2017 has been a great year for risk assets. However, elevated valuations in multiple asset classes and growing political uncertainty mean that as we enter 2018 the case for finding alternatives to diversify away from these asset classes is stronger than for many years.
For investors looking to hedge their portfolios, the outlook for gold (and silver) prices appears very strong, with several key drivers converging:
- The need for global real interest rates to remain negative amid record debt levels
- Global geopolitical uncertainty is high and increasing
- There is increasing evidence that inflation has bottomed
- The dollar is potentially entering a bear market
- Gold remains under-owned
- Broad equity valuations are extremely high
We believe that the first three points are self-explanatory, so we shall focus on the last three.
A potential US dollar bear market
For context, the dollar bull markets of the early 1980s and the late 1990s each lasted around six years on average. The most recent bull market which commenced in 2011, has also lasted just over six years (chart 1).
Several factors we believe make dollar weakness a high probability outcome over the next few years, of which three stand out:
- A likely increase in the US twin deficit;
- Potential increased political dysfunction in the US;
- The fact that the US is more deeply indebted than commonly perceived.
US central government debt is close to 10x total central government income (taxation).
Gold is under-owned
Although there has been pick-up in both gold and gold equity prices in 2017, gold as an asset class remains under-owned. The positive investment cycle in this asset class potentially has many years to run. Current gold ETF (exchange-traded fund) holdings as a percentage of global ETF assets are tiny. As chart 2 below shows, in 2012 gold was relatively well-owned, with gold ETFs over 10% of all ETF assets (including equities, bonds etc.).
Since then ETFs have expanded across asset classes while we have seen strong bull markets in bonds and equities. At the same time, and partly as a result, gold ETF holdings have fallen from over 85mn ounces in 2012 to around 68mn ounces (in August). Gold ETFs as a percentage of all ETF assets are now closer to 2%.
For gold, in a world still awash in liquidity and with financial asset values very high, this is positive. So when investors start meaningfully allocating to gold again, gold ETF holdings have the potential to grow at a pace significantly higher than the 2004 to 2012 period.
Gold does well when equities do badly
Equity valuations are now extremely high, with global equity markets having added close to US$9.5tn in market capitalisation over the course of 2018. Historical data going back to the 1970s shows that over reasonable periods (five years plus) when returns from equities have been poor, returns from gold have been strong.
Gold has been a very good portfolio hedge against equity bear markets and periods of high inflation. Should global equity euphoria weaken in 2018, gold stands to benefit significantly and thus firmly supports the argument for holding a minimum weighting in gold or gold equities in a portfolio.
Gold equities remain very out of favour
If we look at gold equities, we see a similar picture. The current weighting of North American gold equities in the S&P500 and TSX has fallen to just 0.6% after reaching a peak of over 2% in 2012. In fact all North American (US and Canadian) gold producers have a combined market cap of less than $150bn. This highlights the scarcity value of gold equities if a bull market in gold gets going.
The fact that the majority of the companies we invest in have improving fundamentals and are trading at the lower end of their historical valuation range adds further weight to the attraction of this sector in 2018.
In summary, given many asset classes have appreciated so much over the last few years, we see the gold market as broadly overlooked and offering great value as a portfolio hedge at current levels.
