Predicting the future in general is a fool's game, while anticipating inflection points, we have often said, is for market oracles and dummies. That said, one can easily anticipate general themes. The inevitable implosion of an unsustainable economic model is one of them. The only question is how does one hedge best for an event like this. In the past 3 years, precious metals, primarily gold, have served as arguably the best hedge to the absolute loss of purchasing power of the global fiat system. And with increasing global instability, the prominence of gold will only rise. A just released must read analysis by Oxford Economics titled "The impact of inflation and deflation on the case for gold" finds just that, and culminates with the dramatic conclusion that "gold's optimum share of a portfolio to be around 5% in a base long-term case for the UK featuring 2.25% growth and 2% annual inflation. This is higher than levels found in typical mainstream investment portfolios, although this may be in part because the analysis does not include other assets such as index-linked bonds, foreign securities and other commodities." Based on anectodal analyses, gold holdings on average at the institutional level are about 1% or less. Which means that a qunitupling in buying interest will have dramatic implications on the future price of gold (it is no secret that we have been and continue to be very bullish on gold). And just like "nobody could have predicted" the implosion of Italy, so soon nobody will have been able to predict gold rising to $2,000, $3,000 and other multiples of $1,000. Which is precisely what will happen as the next and possibly final lap in the global currency devaluation game is nearly upon us. The only beneficiary will be the one instrument that retains its absolute value as fiat around the world is relatively devalued against one another. Regardless, while the attached study does not break any undiscovered secrets, it is a must read for everyone who is still on the fence, or is considering taking profits with gold once again just shy of its all time nominal price.
From the report:
- Since 2007 the world has seen a period of considerable economic and financial volatility, during which gold has performed strongly with its price more than doubling. This performance has prompted some reappraisal of gold's properties as an investment vehicle.
- Over the very long-term gold tends to hold its value in real terms, but short-run factors can move gold away from its long run equilibrium for extended periods. These factors include financial stress, political turmoil, real interest rates, inflation, central bank activity and the US dollar exchange rate.
- To begin our investigation into gold, we estimate an equation to explain gold price movements over the 1976-2010 period. The modelling approach suggests that all of the factors outlined above are significant short-run influences on the gold price and that shocks to the gold price tend to wear off relatively slowly. The equation also highlights the fact that whilst the current price of gold is comparatively high, the adjustment back to equilibrium could take place via a rise in the general price level, rather than a fall in the nominal value of gold.
- Using the estimated equation and Oxford Economics? Global Model, we examine the performance of gold relative to other assets from 2011-2015 over a number of variant economic scenarios. We find that while other assets outperform gold in the baseline scenario, gold performs relatively strongly in a high inflation scenario and also does comparatively well in a deflation scenario derived from a wave of defaults in the "peripheral" eurozone countries. This is because such a deflation scenario includes a sharp rise in financial stress.
- The scenario analysis confirms gold's properties as a hedge against extreme events; properties that may be especially valuable given the considerable uncertainties still facing the world economy.
- The study then goes on to examine gold's place in an efficient investment portfolio using optimisation techniques and different assumed long-run returns for gold, equities, bonds, cash and property. We find that because of its lack of correlation with other financial assets, gold has a useful role to play in stabilising the value of a portfolio even if the conservative assumption of a modest negative real annual return is made.
- We find gold's optimum share of a portfolio to be around 5% in a base long-term case for the UK featuring 2.25% growth and 2% annual inflation. This is higher than levels found in typical mainstream investment portfolios, although this may be in part because the analysis does not include other assets such as index-linked bonds, foreign securities and other commodities.
- Varying the economic assumptions can imply higher allocations for gold. Gold's optimal share rises in a more inflationary scenario, as well as for more risk-averse investors in a limited growth and lower inflation scenario, thanks to its low correlation with other assets.
Full report (pdf)