal Funds Rate see it peaking at around 5% and then declining starting from H2 2023.
Considering in some detail the case of the U.S., the weighted average maturity of the Federal debt is only slightly more than 5 years . This is an exceedingly short maturity: in fact, in less than 3 years more than 50% of all the outstanding Federal debt will have matured. The practical implication is that more than $15 trillion will need to be refinanced and, because of the currently higher rates, this will lead to a ballooning of the interest expense-to-GDP ratio. The ratio has already grown remarkably in 2022, touching its highest level in 20 years but, more importantly, given the structure of the Federal debt, assuming the currently prevailing rates and that GDP keeps growing at roughly 2% per year, the ratio could rise above 5% by 2026. As shown by the following figure, representing its time series since 1940, there is no historical precedent for such a high value.
In the early 90s, the ratio peaked at around 3%, as a result of the higher interest rates over the preceding decade, which highlights an important point: there exists a significant lag between the peak in the Federal Funds Rate and the peak in the interest expense-to-GDP ratio. So, even if at the moment interest expenses look affordable, it takes years for the higher rates to trickle through the Federal debt structure.
There is, however, a fundamental difference compared to the '80s. At the time, the Federal debt stood at roughly $60 trillion, which is half the current value, and still inflation could only be squashed by raising the Federal Funds Rate to 20%. If rates cannot be hiked that aggressively this time, then inflation will prove to be more persistent, which means that it will take longer to reign it in, which means that rates will need to stay at the current level for longer, which will only make the interest expense problem even worse. I believe a moment of reckoning is inevitable before the end of the decade. At some point, central banks will more or less explicitly throw in the towel in their fight against inflation and abandon their 2% inflation targets. The costs of crushing inflation with only monetary tools are just unsustainably high.
Are there other ways to solve the debt problem? In principle, it could be solved by higher GDP growth rates and/or retiring part of the debt by reducing expenditures, but in practice this is unlikely for a variety of reasons. The most palatable option from a political standpoint is instead to inflate away the debt, i.e. financial repression. By keeping interest rates marginally below the rate of inflation, it is possible to significantly reduce the debt burden over 10-15 years. In this scenario inflation, while volatile, is expected to remain structurally elevated and real rates remain negative, which in turn creates powerful secular tailwinds for gold and precious metals in general. Given that real interest rates are the major driver of gold prices, I expect gold to be one of the best performing assets over the coming decade.
Apart from negative real rates and inflation, there is another fundamental reason to be bullish on gold in the long term: de-dollarization. The war in Ukraine has likely set in motion a chain of events that will result, sooner or later, in a multipolar world. In such a world, trades could be settled in local currencies, rather than dollars, which are then exchanged for gold.
For example, suppose a Chinese refiner needs to buy oil from a Russian exporter. It makes no sense to settle such a trade in U.S. dollars, especially now that it has become clear that the U.S. can and will weaponize its currency for geopolitical purposes (as evidenced by the freezing of the Russian central bank's FX reserves in February 2022). The alternative would be for Russians to accept yuan in payment. But given the lack of trust in the renminbi, it is unlikely it will ever be accepted by most central banks as a valid replacement for the dollar. As a matter of fact, no major central bank currently holds renminbi-denominated reserves, except for the Central Bank of Russia, and even in this case it remains a small allocation.
It is far more likely that the Central Bank of Russia would choose to exchange yuan for gold. If such a mechanism were to become widespread, it would create an additional significant source of demand for gold from central banks. While not a return to a gold standard per se, gold would emerge as the world's reserve asset of last resort.
The case of Russia on the one hand has proved the extraordinary privilege of controlling the world's reserve currency, on the other it might have laid the groundwork for its demise. After having witnessed the Russian central bank lose 60% of all its reserves within 24 hours, other EM countries, especially if considered unfriendly by the U.S., are surely keen to diversify away from the dollar. In fact, when in February 2022, the Central Bank of Russia was sanctioned, and thus became unable to access $388 billion out of a total of $643 billion of its FX reserves, it was basically left only with its $135 billion worth of gold (apart from a small amount in Chinese securities).
