I have just finished the book, “The Great Reflation”. It is an enjoyable book that discusses allocating assets in a turbulent world. This is because investors must deal, not with the should-be world, but with the actual world and its elevated risk and uncertainty.

There have been a lot of misconceptions about Gold as an asset class. Whether including Gold is an excellent choice from a diversification perspective or not. It also talks about Gold as a monetary standard and its investment performance. 

Can you guess what an investor’s holding period return would be if the investor allocates a substantial part of his/her wealth into Gold and holds it for 20 years?

It bewildered me that Gold fell from almost $1,000 per ounce in 1980 to a low of $280 per ounce 20 years later, making for a very unhappy  investment experience.

Gold price rallied over 15% in the last one month. In fact, it rallied over 30% in the last 12 months. This happens when central banks pump money into the economy. 

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Announcement: I am working on an online course on Modern Monetary policies from a practical perspective. It may have 3 classes, each comprising two hours. I would like to focus on some practical aspects of the Bangladesh Money Market. I would like to cover the following. The list will increase and strengthen as I am researching the contents.

• The components of Central Bank Balance sheets of different countries, and what those mean?
• How Central Bank FX reserves are created and what purpose it serves.
• Will touch on some aspects of FX policies and examples from different countries.
• Sterilized intervention in the FX market
• How Central banks create money from a real-world perspective.
• The myths of Central Bank market support
• Will focus on some aspects of  public debt because the creation of new money affects Public Debt
• Will focus on some aspects of the history of monetary policy
• Some practical concepts like QE, Debt Monetization, Fiscal Space, Helicopter Money and which country focuses on what
• How the monetary policies of emerging/frontier economy differs from that of the developed economy

**Please,  let me know if you have any other concepts in your mind that would add value to the participants.

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The book “The Great Reflation” showed a table of return and standard deviation of Gold compared to S&P 500 and 10-Year Treasuries from 1970 to 2009. Below are some excerpts from the book. 

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Why Gold Has Enduring Value?

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Source: The Great Reflation

The real price of gold (i.e., after inflation adjustment) has fluctuated enormously since the end of the gold standard in 1914. These fluctuations have become even more extreme since the first Bretton Woods system collapsed in 1971 and the official price of gold was freed. In spite of this volatility, gold has retained its special mystique based on a track record that goes back thousands of years.

The gold is indestructible; it is revered for jewelry and the arts, and its high value-to-weight ratio makes it easy to store and portable — critical qualities in wartime. It is not a liability to anyone. It is easily transferable outside normal banking channels and hence useful to avoid the grasp of predatory governments. It cannot be blocked in time of war or sanctions against regimes that are out of favor. People have used it for tax – free inheritance planning for centuries. It is useful for hiding wealth, which is important in many countries. But, above all, it has provided long – term protection against the destruction of wealth by maintaining its purchasing power over very long periods compared with paper money. For these reasons, gold has built a track record of trust over thousands of years in preserving wealth, and this is not going to disappear anytime soon, if ever. People who own gold for wealth preservation are long – term holders. They own gold for insurance and hope they don’t need it.

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Gold as a Monetary Standard

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Gold (along with some other precious metals) has been used as a monetary standard since the Greek and Roman eras, and well before then as well. Its monetary function altered somewhat after early experiments with paper money. Virtually all of these ended up in disaster and, as a result, gold ’ s role evolved into one of legal backing for paper issued  by central banks

When people see governments succumb to the pressure of money printing, they buy gold to escape the consequences — rising prices, currency devaluation, and often controls on foreign exchange conversion. Money printing doesn’t work if the public can escape the consequences, which, one way or another, reflect the government’s need to extract resources from the public to cover its expenditures that cannot be financed by taxation and bond issuance.

Governments that adhered to the gold standard 3   made their currencies convertible into gold at a fixed price and held gold as backing to guarantee convertibility. Hence money was as good as gold as long as people trusted governments to follow the rules of strictly controlling the issuance of money according to their gold holdings. As a result, the gold standard did a remarkable job in maintaining the purchasing power of money during the 200 years up to 1914, and maintaining a high standard of personal and economic liberty.

