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Gold: trustless, rustless, shiny, and tiny

As the price of gold continues to reach lofty heights, it might be surprising that it has any kind of place in a contrarian investment portfolio. Yet gold-related securities are among the top holdings in our multi-asset Global Real Return Fund. How do we, as bottom-up investors focused on in-depth company research, think about an asset which produces no cash flows? There are two ways we look at it: from a supply-demand standpoint, and versus currencies. Both are informed by gold’s key characteristics: gold is trustless, rustless, shiny, and tiny.

Supply-demand dynamics

We like to view gold from a supply-demand standpoint, as we do for the price of any asset. Here, gold has two qualities that make it different from copper, iron ore, or lithium. The first is that it’s rustless. It doesn’t degrade over time, so all of the world’s gold is still in existence and theoretically available for sale. This means supply and demand is not purely a matter of mines versus consumers. Second, gold is shiny. Its primary function is not as an input to other products, but as jewellery or a store of value. To those like Warren Buffett who call it a valueless pet rock, you have to ask those folks how much they’d pay for a Rolex watch, a Birkin bag, or for a younger crowd, a rare digital outfit on Fortnite. The value of anything is whatever someone else is willing to pay for it. In this regard, gold has been viewed for millennia as the best store of value available to most people. Being rustless and shiny makes gold a really nice pet rock to have around your finger or hidden away for a rainy day.

On the supply side, gold is tiny—that is, it is rare to find in the ground, and getting rarer. The supply of new gold has been slowly dropping over recent decades. Unlike something like lithium, humans have been scouring for gold for centuries, and the most bountiful deposits have been exhausted. Aggregate mine quality has been dropping for a very long time. This translates into higher and higher mining costs, especially with lower ore grade being met by higher labour and energy costs, plus increasing environmental expenses. Miners require a higher price to justify their higher costs.

On the demand side of the equation, while jewellery demand has been fairly constant, gold has long been the first stop in the wealth accumulation process for much of the world. As the emerging world has been growing a middle class, demand for gold has accelerated in recent years. That has been boosted by gold’s fourth quality: it is trustless. Gold is not anyone else’s liability, and that becomes more valuable as trust becomes more scarce. Coincident with the acceleration of populism and a re-bifurcation of the world into East vs West, both nations and individuals feel less trusting. On top of that, the US has weaponised the dollar system against its adversaries, cutting them off from SWIFT payments and freezing their central bank reserves. Unsurprisingly, central banks for adversaries and non-adversaries alike are buying gold, and we expect that to continue. Gold’s trustless quality is becoming more valuable as trust in the US dollar system wanes.

So, from a strictly supply-demand standpoint, the minimum price hurdle has been steadily increasing with lower mine quality and rising costs, and new demand is outstripping new supply and the urge to sell by current holders. So long as mining costs don’t fall and the drivers of mass demand remain, the price of gold should remain well underpinned.

Gold as a currency

The other standpoint is to view gold versus currencies. Many scoff at this perspective, but being trustless, rustless, shiny, and tiny makes gold very currency-like. Its validity as such has been proven over a long time, with its first official use by the Egyptians in 1500 BC. Further, it’s the only currency-like asset that has not been devalued through governmental mismanagement.

It is important to remember that the number of dollars, pounds, euros or rands you see in an account is only worth what others are willing to give you in exchange. Unlike gold, where the supply is essentially fixed, all paper currencies suffer the same frailty—politicians or their appointees control the printing press, and their desire is generally to get re-elected and their time horizon only extends through their tenure. This makes them inclined to print, spend and give away as much as they are able to get away with. Recently that has been a lot!

On the US government’s own forecasts (using assumptions we consider rosy), Federal debt to gross domestic product is set to rise from today’s 100%, to 120% and beyond. Essentially all of the increase is in mandatory programs like pensions and health care. With more debt and ongoing deficits, interest expense creeps up. This year, the US will spend more on interest servicing its debt than it spends on its entire military. Higher interest expense makes deficits worse, necessitating further debt issuance to plug the hole. With more debt comes higher interest expenses, worse deficits, and yet more debt—it can become a spiral.

