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  • Author : Haydn Ellwood
  • Date : April 2011
ABOUT THE AUTHOR: Haydn Ellwood is Director, Yellow Capital

At USD1,380 an ounce there is definitely something toxic brewing in the financial world. If gold is real money, and a safe-haven (reserve) asset that measures the devaluation of fiat money, then at its current rate of appreciation something ‘stinks’.

I believe that recently the gold price has not only been driven by the competitive global currency devaluation by governments, but also by the fact that the Central Bank Gold Agreement (The Washington Agreement), which ended in September 2008 (at the time of the credit crisis), has led to central banks becoming net purchasers of gold bullion. The reason for their buying includes the heightened currency instability, huge sovereign deficits and the all-time-high gold price.

I also believe that central banks are also now competing for physical bullion with Sovereign Wealth Funds via or perhaps with Exchange Traded Funds (ETFs) and ETFs themselves (the general public) directly. ETFs have swollen all around the world, including the US, UK, South Africa, Europe and Australia, since they were launched – which to my mind proves that gold is still considered real money and carries what many pundits call ‘gold’s stateless money franchise’. This means gold is considered the ultimate medium of exchange in any country or state rather than paper money being a sovereign right to legal tender.

Centralised monetisation

This redirection of gold away from central banks is what a well-known fund manager once called ‘the privatisation of central bank gold reserves’.

Central banks still hold roughly 30 per cent of all the gold stock in the world. Therefore, should they start off-loading their gold reserves as they did in the 1980s it would create an over-supply and a severe fall in price. For people with gold in their portfolio this is possibly the worst short-term scenario, it is highly unlikely the central banks will sell their gold while the price is soaring and looking as if it is set to continue to rise.

I think the balance of power is shifting away from centralised monetisation, and, in time to come, I believe governments and central banks will not be in a position to ‘fool all the people all the time’ by printing money or simply creating credit out of thin air. All that money creation does is to raise the price level of goods and services, which effectively makes the public poorer. This system cannot continue without larger financial collapses, world economic instability and the disequilibrium that continues to perpetuate poverty and unemployment.

Keynesian advocates would argue the opposite no doubt. But here is an easy example that proves their theory is wrong. According to Lord Keynes and his followers:

  • a nominal increase in GDP represents growth;
  • printing money increases nominal GDP; and therefore
  • printing money must generate growth.

Keynesians would argue that business activity has been stimulated, jobs have been created and the economy has benefited. Keynes also famously advocated burying newly printed money and paying people to dig it up as a way to stimulate the economy. Without exposing my political preference, I can think of at least one party who seem to advocate this principle.

Gold standard

Being a staunch believer in a return to a system where our paper money is backed by a physical metal, either gold or silver, I cannot see a return to the classic gold standard; however, there may be a scenario where we return to a gold exchange standard.

Under this system, gold would once again become the numerator in the international monetary system and foreign treasuries would retain the right to oblige other countries, and in particular the US, to settle its accounts in gold rather than in dollars. This is what the French President Charles de Gaulle called the US’s ‘exorbitant privilege’ of being as fortunate as to settling its foreign debts in dollars (that it merely prints at will). This is what has come to be known as the ‘deficit without tears’, or America’s currency and everyone else’s problem.

My fear is that the majority of wealth managers, family offices and other investment managers believe that the USD is still ‘as good as gold’ and continue to purchase low-yielding US T-Bills and Bonds rather than gold or gold-related investments as a safe haven insurance to park client money.

Gold is money and the underlying asset of paper money – paper money is a derivative of gold. Gold is an insurance against the collapse of paper money, hyperinflation or severe currency devaluation.

Too often I hear about investment managers who don’t own gold because they don’t understand it or they can’t value it. Their problem about not understanding gold is inexcusable in my mind, because history and economic history is freely available and not too difficult to understand. On their argument of not being able to value it, I respond by saying that if you don’t know the history of gold then you probably won’t know that it is not something that you value like other investments.

The first principle to remember is that gold is not an asset in the traditional sense. It does not pay a dividend or coupon, and if you were to be discounting future cash flows to find a present value for gold, you would have a difficult time.

It is impossible to put an exact value on anything, let alone gold. Price is a function of supply and demand and if there are more buyers than sellers then the price of ‘x’ will increase. With this basic economic principle in mind – and the knowledge of the factual phenomenon that when real interest rates are negative, an ideal situation for gold and for hard assets occurs – it becomes easier to understand why you want to own gold. It is a macro-economic investment principle rather than a basic valuation metric. Other more noticeable economic factors include mine supply shortage and bottlenecks, and increasing demand from the Far East, India and other countries both through central bank intervention and retail jewellery.

Gold is money. Paper money is a promise to pay ‘the bearer’ on demand a weight of gold equal to the sum quoted on the note he is bearing – at least it was in the days of the gold standard. This changed absolutely in the 1970s when President Richard Nixon finally removed the link between the USD and gold; and as the USD was the world’s reserve currency it made it official in all currencies. The UK had abolished the metallic standard a long time before that.

So many people are oblivious to the origin of the name Pound Sterling. A ‘pound’ as we know it stems from the note being redeemable for a ‘pound’ of silver (sterling), hence the name Pound Sterling. In fact all currency names started out as measures of the weight of either gold or silver. All countries used a metallic standard as a standard of exchange measurement.

From our reasoning that gold is money (real money) and acts as the underlying asset of paper money, it would be reasonable to expect gold to perform well during times of heightened uncertainty with paper money, or the governments who print the ‘paper money’ and promise to pay on demand the same value as quoted on the note. But what about the physical reality of what this note can actually buy you in the open market? Last year, a ‘pound’ bought you ‘x’, this year it buys you ‘x-5 per cent’ resulting in you having to either (a) find higher wages or (b) reduce existing expenditure to accommodate for the rise in ‘x’. This to me is a form of theft. This inflationary force is not created by ‘x’ increasing in its own right, it is merely a function of the ‘pound’ reducing in value versus ‘x’ and this goes for all forms of product or service. The value of the ‘pound’ can only be reduced in any great measure by the increased supply of available ‘pounds’ on the market. This was discussed earlier in our basic economic principle regarding supply and demand.

Insurance policy

This article has covered various topics about gold from its history, the theory of money and some related thinking about gold. To bring together the various issues discussed into a point of reference for money managers or anyone in a fiduciary position, I would strongly recommend considering gold’s function as a store of wealth and, more specifically, as an insurance policy against financial collapse or as a hedge against tail risk.

Additional risk management reasons to include gold into an investment portfolio include the following:

  • gold has excellent diversification qualities;
  • gold reduces systemic risk;
  • gold is extremely liquid (essentially in times of financial turmoil);
  • gold has no credit or counterparty risk;
  • a gold allocation of between 2 per cent and 10 per cent can produce ‘optimality’ in a portfolio mix; and
  • gold tends to have little correlation with other asset classes.

Anyone acting as a trustee for a long-dated trust, such as a pension or endowment fund, seriously needs to consider the benefit of incorporating gold into the portfolio. A serious discussion needs to be had with the investment manager or advisor and to challenge any dismissal of the concept. I have recently attended such a meeting and was absolutely shocked to learn that the pension fund in question had no exposure to gold, but had nearly 15 per cent exposure to ‘alternative’ strategies run by hedge funds. Needless to say, alternative hedging and absolute ‘theory’ are only good for as long as the strategy/opportunity exists or the fund manager gets it right.


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