There is already mounting evidence of increased demand from central banks worldwide. In January alone, Singapore 's central bank bought 44.6 tonnes of gold, which is around 15% of monthly global supply. China has also been boosting its reserves for a fifth consecutive months. Even Russia , despite fears that it might sell its gold holdings to finance the war effort, has actually been increasing them over the last year.
According to the World Gold Council , annual gold demand in 2022 increased 18% to 4,741 tonnes, while supply was only 3,612 tonnes. Net demand from central banks was 1,136t in 2022, the highest on record.
While demand is hitting record highs, supply appears to be constrained. Primary gold production from mines has plateaued and is now gradually declining. In 2022, it still rose 1%, but it remains below its 2018 peak, hobbled by operational issues and lower grades.
Summarizing, I believe we are witnessing the dawn of a new monetary order in which the dollar slowly loses its role as the world's reserve currency and gold emerges as a reserve asset of last resort to settle trades outside the dollar system. Combined with the fact that financial repression is the likely policy choice in developed countries to solve their debt problem, I expect gold to outperform significantly most financial assets over the coming decade. This process will likely be slow and gradual, and will see all other fiats being devalued against gold. Surprisingly, the dollar, while losing its reserve currency status at the end of this process, could still perform strongly versus other fiats. Finally, despite the long-term bullish fundamentals, in the short-term, gold might be overextended, as dollar weakness reverses. Besides, interest rate expectations seem to price in the possibility of a deep recession later this year, and therefore of the Fed intervening by cutting rates aggressively, a scenario that I don't consider very likely.
How to invest
Personally, I maintain a 25% exposure to gold and precious metals via both selected miners and physical gold. While I am not a big fan, gold ETFs can also play a role, by offering some unique advantages compared with physical gold, namely better liquidity and greater convenience. There are many possible choices among gold ETFs, including the Sprott Physical Gold Trust (PHYS), which I discussed in a previous article , and the iShares® Gold Trust Micro ETF (IAUM). The latter has recently come to my attention as the lowest cost physical gold ETF currently on the market, with an expense ratio of only 0.09%.
Like many similar products, its internal workings are quite straightforward. Each share represents a fractional undivided interest in the net assets of the Trust. The Trust aims to track the performance of the price of gold, by holding physical gold with a Custodian (in this case JPMorgan Chase Bank). According to the Trust's prospectus , at the end of each business day, there can be no gold in an unallocated form. That is, all the Trust's holdings must be kept as physical gold bars held by the Custodian.
The Trust can create and redeem shares on a continuous basis. However, to optimize costs, this can happen only in baskets of 50 thousand shares. Unfortunately, retail investors cannot redeem their shares for physical: only Authorized Participants, which are registered broker-dealers, can.
At the Trust's inception, a basket corresponded to 500 ounces of gold; therefore, each share was backed by precisely 1/100 of an ounce. Because of fees and other expenses, the amount of gold behind each share has declined over time. At the moment, IAUM is trading at around $19.88 per share, while gold is trading at $2005 per ounce. In addition, the Trust can trade at a premium (or a discount) to NAV.
Conclusions
In conclusion, while sentiment is running hot in gold at the moment and a correction is possible in the short term, I believe no long-term investor can afford not to have some exposure to gold. My preferred way to do so is via gold miners, thanks to the embedded optionality and their cheap valuations. However, gold exchange-traded funds, or ETFs, can also play a role. iShares® Gold Trust Micro ETF represents a reasonably simple and cost-effective way of investing in physical gold, without dealing with the complications related to assay, transportation, storage and insurance.
For further details see:
iShares Gold Trust Micro ETF: Physical Gold Is A Long-Term Buy