While every day, the camel appears to be fine under the weight of the straw on its back, the risk that the camel’s back breaks certainly exists, with very significant implications for markets and accumulated wealth. In this light, we currently view holding a decent amount of gold exposure as prudent.

Gaining exposure

The next question is how to get that exposure. We do move the elements that make up the portfolio’s gold exposure around over time. The two investable elements are the commodity itself (through exchange-traded vehicles), and gold-related equities.

Recently we’ve shifted some commodity exposure into the miners after they massively lagged the rising gold price, owing principally to their exposure to labour and fuel costs that inflated faster than the price of gold. This set up the very unusual condition whereby the gold miners’ profits dropped despite the price of gold hitting new records. After taking another deep dive into mining economics and interrogating management teams, we’ve developed increased conviction that the miners now have their costs under control, and should costs merely revert to historic increases, with the price of gold where it is, the likes of Newmont and Barrick Gold stand to potentially produce prodigious amounts of cash flow.

At the time of our big shift into miners in February, this market pessimism translated into double-digit prospective free cash flow yields. Miners have appreciated nicely since, but if gold, copper, and oil prices simply stay where they are, Barrick currently trades at a 7.5% free cash flow yield. That’s a better yield than the average global stock, for a stock that is much less correlated with the rest! Those sorts of valuations look compelling to us, and are why we have exposure to the miners as well as the metal.

Reasons to sell

The remaining question is what would make us sellers, and here, gold is not so different from the other holdings in our multi-asset portfolios. Every security is in a continuous competition for capital. In our view, the most likely cause for us to sell gold will be to free up capital for better opportunities—if equities decline and gold holds up better, for instance, fulfilling its traditional diversifying role. A swing in the pendulum towards increased fiscal responsibility or reduced geopolitical conflict would also swing our views, and could make big swathes of the equity and fixed income universe more compelling on a fundamental view. While we hope for that improvement, it looks unlikely to us today. Gold may just prove to shine brightest when the outlook appears to be dimmest elsewhere.

 

Eric Marais is an Investment Specialist at Orbis Investments, a sponsor of Firstlinks. This article contains general information at a point in time and not personal financial or investment advice. It should not be used as a guide to invest or trade and does not take into account the specific investment objectives or financial situation of any particular person. The Orbis Funds may take a different view depending on facts and circumstances.

For more articles and papers from Orbis, please click here.

 

9 Comments
David
October 28, 2024

This is the last you will hear from me on this topic and I write not just to have the last say. The fundamental issue, as I see it, has nothing to do with gold. In a nutshell, why should our money system be such that it ensures the transfer of wealth from savers to debtors over time. I know it is of enormous benefit to governments who tend to be the largest debtors of all. How is this fair for good economic reasons which only the high priesthood would understand? Does economic theory, especially modern monetary theory dictates that a modern welfare state can only function with that kind of money system? Notwithstanding the inflation, it seems to produce a lot of ups and downs on the way, such as global financial crises and other similar and all too regular events. No wonder they call economics the dismal science, but I suspect the word science is far too generous.
A final note on the sterling silver coinage of Australia. After WW2, the silver coinage was debased to 50%. India received its independence in 1947 and the British empire was no longer. Coincidence surely. Enjoyed our banter, thank you.

CC
October 27, 2024

I read people, including Buffett, continually claim that Gold has no use.
that is completely wrong.
the worldwide jewelry trade is worth Billions. Gold looks beautiful to many people. I'm wearing a gold ring as I write.
plus Gold is an excellent conductor of electricity, virtually as good as copper, and it's also one of the very few metals that does not tarnish, corrode or rust, so gold bonding ( eg in LED displays ) is more reliable and longer lasting than copper. Gold would be used extensively in electronics & other industries if it weren't so expensive.
If gold were much cheaper and available than copper, people might be saying that copper has no use...
Take a look at King Tut's mask after over 3000 years ....

