Why gold exposure is desirable during periods of financial repression

In 1971 President Nixon closed the ‘gold window’ by executive order ending the convertibility of the US dollar into gold. This move was predominantly in response to the increasing imbalance in international trade and payments and the mounting pressure on US gold reserves. The fixed exchange rate system established under the Bretton Woods Agreement relied on the convertibility of US dollars to gold at a fixed rate. By closing the ‘gold window’ the link was broken and this, along with other economic and political challenges, led to a loss in confidence in the system. The absence of a reliable anchor for international currencies ultimately led to the breakdown of the Bretton Woods system in 1973 and the global monetary system shifted to floating exchange rates.
 

Gold price post Bretton Woods

In the aftermath the price of gold experienced significant volatility and increased substantially. In this new paradigm all countries had ‘fiat’ currencies with no explicit linkage to a physical asset such as gold. As a result, the demand for gold as a hedge against currency fluctuations surged. The 1970s was also a period of geopolitical tensions, oil crises and increased inflationary pressures, all of which helped to fuel this sharp increase in the gold price. In 1971, when the US closed ’the gold window’, the price of gold was around $40 per oz. By 1980 it had reached a record high of over $800 per oz. 

The gold price was relatively stable for a period, referred to as the Great Moderation, from the mid 1980s through to the mid 2000s. This was due to a more stable economic environment which saw tighter monetary policies to combat inflation which in turn helped to stabilise the value of currencies and thus reduced some of the volatility in financial markets. The 1980s was, broadly speaking, a period of improved economic conditions which also meant that gold, as a potential risk-off or safe-haven asset was in less demand. The US dollar strengthened during this period, making gold relatively more expensive for holders of other currencies. The Great Moderation came to an end around the time of the global financial crisis (GFC) of 2007-2008 which exposed vulnerabilities in the financial system and led to a more turbulent period for financial markets and resurrected gold’s popularity as a safe-haven asset. 
 

Gold as a store of wealth

So why do I believe is exposure to gold desirable in the current environment? Gold is effectively a store of wealth. Consider that post Nixon closing the ‘gold window’, the dollar has lost circa 98% of its value versus gold because we live in a ‘fiat’ age where the money supply has been inexorably increasing. Managing the delicate balance of controlling inflation whilst not damaging growth is an unenviable task.  

The chart above shows that overall Total Global Debt has been falling but not as a result of paying debt back, rather it has been falling because inflation has been soaring and therefore nominal GDP growth has been strong. This positive effect of inflation has allowed economies to de-lever. It could therefore be that we are in a period where inflation is used to reduce the real value of debt outstanding. The flip-side of this, of course, is that it reduces the value of the underlying currency. But currencies are a relative game, one versus another, unless they are valued against something immutable like gold. Another way of asking this is, what do indebted developed economies do to get their debt to GDP ratio down? The answer is that they need a period of negative real rates, that is where the nominal rate minus the rate of inflation is negative. This process is known as financial repression.

Over the past year the traditional inverse relationship between the gold price and long-term real rates has not always held true due to other factors, for example when Russia invaded Ukraine in February and March 2022. The relationship broke down over that period but re-emerged as real yields continued to rise as the US Federal Reserve (US Fed) was more hawkish. This has put some downward pressure on the gold price. There will also always potentially be other factors influencing the gold price like exchange-traded products and central bank purchases which have been more prevalent in recent months, particularly in emerging markets. But don’t let these other factors be a distraction to what is happening to real yields at the moment which are the predominant factor overall. If you think that the US Fed and other central banks will start to pivot later this year and into next as economies weaken and rate rises cease, or even reverse, then that is likely to be bullish for the gold price. When will this happen, one cannot say. 

The difficulty is that the market uses real rates when valuing gold and furthermore the market’s long term expectations of inflation when assessing the current/nearer-term situation. Whether one looks at 10 year Treasury Inflation Protected Security (TIPS) or the nominal 10 year Treasury equivalent less the US 5-year 5-year inflation swap rate, you’re taking a view through the economic cycle, not just a snapshot of where we are in it. The short term obviously has influence, but this is the reason why inflation doesn’t necessarily move the gold price in the short term. This is also why it is important as to whether the Fed pivots before or after core inflation is actually under control, and again this is going to be a subjective judgement because even if it looks like it is under control it might not be.  

Against this economic backdrop, I firmly believe that some exposure to gold in one’s portfolio is a sensible potential diversifier for other idiosyncratic risks, and I have therefore chosen a selection of large, blue chip gold mining companies, diversified across geographies and assets, to gain this exposure.
 

The macro backdrop should be supportive of the gold price

The portfolio has three holdings that provide this diversified exposure. Barrick Gold and Agnico Eagle Mines, which are gold ‘producers’, and Wheaton Precious Metals which is a ‘streaming' company. Rather than mining gold itself, Wheaton buys gold output from industrial miners where gold is produced as a by-product in the production of other metals such as copper. The nature of streaming companies is different to the producers in that they have different cost dynamics. Over the past year, one of the advantages of the streaming model is the fact that they haven’t been as exposed to the same cost inflation pressures that the producers have, therefore their margins have been better protected. Meanwhile, over the past year the producers have had to suffer the exposure to a gold price which hasn’t moved in step with the rising costs of production. As a result, the producers have been caught in a margin ‘pincer’. As headline inflation starts to decline and we start to see deflation in some of the consumable areas of the miner’s cost base, we will likely see rates fall too which should be positive for the gold price moving up. At that point we may be in a position where we see that pincer start to work the other way (opening jaws). In this environment the gold producers would have the potential to perform well. 

We have compared the valuations of these three companies at the current gold price and if gold were to rise to $2,500 per oz. We have looked specifically at the potential leverage of the cashflows and NAV at higher gold prices noting that this would also have a positive impact on the dividend paying potential of these companies. We believe that over the medium term, the macro backdrop (financial repression ie. real rates returning to negative territory) should be supportive of the gold price and therefore beneficial to these three large gold-producing and streaming companies, thus justifying their position in the portfolio, both from a valuation perspective and for the added risk diversification.