June 25, 2019
By the Real Return team at Newton, part of BNY Mellon Investment Management
Although some professional investors believe gold is an outdated asset and does not keep up with today’s complex investment landscape, history shows that gold can serve as a portfolio diversifier and mitigate risks associated with traditional assets like stocks and bonds due to its lack of correlation.
Investors have generally considered some of the following characteristics of gold when considering it as an investment:
- It is not a promise to pay, and therefore not part of the credit system
- It has historically been viewed as an insurance policy in times of credit stress
- It cannot be printed at will
- The supply of gold is fairly flat
- The fluctuation in quantity is quite different from industrial commodities
- Additionally, it has physical monetary attributes (principally lack of degradation)
While the last bullet point may seem irrelevant in this technologically saturated day and age, with the occurrence of frequent cyber security breaches we believe physical assets still have a place in this world.
Scenarios that may prompt investors to increase gold exposure
In our view, investors might allocate to gold:
- If there is a reasonable risk of monetary inflation or debasement of traditional currencies
- If the credit system becomes stressed
- If the prevailing monetary system is under strain
- If faith in the central banks to provide price stability is not sufficient
While the above could be considered extreme scenarios, there are a few other situations that we feel are more likely, which could cause investors to add exposure to the asset class.
These include: increased efforts by central banks to use monetary finance to reflate real economies, rather than reward asset owners, also known as modern monetary theory. We believe this could occur as soon as the latter part of this credit cycle, particularly since central banks appear short on traditional ammunition to counter the next crisis.
Arguably even more pressing, is the current credit cycle and its accompanying issues, including what we believe to be excessive leverage, lax investor protection (covenants falling away) and dubious accounting, or EBITDA adjustments. We think China is currently a poster child for this issue, as it is relatively unmatched among larger economies for its corporate-debt-to-GDP ratio.1
Lastly, let us not forget about the Trump administration’s ongoing effort to reduce bilateral trade deficits, which we think clashes with the current monetary system (a de-facto US-dollar standard) that relies on the US having a structural trade deficit in order for the US-dollar to serve as a global reserve currency.
Current thoughts behind money creation
Gold may get a bad rap as a metal with no intrinsic value, however, people seem to ignore the fact that most other financial assets are merely just paper promises to pay. While it holds true that the global economy has evolved throughout the years into a more sophisticated animal altogether, human nature leads us back to the same pitfalls surrounding money debasement and leverage. At the end of the day, most money is credit created by commercial banks. In our view, this is why they need to be regulated and why, if policy is not well thought out, much of the credit growth can consist of claims on non-productive assets that do not support future global GDP.
We use a theme of financialization, which is when finance dominates economic activity rather than serve it and by doing so, potentially leads to an over-indebted financial system.
Regarding the sheer scale of financialization in the US, some investors have historically chosen to hold gold because it was not anyone’s liability and traditionally not part of the credit system.
While gold may not perform in a conventional manner, in our opinion it has effectively been used as a currency to allocate a portion of assets to for other reasons. It has historically provided ballast, liquidity and value in times of stress for risk assets.
Past performance does not guarantee future results.
All investments involve risk, including the possible loss of principal. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Portfolio composition and allocation are subject to change at any time.
Equities are subject to market, market sector, market liquidity, issuer, and investment style risks to varying degrees. The natural resources sector can be affected by events occurring in nature, inflation, and domestic and international politics. Interest rates, commodity prices, economic, tax, and energy developments, and government regulations may affect the natural resources sector and the share prices of the companies in the sector. Investments in Gold are speculative and may be subject to high volatility. In times of stable economic growth, traditional equity and debt investments could offer greater appreciation potential and the prices of gold and other precious metals may be adversely affected.
Certain investments involve greater or unique risks that should be considered along with the objectives, fees, and expenses before investing. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Currencies are can decline in value relative to a local currency, or, in the case of hedged positions, the local currency will decline relative to the currency being hedged. These risks may increase fund volatility.
Diversification cannot assure a profit or protect against loss.
This information contains projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different from that shown here. The information in this presentation is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.
Newton and/or the Newton Investment Management brand refers to the following group of affiliated companies: Newton Investment Management Limited, Newton Investment Management (North America) Limited (NIMNA Ltd) and Newton Investment Management (North America) LLC (NIMNA LLC). NIMNA LLC personnel are supervised persons of NIMNA Ltd and NIMNA LLC does not provide investment advice, all of which is conducted by NIMNA Ltd. NIMNA LLC and NIMNA Ltd are the only Newton companies authorized to offer services in the U.S. In the UK, NIMNA Ltd is authorized and regulated by the Financial Conduct Authority in the conduct of investment business and is a wholly owned subsidiary of The Bank of New York Mellon Corporation. Assets under management include assets managed by all of these companies listed above except NIMNA LLC, which provides marketing services in the U.S. for NIMNA Ltd. BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally.
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Ballast: To provide balance to a portfolio in an effort to offset equity volatility.
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization): A financial metric used to measure a company’s overall financial performance.
GDP (Gross Domestic Product): The total value of goods and services produced within a country’s borders in a specific time period.