Many investors, seeking to protect their portfolio from inflation and market downturns, have historically believed gold to be their best option. Gold is easier to access than ever before and a lot of investors have been pleased with its performance over the past few years. Some investors may be currently considering the investment as they expect gold’s recent performance to continue. After acknowledging that the geopolitical uncertainty and inflation we have seen in the past few years have been uniquely suited to gold, we’re of the opinion that it’s not a great long-term investment. If you’re an investor who’s made money on gold in the past year or so, we think you should take those gains while you can and recycle them into your broader portfolio.
Gold’s utility as a diversifier and inflationary hedge is high, but in a normalized economic environment it’s a lot less convincing. It’s a purely speculative holding without a lot of economic value. Prices are down to simple supply and demand dynamics, and there’s not a single nation that uses the gold standard for their monetary system.
Today’s PCE reading reinforces our view. Inflation increasingly looks like it’s coming down in a sustainable way. As inflation diminishes, so too does the outlook for inflation hedges like precious metals.
BIRMINGHAM, ENGLAND – DECEMBER 13: A jewellery quarter gold dealer poses with three 1kg gold bullion … [+]
Brief History of Gold
To create an efficient foreign exchange system after World War II, 44 countries congregated together to create the Bretton Woods Agreement. The agreement pegged the dollar to gold, and foreign currencies would be pegged to the US dollar. This series of events set the stage for the dollar to become the global reserve currency, and allowed for the creation of the International Monetary Fund (IMF) and the World Bank. The dollar became the world’s reserve currency as global central banks held it to maintain their currency pegs and US support helped to rebuild Europe in the post war era. International trade flourished and grew as economies globally began to modernize. However, the fixed exchange rate system could not last forever. The US was unable to maintain sufficient gold reserves and eventually the system needed to be scrapped.
It was inevitable – you can’t have different countries all playing by the same rules when it comes to trade flows and currency management. Floating exchange rates became the new norm after President Nixon effectively ended the Bretton Woods Agreement by suspending the dollar’s convertibility into gold. Market forces then began to determine what one country would pay for another country’s currency.
As such, gold had been held at an artificially low price when the dollar was pegged to it, and the establishment of fiat currency meant gold’s price was able to normalize. Subsequent price increases made it an attractive investment option. Since then, it’s become primarily utilized as a portfolio hedging tool, a stable investment used to protect against economic volatility or inflationary impulses.
Gold is Not a Long-Term Investment Despite Recent Performance
The primary argument against gold is that it lacks any sort of economic utility. Fundamentally there’s no cash flow or business to value, there’s no coupon payment or dividend. A fundamental analysis would mark it down as essentially worthless.
Obviously, that’s an extreme way to value it, but even when look at it from a simple scarcity perspective, gold still doesn’t necessarily shine the brightest. A common argument for why gold is valuable is that there’s a limited supply and it’s immutable. Yes, a small quantity gets mined every year, but on the whole there’s a limited supply and we can’t make it out of anything else. Because it’s fixed in quantity, it therefore has value.
But consider this – isn’t the number of shares that an establish company has issued also limited? And if the company has significant competitive advantages, isn’t it also more or less irreplaceable? Obviously companies rise and fall over time, but the market as a whole grows and new companies rise to replace the old ones. These companies not only offer capital appreciation – they go up in value much the same was as any precious commodity – they also have the capacity to provide investors with returns of capital via dividends or stock buybacks. It’s no surprise that the S&P 500 has outperformed gold over the past two decades.
Now, to be totally fair, gold has outperformed the market over some smaller time periods. Where gold has a potential advantage over stocks is in an inflationary environment or during times of significant volatility. The Russian invasion of Ukraine, turmoil in the Middle East, inflation coming out of the Covid pandemic – there are situations where you can point to commodities and precious metals and say they provide a degree of portfolio protection. In these time periods companies are fundamentally grappling with a shift in their input prices and their selling prices – inflation hurts companies over the short term whereas gold is generally stable. Its limited nature reacts to inflation and the value goes up. But over time companies figure out their input costs and raise selling prices. They stabilize and resume their growth.
Today we are at that inflection point. Companies have stabilized. The economy is normalizing. It’s time to take the inflation hedge off the table and pivot back into cash flowing assets like stocks or bonds. The June PCE print supports this perspective. Prices are stabilizing, forward looking rent data is favorable for inflation, and the formerly hot economy appears to be normalizing. Interest rate cuts appear to be on the horizon and labor markets still look healthy. This isn’t the environment to be adding inflation hedges!
Finally, we also have to address the view of gold as a long term hedge against a collapse in the dollar or a true societal breakdown. We would dismiss this perspective – if the systems by which we all transact in the modern economy actually break down, we don’t think gold or anything else is really going to be able to get you much. System collapse isn’t an investment thesis.
The wiring train plying copper cable to the overhead in Tring Cutting during the West Coast Main … [+]
Alternative Investments to Gold
Gold has potential utility during bouts of inflation, but that’s also true of commodities more broadly. We’d rather prefer owning a broader commodity basket with more industrial applications to protect against inflation. To do that, you’re either investing in commodities directly via futures markets, or you’re investing in companies that work with commodities as their primary inputs or outputs. We prefer the later, prioritizing cash flows and real business potential over simply speculating on raw commodity prices.
If you do want to have commodity exposure, and you would like to be invested in companies that have real earnings, we would suggest looking at companies involved in high demand industries with substantial long-term tailwinds. For example, the push for infrastructure construction in the United States has a few themes that we think are durable. In particular, the drive to upgrade the national grid and build new power support infrastructure for AI data centers is going to require a substantial amount of copper, aluminum, and steel. Copper in particular looks intriguing provided the global need to build out power infrastructure and limited new mines coming online in the next few years. Companies like Freeport McMoRan could benefit from copper market tailwinds.
Similarly, the renewed cash flow discipline in the oil and gas industry has made companies like Exxon or Chevron substantially more attractive. They provide operational excellence across integrated businesses and are committed to returning capital to shareholders when commodity prices rise and they create excess profits.
It’s important to highlight here that we would not suggest investing in companies who mine gold as an alternative to gold. While we don’t believe gold is necessarily a great choice as an investment, we acknowledge its simplicity and potential utility during bouts of inflation. Gold miners add a significant degree of complexity to the investment equation and often underperform through inflationary environments, counterintuitive as that might be. Mining is an inherently capital intensive business – equipment and property are expensive, and typically mining companies carry significant debt on their balance sheets. Thus, while inflation boosts gold prices, the subsequent rate hikes negatively impact the cost of operating a mining company.