Owning Gold Is As Much About Diversification As It Is About Capital Appreciation
Regular readers of our content know that we have been building the case for several years now on why gold deserves a place in diversified portfolios. Sure, we see significant upside in gold (unlimited upside, in fact), aided as I will show by the unprecedented rise in US dollar money supply in response to the COVID crisis. But the case for gold is much deeper than simply a story of potential capital appreciation.
These days, gold as an asset class is in an entirely unique position to not only provide upside potential, but also provide a layer of diversification within a portfolio that neither stocks nor risk-free nominal bonds can achieve on their own or even together. Much of this has to do with the rather disadvantageous position of risk-free bonds at the moment that have brought us to the death throes of the 60:40 portfolio. Indeed, with risk-free rates so close to zero (even on the long end), bonds simply don’t have enough convexity (aka capital appreciation potential) left in the tank to act as a sufficient diversifier of equity risk. After all, if the 10-year bond yield drops to 0.00% from the current 0.68%, that would provide owners of that bond with a whopping 6% capital appreciation, which is not nearly enough to cushion a 20% or 30% equity selloff.
Now, things may be different if the Federal Reserve was open to the idea of setting the Fed Funds rate at -3% or -4%, but that idea has been sufficiently brushed into the dusk bin. Instead, the Fed appears more likely to add some form of yield curve control to its policy toolbox. This will relegate risk-free bonds to a purgatory of sorts in which they can provide neither income nor capital appreciation potential of any magnitude.
Conversely, gold provides both capital appreciation potential as well as diversification to equity risk. Said in modern portfolio theory parlance, gold has the potential to bring one’s portfolio closer to the efficient frontier. That can no longer be said of nominal risk-free bonds.
Now, let’s get to some charts to illustrate these points.
The fundamental case for higher gold prices is really quite simple. While many view gold as an asset class that rises when inflation expectations or actual inflation rises, it’s even simpler than that. The quantity of gold is relatively fixed. The quantity of money is not. Therefore, when the quantity of money rises, the price of gold as priced in terms of that form of money must also rise. Sure, inflation may be a consequence of a rising money stock (Milton Friedman’s “inflation is always and everywhere a monetary phenomenon”), but it also may not be (see 2009-2019).
So from an empirical perspective, we observe that gold has a closer relationship with the quantity of money in the economy than it does actual inflation. The first chart below shows the US dollar price of gold compared to United States M2 money supply. The price of gold tracks the quantity of money quite well, with some deviations from trend that have always corrected over a fairly short period of time (see the late 1970s-1980s, early 2000s, 2010-2011).