Gold as the New Fixed Income

 
AUG 22, 2016

• Modern Portfolio Theory:

• MPT is a financial theory from the 1950’s that attempts to maximize portfolio expected return for

a given amount of risk by carefully choosing the percentage exposure to various assets; with the

assumption that a collection of investment assets has collectively lower risk than any individual

asset.

• Traditionally, portfolios have been constructed using equities, fixed income, and cash – and more

recently, sophisticated investments like real estate, commodities, hedge funds, etc (all reasonably

correlated to equities). However, equities and fixed income have always been the largest

allocations.

• Why investors have traditionally bought fixed income:

1. Bonds have performed well in all (strong/weak) markets – equities generally decline during

recessions, so a long allocation to bonds has been an effective hedge for a long equity position.

Furthermore, the long bond position has not necessarily had a negative correlation to stocks (they

can both go up in any given year).

2. Yield – In addition to allowing for capital appreciation, bonds have always provided a steady

source of income – hence the categorization, fixed-income.

3. Minimal counterparty risk – For years, US treasury yields have been considered the “risk-free rate”

because the US government was considered zero credit risk.

4. Valuable collateral – Since treasuries have been perceived as a “risk-free” asset, the ability to

borrow money backed by UST’s has always been easy and cheap relative to other assets.

5. Liquidity – UST’s are the most liquid financial instrument in the world. Investors can exit their

position quickly with minimal transaction cost.

• ZIRP – the game-changer for fixed-income:

• Bonds have been in a bull market for 30 years, beginning in the ex-Fed Chairman Volcker era.

Since then, the downtrend in inflation has reduced the yields of all fixed-income products. Yields

have also come down during this period as a result of the worldwide labor surplus which has

driven down wages, the primary source of inflation. Also, several recessions, the Great Recession

and market collapse of 2008, not to mention the near unlimited purchases of treasuries by the

Federal Reserve and other central banks has reduced yields to near zero.

• The bond bull market has created the perception amongst modern investors that, over time, bond

prices always go up, especially in periods of economic turbulence.

• However, with the Fed Funds rate currently at 0-25bps (and the market currently pricing in a

negative real Fed Funds rate until 2019) – the upside to bond prices is essentially capped. In theory,

bond yields can be held artificially low forever by the Fed, but potential appreciation and yield will

be minimal.

• Therefore, portfolios traditionally considered “balanced” will have major exposure to a decline in

the stock market or slowdown in economic growth. The maximum amount a fixed-income

portfolio can appreciate will be capped by the zero-bound (i.e. rates cannot go below zero for any

long period of time, though the real rate can be held negative for many years as it has in the past).

Therefore fixed-income returns cannot act, as they have historically, as an offset to losses on the

equity side. Similarly, during an economic and stock market up-cycle, the fixed-income portion of

the traditional “balanced” portfolio again will not be able to experience gains as the past given the

zero bound.

• How Gold fills the void left by bonds in a portfolio:

1. Performance in an economic downturn – A portfolio with the traditional 55% equity / 40% bond /

5% cash allocation will be more exposed to an economic downturn than ever before. Historically,

when the economy has slowed, the Fed has cut rates to offset economic weakness, which boosted

bond prices. Today, the Fed has no room to maneuver with rates but can still stimulate the

economy by expanding its balance sheet and the monetary base with infinite bond purchases;

thereby injecting liquidity to the financial market in the hope of creating economic activity. In this

scenario, gold would dramatically outperform any fixed-income product as investors begin to

consider excess liquidity as equivalent to currency debasement.

2. Yield – Gold has never offered a yield; however, for the first time in a long time, the real gold

yield is above the real treasury yield. The gold price need only stay unchanged for it to outperform

treasuries. That being said, the gold price has yielded 17% annually from 2002-2012,

outperforming the return on treasuries. Further, investors now need to move way out along the

yield curve to find bonds with a positive nominal and real yield. Corporate, junk, and mortgage

bonds have higher yields but are driven less by economics and are much more difficult to forecast.

Even so, the real yield on junk bonds is only 2-3%, a historic low.

3. Counterparty risk – gold bullion is one of the few assets in the world with zero counterparty risk

because it is a physical, allocated, and universally-accepted asset. Remarkably gold now holds

even less counterparty risk than treasuries.

4. Valuable collateral – Gold is equivalent to UST’s as a form of collateral. The Basel III accord lists

gold as a tier-1 collateral asset, on the same level as UST’s and other cash instruments. JPMorgan

has accepted gold as collateral for a few years.

5. Liquidity – As mentioned previously, no securities or assets are as liquid as UST’s but liquidity in

the physical gold market is more than sufficient to support an institutional allocation.

6. Performance in various macroeconomic scenarios – Going forward, we believe that gold should

outperform bonds (and in some cases equities) in many market conditions including: inflation,

USD weakness, sovereign default, equity bull market, and equity bear market. Sustained deflation

is the only environment where bonds theoretically should outperform gold, and even that is

debatable. Portfolios that we have priced using our proprietary models show that even a 10%

allocation to gold can have a meaningful impact on potential returns.

• Why other alternative investment assets are not viable as a replacement for bonds:

• Real Estate – Several investment advisors are now advocating REIT’s because of the substantial

fall in real estate prices since 2007. However, the real estate market is usually highly correlated

with the equity market and not a useful hedge if equities were to fall. Also, real estate can be an

illiquid investment and fees are considerable.

• Hedge funds – Some financial advisors recommend reducing the fixed-income portion of the

portfolio, and allocating that money to hedge funds which can net out duration risk in fixedincome

instruments and make money on spread products. There are several problems with this

approach including: performance risk, high fees, illiquidity, and major counterparty risk (hedge

funds fail all the time).

• Commodities – (Assuming commodities are equivalent to a basket of metals, agriculture, energy,

etc.) These products are volatile and not necessarily driven by economic fundamentals: Many are

even driven by the weather and supply/demand fundamentals (unpredictable). Commodities are a

less than ideal hedge for the equity portion of a portfolio and often have poor liquidity. Also, most

commodities cannot be used as collateral. Further, gold can be considered a currency because it is

not truly consumed.

• Gold will give the protection that bonds used to give with optionality to other macro fundamentals:

• We have discussed how gold will provide bond-like exposure now and into the future, but gold

will also benefit from numerous macro trends that are not linked to its fixed-income-like

characteristics.

• The gold price will also benefit from: growth in emerging market wealth, emerging market

demographics, excellent supply/demand fundamentals, rising costs of production, and central bank

buying just to name a few trends.

• Conclusion:

• Wealth managers should not replace their entire fixed-income allocation with gold. Many

prominent investors and strategists recommend an allocation to gold of between 5-15% of the

portfolio. As Ray Dalio has recommended, “most people should have roughly 10% of their assets

in gold, not only as a good, long-term investment, but also for its effectiveness in diversifying the

other 90% of assets people hold.”

• In the future, investors will realize that their fixed-income allocation will not provide the return

characteristics that they are looking for given certain macro environments. In almost all of those

macro environments, positive or negative, even a small 10% allocation to gold can have a positive

impact on a portfolio return.

Dan Tapiero, Co-Founder GBI and Global Macro Hedge Fund Veteran