This article is based on the keynote speech delivered by Robert Armstrong at the LBMA/LPPM Global Precious Metals Conference on 15 October 2024.
Since the outbreak of the pandemic in 2020, we’ve seen an economic cycle which is historically unique, accompanied by monetary and fiscal action that is also unprecedented. In short, COVID-19 massively changed the volume and uses of money globally.
Now, I don’t think gold is money, but as a store of value, gold is always going to be connected to changes in money. And the big change in money has led, after a period of delay, to a furious rally in the price of gold that began in autumn 2023, during which gold’s value quickly rose by 50%, a spike we’ve only seen anything like in the years immediately surrounding the great financial crisis.
Shining a Light on Gold Scepticism
As someone who has been sceptical about gold as a financial asset, in the past few years I’ve begun to rethink this sceptical stance. The first thing that helped me is that the way I learned to think about the valuation of financial assets has not worked in recent years. I was taught that asset valuations revert to a stable mean set by fundamentals, which hasn’t happened in a long time. All we’ve seen in financial markets is cheap things get cheaper, and expensive things get more expensive.
This has led people in finance to think more seriously about another way to consider financial assets, starting with supply and demand instead of fundamentals, specifically for cash and liquidity. This alternative view of valuation gained popularity when the Fed and the Treasury pumped a huge amount of money into the financial system and, at the same time, stock prices rose dramatically.
The core idea here is that, as liquidity in the system rises, investors decide they have too much cash on their balance sheets and desperately try to swap it out for other assets that have some possibility of gain. Of course, at the systemic level, you can’t get rid of the cash. All that can happen is that it gets shuffled from one balance sheet to another. But the attempt to get out of cash and into other assets drives asset prices up. That’s the velocity of money in the financial system.
The problem with this approach is that liquidity, unlike fundamentals like cash flow or earnings, is hard to measure or define, and harder to track. Like all correlations in finance, the link between higher liquidity and asset prices is messy, and it changes over time. But the theory does give us a more sympathetic way of thinking about gold and other assets that do not generate cash flow.
My second reason for rethinking my gold scepticism is the simplest and most appealing of all: gold has gone up a lot, and at a moment when it is supposed to go up. Gold often shines through against human folly, monetary madness and fiscal dysentery, just like we were promised that it would.
Does this heroic view of gold hold up to scrutiny, though? Let’s look at the following five propositions we hear about gold, consider historical and more recent data, and see if these propositions still hold true:
As someone who has been sceptical about gold as a financial asset, in the past few years I’ve begun to rethink this sceptical stance. I was taught that asset valuations revert to a stable mean set by fundamentals, which hasn’t happened in a long time.
‘Gold is a hedge against inflation and government money printing’
It’s pretty well understood that this claim about inflation in gold is conditional. It’s high inflation that gold guards against. Goldman Sachs analysts recently wrote that gold “typically only guards against very high inflation and large inflation surprises caused by losses in central bank credibility and geopolitical supply shocks. Gold usually didn’t perform well in response to positive demand shocks when the central bank responded swiftly by hiking rates”.
But over the long run, it is also true that gold has held its value well against inflation and the expansion in the money supply. The CIP index in America has (approximately) tripled since 1984; gold is seven or eightfold. The M2 US money supply is a little higher than that but, of course, the money supply has to grow with the economy and so forth.
An important piece of context to note is that there are very long periods in which gold has not protected investors from inflation. In the horrifying years of 1984-2004, for example, gold was not a hedge against inflation even as the money supply increased.
Gold has performed particularly well since the beginning of the pandemic, but let us note the pattern of performance. Right after the pandemic, gold rose 20%-25% very quickly as money was poured into the system by the Fed and other central banks. But it then went sideways while CPI inflation was rising and the money supply was going crazy, and has only recently spiked again.
My question to you is: why did gold wait? What happened in the middle? What was gold ‘thinking’ about at that time? By the time gold started to rally again in autumn 2023, the federal funds rate was already at its peak, Fed liquidity provision through quantitative easing and other facilities had been flat to down for two years, the money supply had peaked and started to decline, and CPI inflation had been falling for over a year.
