Wednesday, July 3rd, 2013

All That Glisters Is Not Gold

Last week was spent marketing in the US. It’s always interesting to get out of the office and talk to a different set of investors, especially when it coincides with the birth of a new consensus. Everyone we met, clients and intermediaries alike, was convinced that the 30-year bull market in US Treasuries is over, and that a significant bear market is in prospect.

As yet, there is little agreement about what to do next, and the fiercest controversy is reserved for Gold, partly because of the recent volatility in the price. Some bulls cited the risk of inflation in the US as the economy recovers, but some preferred the safe haven argument in relation to the break-up of the euro. Bears cited the impact of US interest rate hikes, and increasing international confidence in the US dollar. So, where do we stand?

Our view can be summarised as follows.  Gold is an alternative asset, which is most attractive when the other main asset classes are least attractive. That should make Gold a buy for US investors, given our concern that US Treasuries and US Equities may produce negative returns at the same time. However, the main part of the bull market in Gold coincided with the last leg of the bull market in the long-dated Treasuries from 2008 onwards, so it is more likely that investors were reacting to the threat of a banking collapse, rather than the threat of inflation.

Therefore, if Fed tapering is a sign of the improving health of the US banking system, this should be regarded as a negative for Gold, over and above the impact of rising short-term rates. It may still be sensible to own Gold as insurance against a banking collapse, but this is no longer an argument about the US; it has to be justified in terms of a view on Eurozone or Chinese banks.

In our view, the rise in the price of Gold was primarily a response to the onset of the US financial crisis. The beginning of the end of QE is a sign that the US banking system is returning to health. Before we knew it was sick, back in August 2007, Gold traded around $700 an ounce. Last Friday it closed around $1,250. This is not a forecast, and certainly not a trading recommendation. But it is an important reference point, if you believe, as we do, that US banks are once again adequately capitalized. Between 2007 and 2012, Treasuries and Gold went up together. They could go down together as well.

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