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50K reasons to stay invested in gold

Just like the Europeans realized the importance of the humble potato investors and savers need to realize the importance of gold and always have it in their portfolio (Photo: Alamy)Premium
Just like the Europeans realized the importance of the humble potato investors and savers need to realize the importance of gold and always have it in their portfolio (Photo: Alamy)

  • With India entering a difficult economic period, chances of the rupee continuing to lose value against the dollar remain very high and gold is likely to benefit from that
  • By investing in gold, investors will end up betting against the system. In such uncertain times, it might make sense to own a substantial portion of gold in the physical form

The potato first came to Europe sometime in the 16th century and was slow to catch on. Multiple forces opposed it, including the clergymen who “forbade their parishioners from eating potatoes in England," because “they are not mentioned in the Bible."

But it was war that finally helped farmers see some logic. As Matt Ridley writes in How Innovation Works: “Invading armies stripped the barns of stored grain and of animals, and trampled or grazed the crops, leaving the population to starve."

But the humble potato somehow survived because it was in the ground and took “too much trouble for soldiers to lift". This ultimately led to “farmers who planted potatoes" surviving “better during wars" and thus “spreading the habit".

In that sense, people realized the importance of the potato only when the going got really tough. Along similar lines, lately, people have been realizing the importance of having gold in their investment portfolio.

While all other forms of investing have floundered, the yellow metal has given around 53% return in the last 18 months. But this return is now a thing of the past. What does the future hold for gold? Will it continue delivering returns over the next few years? The chances of this happening are very high. Let’s look at the reasons one by one.

The returns

Over the years, gold has given decent returns in rupee terms. Since 2001, gold has given a return of 13% per year in rupee terms, the best among the major global currencies. Over the last 15 years, gold has given a return of 14.7% per year. Over the last 10 years, gold has given a return of 10.1% per year. Over the last five years, it has given a return of 12.8% per year.

Of course, a bulk of these returns have come in brief spurts. But that’s the case with stocks as well. Hence, it makes sense to have a part of the portfolio always invested in gold, but at the same time not bet one’s life on it.

The reason for high rupee returns lies in the fact that gold is bought and sold internationally in US dollars.

In 2018-19, India produced just 1,664kg of gold. Hence, gold has to be imported in large quantities. In India, gold is bought and sold in rupees. Over the years, the rupee has consistently lost value against the dollar and that spruces up the rupee returns of gold. With the country entering a difficult economic period, the chances of the rupee continuing to lose value against the dollar remain very high and gold is likely to benefit from that.

There’s the bigger picture too: the International Monetary Fund in the June 2020 update of the World Economic Outlook has said the global economy will contract by 4.9% in 2020. While this can be attributed to the collapse in economic activity due to covid-19, the world economy was already slowing down before the epidemic struck.

As Ronald-Peter Stöferle and Mark J Valek of Incrementum write in a research report titled: The Dawning of a Golden Decade: “[The] world trade volume, which normally grows about 5% per annum… last year declined by about 0.5%. This marked only the third decline since 1980. The other two declines happened during the deep recessions of 1982 and 2009."

Over and above this, the Federal Reserve of the US decided to stop shrinking its balance sheet. In early September 2008, the balance sheet size of the Fed had stood at $905 billion. This was before the financial crisis of 2008 properly broke out. Once it did, the Fed printed and pumped money into the financial system. The idea was to pump more money into the financial system, drive down interest rates, and encourage people to borrow and spend more, and businesses to borrow and expand.

The Fed pumped money into the financial system by buying bonds. These bonds accumulated on its balance sheet pushing up balance sheet size to more than $4.5 trillion by July 2015.

It then paused and gradually started to shrink its balance sheet by selling the bonds it had bought, pulling out the money it had printed and pumped into the financial system. In the process, it reduced the size of its balance sheet. By July 2019, the size of the Fed’s balance sheet was down to $3.78 trillion. After that, the Fed stopped shrinking its balance sheet any further. It could smell a global recession was on its way.

This also tells us that the Western economies by now are addicted to money printing (or quantitative easing as they like to call it) and the moment they slow down on it, there is a problem with the economy.

In March 2020, the Federal Reserve announced unlimited quantitative easing. The Fed’s balance sheet now stands at $7.08 trillion (as of June 24), having printed and pumped close to $3 trillion into the financial system between 26 February and 24 June.

In April, the Bank of England decided to print money and finance the expenditure of the British government. The Bank of Japan has been printing money continuously and the size of its balance sheet has increased by 428% to 638.6 trillion yen during the period, over the last decade.

Gold prices tend to be directly proportional to the new easy money being created in the global financial system by central banks.

The inflation factor

As Stöferle and Valek write in their 2019 report In Gold We Trust: “Gold has been excellent at offsetting stock losses during recessions".