The stability came to an end in 1914 with the outbreak of World War I when countries could no longer stay on the gold standard and finance their war efforts at the same time. Great instability followed in the 1920s and into the 1930s. In March 1933 President Roosevelt closed the gold window, confiscated private  Americans ’   holdings of gold and silver, and imposed draconian penalties for disobeying the recent law ($10,000 fines and/or  10  years in prison). He then promptly raised the price from the long-standing $20.67 to $35 a troy ounce. Quasi – stability in the U.S. monetary system lasted until President Nixon broke the last link between the U.S. dollar and gold and set it free to float. Prior to that, the Federal Reserve had a legal requirement to hold a certain percentage of gold against the currency is issued.

The modern era of gold began in 1971 when the gold price, fixed for almost 40 years at $35 per ounce, was set free. Over those 40 years, the inflation – adjusted value of gold had fallen by about 65 percent. Gold was obviously a poor inflation hedge and, as a result, had become much undervalued by the time formal discipline on the  Federal Reserve was removed. Gold entered its fi rst truly global bull market in 250 years, totally unhinged from the gold standard.

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What  Drives  the  Long -Run  Gold  Price

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The United States increased its net short-term liabilities to foreigners at a very high rate for decades by running deficits with other countries. Clearly, the precarious position of the U.S. dollar because of the massive U.S. liabilities to foreign central banks is a major factor in the appeal of gold. Even though the United States is not on the gold standard, it is useful to see what the theoretical price would have to be to raise the value of the U.S. gold stock high enough to pay off all of its short – term liabilities. 

Source: The Great Reflation

There was a fairly close relationship between the two until about 1985, but since then, the theoretical gold price has exploded upward, recently reaching a level of $20,000 per ounce. It seems totally unrealistic to think of the gold price moving to these levels, but it does put into perspective the massive imbalance in the global monetary system and the potential for gold to move up should the United States fail to get its twin deficits — fiscal and international — under control. In that case, monetary chaos would eventually be guaranteed.

There are other ways to gain perspective on the gold price. One is the bilateral relationships between the price of gold and oil, and gold and other commodities. When general inflation took off and gold was allowed to float freely, all three rose sharply.

It is interesting to note that, despite the great volatility over the past 40 years, the gold/oil ratio is not far off its starting point, with gold slightly ahead. However, gold has outpaced commodity prices by a factor of five since 1968. The conclusion from these data is that gold may not have a lot of upsides in the near term unless oil and other commodities move up quite sharply from late 2009 levels.

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Gold as an Investment

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The motivations for holding gold are safe haven, protector of wealth, and hedge against catastrophe. There is no question that gold has always lived up to its reputation for those in perilous situations. But for most of us, this is not particularly relevant now or in the foreseeable future. The focus should be on whether gold can consistently add value to a diversified portfolio.

Proponents of gold have argued that it is a useful asset in portfolios because of its negative correlation with stocks and bonds. This was true in the 1970s when gold went up while stocks and bonds fell sharply. However, since then, the evidence is much less clear. In fact, from 2002 to 2008, all three assets were closely correlated. In 2009, gold has again been positively correlated with stocks and bonds (particularly corporate bonds). Overall, even including the experience of the 1970s, gold has not provided much long-run diversification benefits since 1969. Gold and S & P total returns have had a correlation of 0.52. Gold has had a .65 correlation vis-à-vis Treasury bonds over the same period.

Therefore, from a diversification perspective, it is hard to make a strong case for gold in a balanced portfolio. However, that is a separate issue from the insurance motivation to provide a hedge or protection against geopolitical and/or financial catastrophes. Those are rare events and do not lend themselves to correlation statistics.

Thanks for reading. My next read is “Disunited Nations” by Peter Zeihan. It is a tough book and just released recently. I read his first two books too. The Accidental Superpower and The Absent Superpower. He is a Geopolitical Strategist. My learning on Geopolitics is shaped by reading his books. I have also watched a webinar a few days back organized by CFA Society Mumbai on “The Global Geopolitical Order”. I found it a bit benign compared to other materials on Geopolitics. Still, it is worth watching.