How risky is the modern gold rush?
Gold has been on an incredible tear. Gold prices have soared more than five times since 1999, from $300 an ounce to the current $1,720 range. Gold is down almost 11 percent from its peak in the fall of last year.
I've never been a fan of gold. It's a pure speculation -- a fallow investment with no real intrinsic economic wealth. What I find fascinating is that speculating in gold these days isn't really a bet against the Fed. It's putting down a marker on the duration and extent of emerging market "financial repression" toward domestic savers.
Of course, the precious metal is a traditional haven from economic and social upheaval. We've lived through enough turmoil, including war in Iraq and Afghanistan, the global credit crunch, the Great Recession and the worst labor market since the 1930s. There's plenty of remaining uncertainty, ranging from revolutions in the Middle East to rising tensions between the U.S. and Iran to the risk of a European sovereign debt implosion.
Still, the main factor gold bugs repeatedly cite for the precious metal's remarkable run is fear of high and rising inflation. The value of the dollar has been debased by the Federal Reserve's unorthodox monetary policies. Other central banks have also cheapened their money with loose monetary policies. Gold is a class hedge against inflation. Warren Buffett, the Wizard of Omaha and head of Berkshire Hathaway, has brilliantly illustrated the flaw in owning gold in an article for Fortune, Why stocks beat gold and bonds. It's a tantalizing preview of his famed annual letter to shareholders.
Buffet is worried about inflation. There's no question about that. His skepticism lies with turning to gold as an investment. He calculates that the world's gold stock is some 170,000 metric tons. Meld it together and it would form a cube of about 68 feet per side worth $9.6 trillion. (Gold was at $1,750 per ounce when he wrote the article.) He calls the cube "pile A."
Let's now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
I can't. The wealth of a nation lies with its physical and human capital, from productive farmland to skilled entrepreneurs.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops -- and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil (XOM) will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Of course, that's a long-term perspective. What about the short-term? Well, I also don't buy the argument that U.S. inflation is driving gold prices higher. Consumer price inflation has been well-behaved for the past decade-plus, even as gold powered ahead. Inflation has stayed within a band between 0 to 5 percent, with an average rate hovering around 2 percent.
Investors aren't exactly fleeing from future inflation, either. For example, the difference between the yield on 10-year Treasury notes and 10-year Treasury Inflation Protected Securities (TIPS) is a market-based measure of expectations about consumer price inflation. Investors are anticipating consumer price inflation will average 2.2 percentage points over the decade.
No, betting on gold these days is a speculation that emerging market economies will continue to block their citizens from making a decent return on their savings. That's the insight in Emerging Consumers Drive Gold Prices: Who Knew? by Amit Bhartia and Matt Seto of GMO, the global investment management firm.
Gold purchases over the past 10 years have been derived increasingly from emerging markets, especially emerging Asian countries (with India, China, and Vietnam accounting for the bulk of the increase in demand). Whereas in 1999, emerging Asia accounted for only 39% of global gold demand, by 2010 this figure had reached 57% and has increased since then.
Emerging market governments have placed strict limits on returns on savings and equity markets aren't that deep. So, where is the saver going to put their money --gold (and real estate).
Bhartia and Seto note that emerging market "financial repression" means that the gold rally can continue until India, China, and other emerging markets loosen their capital controls and make it more attractive for savers to put money in banks and equities. "Our intent is not to make predictions about the price of gold, but to create awareness that emerging markets represent a significant factor in how gold is being, as well will be, priced in the future."
In other words, the bet on gold going from its currently expensive price to even higher prices isn't a traditional speculation about U.S. inflation rates. It's evaluating the current and future options available for emerging market savers -- a very different game.