As of now, the American stock market investors are getting very jittery with the idea of Joe Bidden becoming the next American president. The way American stocks move has an influence on stock markets all over the world. Hence, if American stocks go down that might be good news for gold.

Moreover, all the money printing post the 2008 financial crisis hasn’t translated into inflation, in the conventional sense of the term. Prices of consumer goods and services have not risen at a rapid rate. But asset inflation (high stock prices, high real estate prices, and high bond prices) has showed up across large parts of the world.

How will all the money printing in the post-covid world play out? With the massive demand destruction that has happened across large parts of the world, any chances of inflation at least in the current year can be ruled out. But the years to come might be different.

Stephen Roach, former chief economist of Morgan Stanley and currently an economist at Yale University, recently said that in order to combat the negative impact of covid-19, the governments have increased their spending big time and huge income support is being provided to people in developed countries.

Hence, a latent consumer demand will keep building. Once a vaccine is available, consumer demand in the Western world will be back with a bang. This will possibly lead to inflation simply because supply will not be able to keep up with demand. The possibility of this happening needs to be kept in account. Gold has always acted as a hedge against inflation. This is another reason to own gold.

Other investment avenues

The future for other investment avenues looks bleak. The interest on fixed deposits is largely down to 5-6% irrespective of tenure. Also, interest rates are likely to remain low as bank lending growth will slow down further in the time to come.

The BSE Sensex, India’s premier stock market index is down by around 16% from the high it had achieved in mid-January earlier this year. Also, the Sensex has been very volatile. It reached a high of 41,952.63 points on 14 January, only to fall dramatically by 38% to 25,981.24 points as of 23 March, wiping off huge investor returns in the process.

What is really driving stock prices up with company earnings expected to take a beating in the post-covid scenario?

A major reason for stock prices remaining strong lies in the sustained investment in stocks through the systematic investment plan(SIP) route.

Between April 2017 and May 2020, a period of a little over three years, 2.76 trillion has been invested into mutual funds through the SIP route. A bulk of this investment has been in equity mutual funds which in turn invest in stocks. In fact, in each of the months between December 2018 and May 2020, a period of 18 months, more than 8,000 crore has come in through the SIP route.

Now compare this to the foreign institutional investors. They have net invested 59,274 crore in Indian stocks between April 2017 and now. Of this, 29,517 crore, a little less than half, has been invested between April and June this year.

It’s the constant inflow of money into stocks from SIPs that has held up the market, over the last few years, and not a steady growth in company earnings. Hence, stocks remain a tricky proposition to invest in.

This leaves us with real estate. In many parts of the country, home prices have fallen over the last few years. If we look at the RBI House Price Index, homes have given an average return of 5.1% per year between December 2016 and December 2019 (the latest data available) on an all-India basis. This return does not take into account the different costs of owning a home.

After taking these costs into account, it is safe to say that the return from owning a home in many cases has been in negative territory over the last few years.

Among all this, gold has stood tall. In fact, between January 2019 and now, the yellow metal has given a return of close to 53%. The thing with gold is that it gives returns in spurts and especially during times when other investment classes are not doing particularly well. And that’s primarily because investors look at gold as a safe haven during tough macroeconomic times. The tough times are upon us.

Of course, this brings asset allocation or the importance of spreading one’s investments across different asset classes, into account. Gold should form a part of the overall portfolio of investments, depending on the risk that an individual can take on. One shouldn’t bet one’s life on it.

In conclusion

Since 1971, the global monetary system is a pure paper fiat money system. The monetary systems that existed before 1971 always had some commodity, typically, gold or silver, backing it. Currently, governments through central banks can create money out of thin air (and hence, it’s termed fiat money).

As mentioned earlier, since late 2008, the world at large has been addicted to continuous money printing.

In fact, parts of the world are now seeing negative interest rates. Banks simply don’t know what to do with all the money that is floating around. In this scenario, the global monetary system that has evolved in the last five decades is on shaky ground.

As Jim Reid of Deutsche Bank writes in a concept note titled Imagine 2030: The Decade Ahead: “The forces that hold the fiat money system together look fragile, particularly decades of low labour costs. Over the next decade, some of these forces could begin to unravel and demand for… gold… could take off." This is a possibility that investors need to take into account.This means looking at gold as a safe haven to invest in. As Stöferle and Valek put it: “Savers and investors will find it increasingly difficult to navigate their assets safely through the coming times. While the world is threatened by a flood of fiat currencies, safe havens are scarce. Gold could also increasingly compete with bonds in an era of negative interest rates."

Hence, by investing in gold, investors will end up betting against the system that currently prevails. In such uncertain times, it might even make sense to own a substantial portion of gold in the physical form.

To conclude, just like the Europeans realized the importance of the humble potato, investors and savers need to realize the importance of gold and always have it in their portfolio.

Vivek Kaul is the author of Bad Money.

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