Vijay Kumar Gaba

 In the past one month, the bond yields in most of the developed world have risen sharply, devastating the bond portfolios, especially the leveraged portfolios. Even most emerging markets have seen their bonds declining in value. Consequently, the global currency markets have also seen high volatility. The USD index has reached the highest level in two decades, as JPY, EUR and GBP have declined to lowest levels in decades. Even PoBC is cutting the reference range for CNY sharply and USDINR is at historic lows.

The sharp rate hikes in most parts of the world, and tighter money markets have so far not been able to rein the runaway inflation. It is expected that the central banker may continue hiking aggressively for another quarter at least. Accordingly, the forecast of a severe recession in 2023 in most parts of the western world on both sides of the Atlantic is fast becoming a consensus.

Poor demand outlook due to recessionary conditions is causing severe correction in the commodities markets. Industrial metals and crude oil have corrected sharply. The shipping container rates have also collapsed. Even if we normalize the commodity prices and container rates for the Covid related abnormalities, we are heading towards prices lower than the average of 2018-19.

In all this global turmoil, the most puzzling piece is precious metals. Both gold and silver have not behaved in the expected manner. Traditionally, during periods of high inflation, geopolitical uncertainties, war, money-debasement (due to quantitative easing or hyperinflation) etc. gold and silver had provided a safe haven, protecting the wealth of investors. In the latest episode of crises, precious metals have actually belied their safe haven status.

Despite, inflation ruling at four decade high level; Russia-Ukraine war; tension in the China Sea; and massive money debasement (US Fed alone printing US$7trn in the past 30months), international gold prices have actually fallen over 10% since January 2021 in nominal USD terms. In real terms, the losses are even more. Though, in GBP and EUR terms gold prices are higher, but certainly not commensurate with the circumstances and historical trends.

The trend in gold prices becomes even more intriguing, when we factor in the requirements under Basel III regulations that may require much higher holdings of physical gold by the global central banks. In fact a number of central banks like Bundesbank, PoBC, Central Bank of Russian Federation, RBI, etc. have increased their holdings of physical gold in the past 4years.

A few months ago, I had expressed my apprehension that yellow metal might be losing its luster (see here). The recent trend further strengthens my fear that in the new global order that is emerging post the pandemic, Gold may not be a key component. Declining consumption demand (the share of gold & silver ornaments has fallen below 1% in Indian household savings, from 1.7% just 5yrs ago, see here); competition from digital currencies; higher security risk and higher cost of security; and rising cost of production etc. are some factors that seem to be working against the gold.

Nonetheless, I am inclined to believe that we may get a very good trading opportunity in gold sometime in the next twelve months. I shall look to allocate some tactical money towards gold, if it falls another 8-10%.

Crypto currency (e.g. Bitcoin) is proving to be the best asset class for the Covid-19 infected FY21. Most crypto currencies have yielded astronomical returns in a year that suffered the worst synchronized global recession since the great depression of 1930s. Against this, the traditional safe haven Gold, Swiss Franc (CHF), USD and US Treasuries have yielded insignificant return. USD Index (DXY) in fact has declined over 10% YTD FY21. Silver is the only traditional asset, besides equities, that has yielded strong return in past 11 months.

Regardless, the overwhelming consensus amongst global strategists appear to be favouring gold and silver as overweight in asset allocation of non-institutional investors. Most wealth managers and investment strategists are suggesting upto 15% allocation to gold (for example see here). Many globally popular and prominent traders, chartists and strategists have suggested a massive bull market in Silver in next couple of years (see here)

Meeting with a senior asset allocator last week was quite revealing in this context. The gentleman advocated 10% allocation to gold, besides 10% allocation to global equities (mostly US equities). He strongly advised to avoid crypto currencies; though he expects a rather lucrative trading opportunity in silver. On a little deeper probing, he offered the following rationale for his asset allocation strategy:

(a)   Given the status of quantitative easing (money printing) by major central banks, global hyperinflation is inevitable. It is only a matter of time when the prices of all real assets and commodities explode. In these circumstances gold will provide safety cushion to the portfolio.

(b)   Stagflationary situation in US could lead to sharp depreciation in USD value and chances of return to gold standard could enhance.

(c)    Gold-Silver ratio is breaking out on technical charts. From a 10yr high of 120, the ratio has already corrected to 60. Technically it is expected to test the 10yr low level of 30 in short term. This implies a sharp rise in silver prices.

(d)   Unwinding of monetary stimulus would also lead to unwinding of carry trade in USD and EUR. This may lead to reversal of flows away from emerging markets to developed markets. Therefore buying some developed market equity is desirable. It is also desirable from (i) diversification viewpoint and (ii) strategic viewpoint, i.e., to take stake in global businesses doing very well.

His arguments were quite convincing on first hearing. But on second thought these left me mor confused than ever. What I could not understand from his detailed presentation was:

(a)   If a hyperinflationary situation does materializes as popularly believed, won’t I have much serious problems to deal with. How 10% gold will solve these problems?

(b)   If USD and EUR get debased due to excessive money printing, INR will naturally appreciate against USD. Since gold is mostly priced in USD terms, won’t any appreciation in gold in USD terms will get neutralized by appreciation in INR vs USD.

(c)    What is the guarantee that gold does not suffer from the same malaise as USD? Is it totally improbable that the physical stock of gold has been leveraged many fold to issue paper gold?

(d)   Why can’t the targeted Gold-Silver ratio be achieved through fall in gold prices rather than rise in silver prices?

(e)    If USD and EUR do get debased, why would an alternative currency not emerge to maintain stability in global trade?

(f)    Since anticipated hyperinflation is mostly expected to be the outcome of a supply shock rather than a demand surge, a further dose of quantitative easing might be in order to encourage building of new capacities. If that is the case, then the whole premise of higher yields and hyperinflation might fail.

(g)    If USD and EUR debasement is a serious concern, then how does investing in global equities make sense?

(h)   A hyperinflationary condition may lead to material monetary tightening in India. Higher rates shall then warrant serious de-rating of equity valuations which are assuming prolonged period of lower rates and lower inflation. Even real estate may also suffer from poor demand due to higher rates in that case. We may need to worry more about INR debasement in that case rather than USD or EUR!

Many more such questions bothered me for couple of days, before I reminded me of the following basic learnings from the first chapter of my investment strategy book:

1.    India has 1.38bn people who need to eat & wear clothes, want decent healthcare, and aspire to have a decent shelter of their own. These needs and aspirations will continue to create many decent investment opportunity for me in India for next few decades at least.

2.    A tiny investor like me should never bother about diversifying the investment portfolio too much. A totally unproductive commodity like gold and mostly unknown animals like foreign equities are for large investors and traders with much stronger risk appetite. I should be happy with ordinary assets like high quality domestic equity (businesses which I can see and feel everyday); debt to my government and some large corporates; a house for myself; share in portfolio of good rental properties; and some liquid money in bank. Chasing few extra bps of returns is meaningless and fraught with risk which I can hardly afford. I cannot afford to risk even a single penny for earning few bragging rights.

3.    An information that has travelled seven seas to reach a commoner like me has no arbitrage value. If I know that USD hegemony is under threat; hyperinflation is on the anvil; silver is going to rise astronomically, then I must strongly believe that these happening will NOT shock the markets in any manner whatsoever.