For decades, Berkshire Hathaway’s chairman and vice chairman, Warren Buffett and Charlie Munger, respectively, built a convincing case against gold. In his 2018 annual letter to shareholders, Buffett went as far as stating “The magical metal was no match for the American mettle.” This long-standing aversion to gold appears to have changed. In its Q2 regulatory filings released on August 14, Berkshire reported that it established a new US$563 million position in Barrick Gold, the world’s second largest gold producer. While the size of the investment pales in comparison to Berkshire’s investment portfolio, the message that is echoing across global capital markets is that Warren Buffett is losing faith in the U.S. dollar.
To understand the road linking gold and the U.S. dollar, we must first transit through the economic variable known as inflation (Consumer Price Index) and understand how and why central banks try to control it. Too much inflation or the opposite, deflation, are both potentially damaging to the economy. Erosion of purchasing power, regressive effect on lower-income families, increased uncertainty for business investment, potential labour disruptions and higher borrowing costs are among the chief concerns of excessive inflation.
On the other hand, deflation expectations can lead to deferred spending behavior and economic contraction. This is why central banks try to achieve a Goldilocks outcome of “not too hot, and not too cold’ by targeting an annualized inflation rate of 1%-3%. The primary mechanism of “controlling” inflation is through monetary policy: adjusting of interest rates and the supply of money in the marketplace. All else held equal, a reduction in interest rates and corresponding increase in the money supply aims to boost economic growth and is considered inflationary. Similarly, higher interest rates are intended to rein in inflationary pressures.
Despite decades of declining interest rates, the failure of inflation to materialize has led some market followers to assert that the inflation model is broken and no longer poses a danger (after all, it’s been over 40 years since inflation menaced the economy). However, there have been two powerful forces that have been dampening the inflationary impact of declining interest rates: globalization and productivity enhancement through technology. The extension of supply chains into cheaper jurisdictions (e.g. China) has played a deflationary role for most importing countries, while investments in technology have boosted labour productivity domestically and abroad.
The pandemic and geopolitical head-butting has altered the decades long status quo. In reaction to sharp economic contractions triggered by the pandemic-induced shutdowns, global central banks have rushed to drop interest rates and pumped trillions of dollars of liquidity, while governments have resorted to record levels of deficit spending to cushion the economic fallout. At the same time, tensions between the U.S. and China, the two largest economies, and the trend toward nationalism in many regions is expected to crimp the rate of globalization. The combined effect of these forces has the potential to align the inflationary stars, particularly in the U.S.
“IN GO(L)D WE TRUST”
Global faith in the strength of the U.S. dollar has resulted in the currency being the number one choice for other central banks’ global reserves (i.e. the global reserve currency) and the international unit of trade for goods and services. Over the past twenty years, many central banks have reduced their gold reserves and replaced them with global currencies, namely the U.S. dollar.
This faith in paper money blossomed even after the U.S. dollar officially stepped away from the gold standard in 1972 (under the gold standard, other central banks could exchange US$35 for an ounce of gold). Since 1972, faith in the U.S. dollar has been based on the expectation that the U.S. Federal Reserve will preserve the integrity of the U.S. dollar by controlling the de-basing effect of inflation. Except for a relatively brief inflationary period in the 1970’s, which the U.S. Federal Reserve aggressively tamed, faith in the U.S. dollar hasn’t wavered. Until now.
Efforts to fight the economic consequences of the pandemic have unleashed unprecedented levels of spending by the U.S. Treasury that are being financed indirectly by the U.S. Federal Reserve through the printing of trillions of U.S. dollars. U.S. M2, the official gauge of the money supply, is increasing at rate of 23% year-over-year (as of July 2020) after averaging only 5% year-over-year growth since 1990. More dollars chasing the same quantity of goods and services is expected to be inflationary. The threat of de-globalization has added to inflationary worries. Compounding matters further, the U.S. Federal Reserve is expected to announce (as early as September) a new inflation targeting strategy that some experts believe will allow the central bank to tolerate higher levels of inflation.
Historically, assets that have embedded inflation protection include real estate (i.e. rents increase with inflation), inflation-protected bonds, and commodities. The latter (including gold) tend to appreciate because they are denominated in U.S. dollars and because their supply is not readily adjustable. Given current circumstances, it isn’t surprising that gold and gold mining companies have been appreciating through the entry of incremental buyers such as Berkshire Hathaway.
In recent months, we added exposure to gold in our managed portfolios through a sizable position in Dynamic Precious Metals Fund. The Fund owns shares of mining companies (including Barrick Gold) and is actively managed by Rob Cohen, a 15-year veteran of the sector.
We think the inflation thesis is credible and that gold is under-owned by most institutional investors. Despite this year’s rally, we think gold has further upside.