‘Gold’s value is inversely correlated with real interest rates, which are the opportunity cost of holding it’
Another interesting consequence of the timing in the rally of gold has been for its inverse relationship with real interest rates, which has been reasonably consistent since the financial crisis, but seems to have either reversed or disappeared. It was only after the opportunity cost of owning gold began to rise rapidly that gold really found its mojo.
‘Gold strengthens as the dollar weakens’
The dollar and gold are almost always inversely correlated, as gold is priced in dollars, and both gold and the dollar are linked to US interest rates. But, during H1 2024, gold and the dollar rose in tandem. The relationship has since normalised, but this break from the usual pattern is very striking.
‘Gold is a hedge in times of market chaos’
Gold does really well when risk markets do really badly. Throughout history’s most monetarily uncertain periods, gold is the outstanding asset. I would argue that the reason we own gold is that it allows you to rebalance when bad things happen.
However, it is interesting to note that, even while gold outperformed stocks and bonds in 2022, the period when the market was adjusting to the fact that inflation was perhaps not transitory and higher rates were on the way, it fell in absolute terms. Perhaps it was anticipating higher real rates to come, but when real rates rose, it shot up. Was it anticipating something else? Why wasn’t it better in 2022 when you’d hope gold would shine?
‘Gold miners are a leveraged play on the gold price’
There has been a lot of talk about how gold mining performance has been quite poor relative to the price of gold recently. But this trend is not that recent. Ever since the financial crisis, gold mining equities have risen with gold when gold is rising, but trail gold badly when the price is falling.
A couple of things are clear: there’s a lot of investor scepticism about capital allocation among miners generally, and a lot of scepticism about gold miners specifically and their capital allocation choices. Value stocks have generally fallen out of favour with investors, and there is something about owning the metal gold through the increasingly popular ETFs that a hedge-seeking investor simply prefers to owning a gold miner. This unhappy relationship, unlike the others, has held since the pandemic began.
What Is Different About This Gold Rally?
Despite these five propositions, it seems pretty clear that the big rally in gold, at least the one that began in autumn 2023, has a different character than the other rallies in recent decades. Gold did not respond to inflation and the expanding money supply until both grew. Gold’s traditional relationship with real rates and, for a while, the dollar reversed, and gold did not rise.
A possible explanation for the change in relationship between gold and other financial assets is the de-dollarisation at work. In particular, central banks have increased gold buying, changing the relationship between gold supply and demand.
Maybe part of the issue is that people trust and have more faith in central bankers than they once did. It is a striking fact that, during the recent worldwide inflationary episode, medium and long-term inflation expectations rose only briefly. This suggests that people believed central bankers would eventually get inflation under control, and that people trusted central bankers now in a way they maybe didn’t in the 80s or 70s. If that’s true, it’s surely the case that gold is going to behave differently than it did before.
Another explanation is that we live in a world that is awash in liquidity. We have these enormous flows of savings and cash that need to go somewhere, and I wonder if gold, before a pure hedge for bad times, is now more like other risk assets. Maybe now gold is a place where people store their excess liquidity, or people try to get rid of excess liquidity by putting gold onto their balance sheets.
Finally – and this contradicts one of the earlier explanations about central banks – it may be that the strong rally in gold is a response to a changing view about what the neutral rate of interest is. There’s a lot of people who argue that the neutral rate of interest is rising because governments are spending more money and because demographics are changing the world. As such, the target that central banks are now shooting for may be higher now. And if that’s true, we’re going to have incidents of inflation as policy rates bounce up against this higher neutral rate of interest. This means gold has not responded to an inflationary incident just now, instead responding to a sea change in the world of interest rates.
The key point is that, in a moment of change and dislocation, gold has come through for investors overall. If it can hold on to those gains over the next year or two, all a sceptic like me can do is tip his hat.
GOLD OFTEN SHINES THROUGH AGAINST HUMAN FOLLY, MONETARY MADNESS AND FISCAL DYSENTERY, JUST LIKE WE WERE PROMISED THAT IT WOULD.
