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Gold Is Expensive, and May Be Just Warming Up

Gold Is Expensive, and May Be Just Warming Up

Friday, 7 August, 2020 - 06:00

As I write, gold has surged to yet another record, topping $2,050 per ounce. Is it overpriced?

The question is impossible to answer. Gold’s value rests in the eye of the beholder, and over recorded human history people have continued to find it beautiful. It pays no income, and its intrinsic value is set by the market. Valuation techniques that work for other assets won’t work for gold.

The fact that we will never scientifically arrive at a “correct” price need not stop us from trying, however. And after going through the various valuation exercises, the rally looks rational. While the current price looks expensive, it could easily rise further.

One way to measure gold is to compare it to other commodities. Back in the 1970s, the oil-price shocks could be seen as a way for petroleum exporters to keep the value of their product constant in gold terms, once the dollar’s peg to the metal had ended. On this basis, gold looks expensive. The ratio of oil to gold, or the amount of metal it would require to buy a barrel of crude, hit its lowest since the peg’s end earlier this year as oil tanked. There has been a rebound since, and a further recovery for oil would help gold, but the shiny metal is plainly not cheap on this basis.

Another possibility is to look at money illusion. The gold price in dollars depends on the value of the currency as much as on the value of the metal. The dollar has weakened sharply in the last few months. But if we look at gold in euro and yen terms, there is more to this than dollar weakness. Gold hit an all-time high against both these currencies last year. It is currently at a record in all three.

Then we come to the issue of inflation. Gold is seen as a store of value. This value will naturally tend to rise when people expect inflation ahead. On this basis as well, gold might initially seem overpriced. The Federal Reserve has received a lot of deserved criticism for its handling of the US economy over the last two decades. But on one important measure, it has been undeniably successful — nobody has ever thought that inflation will take off. The Fed’s target is to keep inflation between 1% and 3%. Since 1998, 10-year inflation expectations derived from the bond market have never exceeded 3%, and have dipped below 1% only very briefly.

Inflation expectations have been rising fast following the Covid shock, which helps explain the rise in gold, but remain at a level that makes an all-time high look hard to justify.

But now we come to the most important influence on gold, which is the real yield available on bonds. Gold doesn't pay an income, and this becomes less and less of a problem as bonds pay less in real terms. At present, real 10-year yields are more negative than they have been since inflation-linked bonds became widely available. One crucial development of the last year is that the US has joined Germany in having very negative real yields (which presages a weaker dollar, as well as higher gold prices).

Real yields form the backbone of one of the most interesting models of “fair value” for gold, produced by City of London veteran Charles Morris, the founder of The model is essentially a zero-coupon 20-year Treasury inflation-protected security, or TIPS, and thus rises as long-term real yields fall. In brief summary, the factors included are:

Major factors:

1. Realized inflation

2. Real interest rates (20-year expected)

3. Speculative premium/discount

Minor factors:

1. US dollar (consequence rather than cause)

2. Central banks, wars, bad news

3. Jewelry demand (counter cyclical)

4. Mine supply

The key points are that fair value has risen sharply to reach its previous record in recent weeks, and that the actual price is significantly higher. The premium as of early trading Aug. 5 was 23.7%.

The point for a trader is that when gold is in a bull market, it has shown a propensity to move even further above fair value. So gold is expensive, but it is still significantly less expensive than at the previous peak in late 2011.

For those wanting to play the dangerous game of predicting a speculative surge, Morris offers another important data point. Equity bull markets tend to peak when retail investors are sucked in, a process that appears to be happening for stocks. The same was true for gold during its massive peak in real terms in 1980, when news bulletins were full of footage of people happily emerging from shops having converted their life savings to a small pile of gold sovereigns (transactions that would have taken decades to work out), and again in 2011 when the weight of gold-buying through exchange-traded funds reached a high. This rally has plainly been fueled by something other than ETF-buying.

The bullish scenario is that central banks keep doing what they’re doing. squashing real yields ever lower, and continuing to raise the fair value for gold. Then inflation at last begins to come untethered and rise toward or even above its upper 3% target (which is conceivable but still some years away). And then retail buyers enter in a big way. A while after this, gold would probably go splat, but the ride to get there would be lucrative.

The risks would come in a change of central-bank behavior — just as the last gold peak turned into a bear market once the Fed started to try to move away from its unlimited asset purchases. Such a change looks less likely this time. Gold does look expensive then, but there is little reason to expect it to fall much anytime soon.

Some good news on the coronavirus. The Sun Belt’s single scariest Covid-19 outbreak came in Arizona, where the state health department’s website added to confusion by adopting a very conservative policy over when to add new cases and hospitalizations to its running totals. The single most useful data it offers are the number of positive or suspected Covid patients in hospital. As physicians know how to recognize Covid symptoms these days without waiting a week for test results, this is the best real-time indicator. And it is obvious that the virus is now coming under control.

Meanwhile, cases are worryingly on the rise in the upper Midwest and the virus is showing signs of establishing itself in rural areas.

Rather than focusing on cases in the Sun Belt, I suspect we need to get used to looking at some new charts. First, and very hopefully, far fewer people are dying of Covid-19. Will this continue, or will deaths begin to rise as patients in the Sun Belt who have been hospitalized for weeks finally succumb? If deaths in Florida and Texas, two states in focus because their Republican governors made a big deal of reopening their economies, stay at current levels, it will suggest that risks are more manageable than had been thought.

Beyond the US, developments in Europe are of growing importance. Spain and Greece, two Mediterranean countries with huge tourism industries, have had differing experiences to date. Greece largely avoided Covid-19 while Spain had one of the world’s worst outbreaks. But attempts to reopen for tourism have seen daily new cases rise to a fresh high in Greece, and also increase in Spain. These are worrying developments. It begins to look as though we cannot rely on the coronavirus to stay stamped out. It also looks as though it is proving too early to reopen for tourism, so prospects for a return to other forms of travel look grim.

If lockdowns won’t make the disease go away, and medicine cannot eradicate the harm done (which it cannot), then two options lie ahead to return us to normality. One is the prospect of “herd immunity,” where enough people have the disease and develop immunity that it can no longer spread; the other is in a vaccine.

It is possible that the Sun Belt states have unwittingly adopted a “herd immunity” strategy. But the most interesting test will be in Sweden, the one significant developed economy that deliberately eschewed lockdowns in favor of attempting to build herd immunity. Denmark, joined to Sweden by a bridge, provides a natural comparison. It went through a strict lockdown. Until now, this doesn’t appear to have helped Sweden much economically. But it should be well positioned for herd immunity.

So what of the vaccine? There is intense interest in the numerous different attempts to develop one. The looming issue is that it may prove impossible to get enough people to take a shot. A recent poll in Canada found that a third of Canadians would wait, and try to make sure there were no side effects. In the US, a Politico/Morning Consult poll found 64% of Americans saying they were prepared to wait and wanted developers to take their time. In the UK, a poll by YouGov found about 6% of Britons would definitely not get vaccinated, while 10% would “probably not,” and 15% weren’t sure.

Such levels of hesitancy are far too high for the pandemic to be eradicated, even if an effective vaccine with minimal side effects can be found. The notion that the hunt will have a binary outcome, with a successful vaccine meaning the end of Covid-19, is wrong. Distrust of the vaccine, of the profits that the manufacturers could make, and the speed with which they are working, is even more prevalent than the coronavirus. This isn't great cause for confidence.


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