Gold's star shines bright

The inevitable hangover from central banks' QE experiment will see investors flock to the yellow metal to protect their wealth.

Confounding forecasts, gold has been a star performer in the first few weeks of the year. In US dollar terms, the yellow metal is up just under 9 per cent, which turns into a 13 per cent gain in Australian dollar terms (a 14 per cent annual lift).

This is an odd move for an investment that has attracted so much ridicule, with critics scoffing at the ‘gold bugs’ who risk saying anything even remotely positive about the yellow metal. As it turns out though, such terms have proved to be little more than school yard taunts -- and as sophisticated in their application.

In the real world, gold has retained its value well, notwithstanding a bizarre, puzzling slump in 2013.  Even so, that gold panic lasted just four months. Since then, prices have stabilised into a still-high range. Medium- to long-term investors have made substantial gains -- and kept them. 

Now that’s not to say that gold will continue to put on 13 per cent or so every year for Australian investors. Indeed it could be the case that gold has done its dash. There is a lot of volatility in commodity markets at the moment, and generally, fundamentals (supply and demand in physical markets) have very little to do with any of it. Yet whether gold puts on 13 per cent or loses 20 per cent in the short term is beside the point: They are simply moves which distract from the primary rationale for holding gold -- as a store of value and a wealth protection strategy.

Funnily enough, its actually central banks who underpin support in the gold market and its highly unlikely that will change over the next decade. Indeed there is every reason to think official buying will intensify. So while some commentators may giggle like children after using the term ‘gold bug’, countries such as the US, Germany, Italy and France take it very seriously -- to the point where they hold 65-70 per cent of their reserves in gold. Similarly, other nations are increasingly choosing to diversify reserve holdings into gold -- and that’s just what we know of. Increasingly, many countries either don’t allow audits or don’t report their reserve holdings.

So why the increased ‘official’ interest in gold? Because the truth is, quantitative easing, money printing, whatever you want to call it, is going to be a part of the policy tool-kit for the foreseeable future. Think about it: regardless of whether the Fed hikes in 2015, (or as likely doesn’t) we know that the pace of the next tightening cycle will be very slow. Indeed as recent activity shows, central banks are still very much in easing mode.

Against that backdrop, we shouldn’t forget that the economic cycle hasn’t ended and at this point, it’s looking more likely that we’ll have another downturn well before rates can be ‘normalised’. A downturn will probably hit even before central banks can build up a decent policy buffer to deal with the next slowdown.

Monetary policy is worthless and ineffective, so printing is and will remain the operation of choice. Smart governments are taking notice and acting to protect the wealth of the nation. Currency is too risky and increasingly worthless and without any change a crisis at some point is a certainty.

Then of course, quantitative easing is inflationary. This is a fact and it’s no different now. The only difference now is how that inflation manifests. So for instance, the only reason inflation hasn’t trickled down into consumer prices during this current bout is because commodity prices have slumped. Contrast that with the pre-GFC period when soaring commodity prices drove consumer price inflation. Yet we do still find inflation -- rampant asset price inflation in the equity, bond and property space. Meanwhile, commodities are driving consumer price disinflation.

Anyway, the point is, and as a particularly prescient investor explained to me some years ago, QE alters the nature of markets and investing. In a high-inflation world, bubbles appear within bubbles -- and can disappear just as quickly. Fashion and rumour dictate trends as much as anything and volatility can be extreme at times.

Some would argue that there is nothing new in this and to a certain extent that is true. But we are only in the early stages of this global QE experiment. It could have a decade or more to run and the volatility of the past may be tame compared to what we can expect going forward. Indeed, central banks warned investors repeatedly last year that they were too complacent. There is a reason for that: think of the volatility that will occur over the next decade or so as central banks cease and then inevitably recommence QE program after QE program. Amid such uncertainty in such a volatile, high inflation world gold will shine bright as the only available safe haven left.