Stephen
October 27, 2024

i agree with Eric Marais that it is good to have gold in your portfolio. i have recently completed a backtest showing the performance of a portfolio 50% invested in the All Ordinaries Accumulation Index and 50% invested in the Global X gold bullion ETF over the last 25 years. The performance of each asset compounded at approximately 9% pa. In five years shares went down but the bullion went up. In five years gold bullion went down but shares went up. The volatility of the combined portfolio was way less than each individual asset, with the worst loss being 4% in calendar 2008. As they say, diversification of negatively correlated assets is a free lunch in the share market. these two assets are the most negatively correlated assets among all major asset classes that I have seen. What surprises me is that the institutions and financial planners largely ignore a decent stake in gold bullion as a diversifier, ie 20% or more. Usually there is a token amount of 5% or so which is ineffective. The excuse is that it doesn't pay an income, but the long term return from gold bullion is about the same as the Ords Accumulation Index. And there is the considerable benefit of the diversification.

David
October 27, 2024

The above sentence "gold was not money" is factually wrong. Since the gold rushes in the mid 19th century, Australia had gold money in regular use. From 1855, the Sydney mint began minting gold sovereigns and half sovereigns. The Melbourne and Perth mints followed, and they continued right up to the early 1930s. These gold coins circulated routinely and widely, not just in Australia, but throughout the British Empire until, following the US ban, they were compulsorily withdrawn in Australia and holders had to surrender them to the Reserve bank. The USA had a beautiful circulating gold coinage dating from the late 18th century, of which they were very proud. the $10 dollar denomination was called the golden eagle, and they had half and quarter eagles, and latterly double eagles, being $20. These contained almost a troy ounce of gold each. The designs featured a representation of liberty on one side and an American eagle on the other.They were certainly gold money and were in regular use till 1933, until they were forcibly confiscated on pain of a ten thousand dollar fine. Paper notes were provided instead. Both the paper and the coins were US dollars and both served as money. Today those same paper notes are worth $20 and are valid currency, but have lost almost all their then buying power. The $20 dollar double eagle coin has about $US 2,700 worth of gold in it, and surviving examples sell at least for their gold value. The legal backing you are referring too, I assume is the Bretton Woods agreement, set up in 1944 at an international conference, which Richard Nixon unilaterally abrogated in 1971. I request that you carefully independently check all the information I have provided and confirm that it is not misinformation.

Economist
October 27, 2024

Minted coins made of gold does not mean the gold itself was money. The coins being minted made them money with a value related to the pound. They could have minted coins made of anything.
The breakdown of that system was for sound economic reasons that I won't go into here.
You can keep trying to.justify your erroneous thinking, but The Wizard of Oz said it all - the yellow brick road leads to a false hope of security and prosperity.

David
October 27, 2024

One point only I would like to comment on. "They could have minted coins made of anything". Throughout history, this has been tried and failed. It is called debasing the currency. The famous British economist, John Maynard Keynes understood this well. When governments had to resort to it, it typically signified weakening of their power. At the height of the power of the Roman empire, good gold and silver coinage was minted and circulated, but by the 3rd century AD, the quality of the coinage fell, with silver plated copper coins replacing solid silver, and gold becoming quite scarce. The fall of the empire was approaching and the barbarians were at the door.

Economist
October 27, 2024

Nonsense David. We have coins that aren't made of anything precious, as do most countries. That fact hasn't caused inflation (or debasement as you call it). It's irrelevant. Like gold.
I'm not going any further down this ridiculous rabbit hole.

David
October 25, 2024

Just to dispel a few myths. The technological advances in gold mining have ensured that the amount of mined gold today has in fact kept pace with the increase in world population. There is the same amount of mined gold per person in the world than there was 100 years ago. This does not mean it is evenly distributed though. Australia has some of the best known reserves going into the future. It still functions as money, even though there are no governments in the world which facilitate its use as such. Even BRICS is not brave enough to do so as a USD alternative. Gold as money was outlawed in 1933 by F.D Roosevelt, because it was too good as money. He wanted bad money (ie worthless paper which would be guaranteed to inflate away to no value, so people would be forced to spend it and not save it) . That"s what we have now. The price of gold is accelerating now because people are fed up with having to trust government, whereas as the author states, you do not have to trust gold, and no one guarantees its value. The new US motto : "In gold we trust".

Economist
October 25, 2024

Disagree. Gold was not money. It was the legal backing for money for a relatively short time, but the US dollar was money.
The comments made here are the usual..misinformation promulgated by gold bugs.

 

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