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Gold, a Hedge Against Financial Repression?
Had those with money tied up in the Cypriot banking system owned gold instead, they might have been able to watch the unfolding crisis relaxing on the beach. So why isn't gold going through the roof? Is Cyprus too small to matter? Can it happen in the U.S.? Should investors hold gold?
First, be aware that bank failures do happen, in Cyprus and the U.S. alike. A bank deposit is nothing but a loan to the bank. To the extent that these deposits are guaranteed, the creditworthiness of the guarantor should be considered. In Cyprus, the government guaranteed deposits up to €100,000; in the U.S., the FDIC guarantees deposits up to $250,000.
In the U.S., unlike in Cyprus, there is a well-defined process to seize and unwind insolvent banks. Crises will happen, but they are less stressful when sound institutional processes are in place. The other key difference is that U.S. banks have generally rebuilt their balance sheets, whereas some European banks have dragged their feet, hiding behind national regulators. Stern words from the European Central Bank (ECB) to get their act together have fallen on deaf ears. As the European Parliament just voted to give the ECB central banking supervision authority, the Eurozone is inching in the direction of a more coherent regulatory framework. Even so, neither a pan-Eurozone bank guarantee scheme (that would imply Germany is on the hook for all deposits), nor a strong resolution authority are on the horizon.
But fear not, the Eurozone is listening - if not to policy makers, than to the market. First, it was the bond market imposing structural reform on policy makers. Now it may be depositors voting with their feet, causing weak banks to shrink. That's a good thing, as zombie banks must be recapitalized or liquidated. What's not so good is that bank runs tend to be disorderly. And once depositors flee, banks must liquidate investments, potentially causing a broader selloff in other markets.
It's tempting to dismiss this as a Eurozone problem; however, the drama unfolding on TV may be masking the bigger challenge that many players, including the U.S. government, have made too many promises: there is too much debt in this world. The challenges may manifest themselves through different dynamics in different places. In Europe, we have seen the playbook. To deal with excessive debt loads, the Eurozone imposes a mix of austerity and restructuring; restructuring is a fancy word for defaulting on one's obligations. When deposits are lost, depositors get to experience financial repression rather directly.
In the U.S., in contrast, financial repression is exerted less explicitly by imposing negative real interest rates on savers. We are told quantitative easing is for the greater good, as it helps the economy heal. Pimco's El-Erian argues savers don't revolt, thus making them an easy target (that was before Cypriots went to the streets protesting the then proposed "tax" on insured deposits). Incidentally, El-Erian at a recent speech at Stanford University also appeared to suggest the U.S. will heal, if the Fed only buys enough time. As we point out below, we don't believe buying time will prompt our policy makers to get their act together.
More broadly speaking, inflation is also a form of financial repression. Simply put, the interests of governments and savers are not aligned. Through financial repression, debt burdens may be reduced. So why isn't gold going "through the roof"? Let's look at the common arguments:
The Eurozone banking crisis is contained. We were quoted last week as arguing "there's no contagion" - we didn't argue that there couldn't be contagion, but merely stated that the market was not pricing in contagion. Spain, for example, early last week had a Treasury Bill auction in which it paid the lowest yield since 1991. As fear flares up that those holding large deposits in Italian banks might be at risk, such contagion might flare up, potentially propelling gold higher. However, keep in mind that unlike Russian money that had few other places to go (few banks welcome Russian money these days), Italian savers have long had the opportunity to move money abroad. Italian banks have taken actions to bolster their balance sheets. Having said that, given the slow-motion drama on display in Cyprus, markets are likely to remain nervous. As such, holding gold as an insurance against a broader run on banks might be prudent insurance; please consider that the time to buy insurance is when you don't need it. We are not suggesting there will be a bank run throughout the Eurozone, and we hold our gold for different reasons. But gold we hold.
Interest rates may rise. One reason why gold has been trending sideways for a considerable period now is that investors might expect the Federal Reserve (Fed) to embark on its "exit"; the argument is that as the economy grows, negative real rates might turn into positive ones, thus yielding more than gold. We agree that should the world embark on a major tightening cycle, it may spell bad news for the price of gold. It's a risk investors have to consider. It's just that we consider that risk to be rather small in the context of the debt burdens outstanding. Many at the Fed believe longer-term, long-term interest rates may converge around 4%. The trouble with that view is that it may not be possible to finance U.S. government debt, should the average cost of financing move back to 4%; it's currently at a little over 2%, down from about 6% in 2001, yet our debt is up by trillions and growing. As maturing bonds are refinanced at lower rates, that cost of borrowing continues to trend downward - for now.
There is no inflation. Depending on the metric one looks at, inflation expectations are reasonably well "contained," although such inflation expectations inched when the Fed decided to embrace an unemployment target. However, the only person, for whom the average cost of living might have been declining just about each year over the past decade, is a person living on their personal gold standard. Yours truly has done that with regard to a college savings plan: the cost of college tuition went down each year, when priced in gold. However, applying historic measures of inflation, such as how the Consumer Price Index (CPI) used to be defined, say in the 1980s, would suggest we have rather high levels of inflation.
Personally, I hold about half of my non-real estate investments in gold. That's a high multiple of what many investors assign to the precious metal. The reason I hold gold is because I don't think we have seen anything yet with regard to financial repression. What we see unfold in the Eurozone is sad and may boost the price of gold under some tail-risk scenarios. But what we see in much of the rest of the world may, frankly, be more worrisome:
Japan. Japan's finance minister wants to borrow from the toolbox of the Great Depression in pursuing fiscal policy. The Bank of Japan wants to achieve a 2% inflation rate within 2 years and is about to announce concrete steps to get it there. With a debt-to-GDP ratio exceeding 200%, we don't see how the bond market can support a 2% inflation rate. Should the Bank of Japan monetize the debt to make it possible, the yen may indeed become worthless. Forget about contagion from Cyprus. Japan, in our view, provides the much more compelling argument to own some of the yellow metal.
UK. The UK is paving the way for incoming Bank of England (and outgoing Bank of Canada) Governor Carney to increase the BoE's inflation target or to engage in nominal GDP targeting. The UK already suffers from stagflation; again, upcoming BoE's policy may well have a bigger impact on the price of gold than a typical day in the Eurozone where Italian savers grind their teeth.
US. In our assessment, without meaningful entitlement reform, the U.S. will go bankrupt. We are actually optimistic that entitlement reform will come; however, we don't think it will come before the bond market pressures policy makers into action. In our analysis, however, the U.S. dollar may be far more vulnerable to a misbehaving bond market than the Eurozone has ever been. Again, the potential fallout - with its implications for gold - dwarf concerns about the Eurozone.
What will trigger all of this? We believe the biggest threat the market may be facing is economic growth. That's because economic growth might get the bond market to sell off, in the US, UK or Japan, exposing the vulnerabilities. As long as we have this muddle-through economy, things are "contained."
We don't know whether our forecasts will pan out. But investors that believe that there's a risk that some may pan out, may want to consider taking it into account in their portfolio allocations. To continue the discussion, please register to join us for our webinar on Thursday, April 18, 2013. Also, make sure to sign up for our newsletter as we help make sense of global dynamics and their implications for gold and currencies.