Ichiro Suzuki
Gold price is rising. Since the middle of February, it rose 20% in the next two months, hitting $2,400 in mid April. An upward momentum on gold this time is uncharacteristic since it tends to rise amid the dollar’s strength in recent decades. Gold’s first historic rally was ignited in 1971 when President Richard Nixon decided to break the convertibility between gold and the dollar, which became overvalued, sending the greenback into a tailspin against the world’s major currencies as well as gold. In the latter half of the 1970s, even a so-called ‘dollar crisis’ had emerged. Since that time, shelf life of the dollar as a reserve currency has been a topic that comes up in the financial market once in a while.
The 1970s was also characterized by run-away inflation, as a result of lax fiscal policies around the world, which included expansion of social securities and the Vietnam War. A supply shock was added to such a macro economic environment when oil producing countries in the Middle East formed a cartel (OPEC) and raised crude prices dramatically. Since then, inflation expectations have been under control but COVID-19 has revived them through disruptions in global supply chains. Resurgent inflation in the 2020s, however, is nothing compared to the one half a century ago. Nonetheless, it is still an inflation that hasn’t been seen for a few decades, problematic enough to drive investors to buy gold. Under the normal circumstances, a strong dollar suppresses inflation through lower import prices. But this time around, supply chain disruptions have made a radical change on inflation expectations.
For Chinese households gold presents a rare window to the international financial markets. Both real estate and equity markets in China have been in despairing conditions in recent years, as the Communist Party drove real estate prices to the point it could only go south. Worse, the CCP enforces tight capital controls on China, making it extremely hard for average Chinese households to let their wealth leave the country. Wealthy segments of the population nonetheless are making every effort successfully to land their financial assets in houses in the developed world, or more recently in Japanese stocks. While such moves are beyond the scope of the vast majority of Chinese households, a window for gold is still open to them. So why not buying it? Gold ETFs sold in China are commanding a 30% premium over its net asset value, for those who don’t buy into gold itself.
Aside from such macro economic developments, gold’s run-up in recent years has been attributed to central banks’ buying spree. Among them, the People’s Bank of China has been a very aggressive buyer, it has been reported. China has been vocal on the status of the U.S. dollar as a reserve currency. China has ceded the position of the top holder to U.S. Treasury securities to Japan. Since China’s current account continues to be healthy, surpluses have to be parked in some assets, with U.S. Treasury securities as the most convenient asset to serve such function. But China has a dream of dethroning the U.S. dollar as the world’s reserve currency, hoping to replace it with its own renminbi. China, therefore, is only a reluctant buyer of T-notes and bonds. On top of it, recent geopolitical developments drove the U.S. to weaponization of the dollar, by not allowing the greenback to be used in international transactions or freezing assets held in the dollar. For the sake of the freedom of not nodding to the U.S., shifting the country’s foreign exchange reserves away from the U.S. dollar makes sense. Gold is a good asset to pick up the slack left by the sale of Treasury securities. The Global South in general follow the suit of China, as an anti-America camp.
Here’s a catch, however. The market for gold is way too small to accommodate China’s assets and ambition. At an estimated 2.5 to 3 trillion dollars, the global gold market doesn’t even match equity market capitalization of Microsoft, the world’s largest corporation. By directing its growing assets to a precious metal of a tiny market size, China and the Global South are driving its price up. The move obviously pleases Chinese households, but taking it too far up would make it too expensive relative to other assets, to be followed by corrections. It might already be much overvalued, rising in circumstances that are traditionally against gold. Distorted valuation might work against it in the long run. The next Fed’s rate cut cycle could fail to lift gold higher, at least not much higher, contrary to what usually happens, since it has run. Worse, an unforeseen macro economic upheavals might force the Global South to dump their gold holdings. Developing countries in general have hardly been known for their prowess to manage the economy. Forced selling in a thin market could send gold into a tailspin, as it can happen to any asset.
Is gold the ultimate store of value, especially as opposed to bonds and stocks in the U.S.? Gold is considered better than bonds that get crushed by inflation. Stocks suffer a severe correction once every few years and very severe one every few decades but bounce back eventually and are capable of rising, too, amid inflation. Unlike bonds and stocks, however, gold along with other commodities, pays no interest or dividends, and costs some money to store. Interest and dividends constitute a very meaningful component of returns from bonds and stocks, especially if they are held for a long time. Without an income component, gold has to rely solely on appreciation of its price for return. Absence of income makes gold less stable than it looks on the surface. The Dow Jones Industrial Average closed at 856 on Friday, August 13, 1971, on the eve of President Nixon’s announcement that shocked the world. Since then, gold rose to 2,400 way up from 35, for a 68 fold ascent and for an annualized return of 8.3%. The Dow traded at around 38,000 in mid-April for a 44 fold gain and a 7.4% annualized return. The Dow’s number, however, is without dividends that averaged over 2% for over half a century, which are more than enough to compensate for ‘weaker’ price appreciation than gold. The 1970s is still remembered as a horrible decade for equity investing. The Dow hit the historic 1,000 mark in 1972 and was still there ten years later, having suffered 50% correction after hitting 1,000. While inflation is generally considered positive for stocks, fears of deteriorating earnings quality caused by inflation held back stocks in the 1970s. (This suffering is considered as a very isolated experience, probably not to be repeated again. Inflation today simply isn’t comparable to surging prices in the 1970s.) Then the stock market took off in the 1980s as inflation was conquered, and the rest is history. Worship of gold might had better be reevaluated. Gold offers attributes that locate somewhere in between bonds and stocks. The former are relatively stable but vulnerable to inflation while the latter are more volatile than gold and offer higher returns with income streams that reduce volatility. On top of it, gold is a lot less liquid than bonds or stocks. China and the Global South are buying gold for political reasons but total disregard of investment logic could cost them in the long run.
About the author: Mr. Suzuki is a retired investment banker based in Tokyo, Japan.
