When discussing why investors might allocate to gold or silver, I am often presented with the statement, “I can’t own gold because I don’t know how to value it”.
The honest truth is you can’t value gold, but you can value paper currencies, such as the pound, the dollar, the yen or the euro. For hundreds of years, major currencies such as sterling and the US dollar held their value while tethered to the disciplined anchor of the yellow metal.
That all changed in 1971, when President Richard Nixon, in effect severed the last remaining ties between the historic gold/currency relationship.
For the modern-day investor contemplating an allocation to precious metals, the chart below is perhaps the single most compelling reason why, I believe, gold and silver should form an essential part of any portfolio. Since 2001, the point at which central bank intervention in the interest rate mechanism accelerated markedly, we can see the extent to which a whole range of paper currencies have lost their purchasing power relative to an ounce of gold.
The chart dates back to 2001 when former US Federal Reserve chairman Alan Greenspan intervened in the interest rate mechanism by taking US interest rates below 2 per cent. Since that time, investors have consistently been confronted with an environment of negative real yields in most major developed economies. This negative real yield world helped generate a debt boom and a misallocation of capital problem. The structural phenomenon was further compounded once the bubble burst in 2008, as interest rates were then lowered yet further, producing even more loose lending and further capital misallocation.
Investors will know that in an attempt to stave off a worldwide recession, central banks such as the US Federal Reserve and the Bank of England hugely expanded their balance sheets since 2009, pumping ever increasing amounts of liquidity into the system. This expansion can only serve to strengthen the argument that the trajectory for both the US dollar and the pound against gold will continue lower.
What I find particularly interesting when looking at relative paper currency debasement since 2001 is the interplay of gold prices, burgeoning current account deficits and actions by central bankers to stimulate the market’s expectation of rising interest rates. Around 2011, as can be seen from the chart, the pound and the US dollar were, on a relative basis, depreciating more rapidly against an ounce of gold than other currencies.
The US Federal Reserve and the Bank of England, in perhaps a veiled attempt to shore up their respective currencies, reacted by signalling that an environment of rising interest rates lay ahead. In reality it took the Fed four long years to deliver even one hike, which the Bank of England has not to date, despite its intermittent promises of an imminent rate hiking ‘cycle’.
This attempt by policymakers to hoodwink investors worked for a while, until market watchers saw through it. Recently, central bankers have started again claiming they can, and will, deliver interest rate normalisation, no longer keeping interest rates artificially depressed. I would contend, however, that market watchers will have something else to focus their attention on in the not too distant future: the race to the bottom of paper currencies’ value relative to the yellow metal.
Ned Naylor-Leyland is manager of the Old Mutual Gold and Silver fund.