Longer-term Outlook for the USD and Gold
Our positive view on gold has worked well for us, with the precious metal up some 7% YTD (as at 20/2/17). Silver has done even better, up c.13% over the same period. Some may have found the move in gold perplexing as it has risen in an environment of strong equities and an improved earnings outlook, usually negative for gold. The dollar though has weakened over the same period and gold, as one would expect, has behaved as a good hedge for a weaker USD.
As I highlight in our Annual Outlook report, we remain positive on precious metals even with the expectation of a stronger dollar. While, to many that won’t make sense, it should be highlighted that we had the same view last year and both performed well.
Key though, is the timing of my various views on the USD and gold. As with any investment, it is both short term but also, more importantly, longer term trends that drive one’s outlook.
In the case of the USD, my longer-term view is the expectation to see the dollar standard, slowly at first and then very rapidly, coming to an end. The standard has been around since 1971, when Nixon effectively decoupled the dollar from gold and it became purely fiat. Until then, dollar notes where either pegged or partially or fully backed by gold. No longer. With the USD being the reserve currency and most commodities being priced and paid for in USD, the US has had a huge advantage, allowing it to build massive trade deficits. This will change going forward.
Several oil exporters are slowly shifting away from selling oil for dollars and as China and other nations gain economic and military strength, the gradual shift away from dollars will accelerate. China is already pricing and paying for some commodities in Yuan. If one looks back over the last century, currency standards have typically lasted some 30 to 40yrs. The dollar standard has been with us for 40 and is starting to fray at the edges. The reign of all ‘global superpowers’ comes to an end and similarly the predominance of their currencies.
What will replace the USD?
What will replace the dollar as the ‘global currency’ is the real question. In my view, it is likely to be a basket of global currencies of which the dollar will be a part, but most definitely also the Chinese yuan. The new currency would likely be issued by the IMF, as part of its SDR.
In 2008, it was the central banks that bailed everybody out by increasing their balance sheets multi-fold, providing liquidity and support to the system. In the next crisis, it will be the central banks that are in the thick of it. For the most part, they have little fire power left to support the system.
Many would disagree with this, but one needs to consider the facts.
The Fed’s balance sheet has gone from c.800m to over c.3trl, since 2009. We’ve seen similar increases elsewhere.
Rates have also gone from c.5% in the US to now 50bps, having stayed at zero for longer than any time in history.
Similarly, the ability to increase fiscal spend has also decreased with US government debt having gone from USD9trl in ’08 to USD19trl currently, an increase of USD10trl in only 9 years. Again, we have seen similar percentage increases in other major economies.
Central banks and governments simply have less leeway to stabilise the system, without taking such monumental steps that the loss of confidence becomes a potential reality.
While critics of this view would argue that central banks can take rates way into negative territory, this would likely cause a run on the banking system, as depositors would look to store their currency in physical form or indeed in alternatives such as gold and bitcoin. This in part explains why governments are cracking down on large denominations, as it’s harder to store a few million under the mattress in small notes.
Likewise, while fiscal spending could increase dramatically, in time investors would caution on the debt/GDP level and the viability of the debt, pushing up yields and putting pressure on government finances. This hasn’t happened in Japan even with a 250% debt/GDP level, but for the simple reason that Japanese debt is owned by the Japanese. In the case of the US, c.47% of government debt is owned by offshore interests and, when confidence is lost, they will look to sell out and diversify their currency holdings. We are already seeing early signs of this.
So, when is this potential crisis coming?
Timing is always a tough call, but I have little doubt it will come. We have seen two crises in the past two decades alone. Each was driven by excessive central bank action, an accumulation of mal-investment, over indebtedness and an easy regulatory environment.
The current business cycle is getting stale, with unemployment down to historically low levels and, while there is still some slack in the economy with low participation rate and under-utilised capital, this normally marks that we are close to a turning point. Trump’s policy may extend it for a few years but then the eventual bust will be that much larger as government debt will be that much higher. Of course, you have those that will argue that government debt can go much higher, but for an indication of what eventually unfolds look no further than Zimbabwe or Germany in the 1920s.
This is not to say that the next crisis will occur in the next few years or even at the end of the current business cycle. The Fed will be reticent to put the brakes on aggressively allowing the economy to overheat for a few years and potentially extend the business cycle. So, timing all of this is a tough call.
In the short to medium term, however, gold is likely to be impacted by movements in the dollar and investors’ view of risk assets. A strong dollar and an improving underlying for risk assets, will likely be a headwind. The tailwind though, will be investors preparing for my potential end scenario.
It should be noted that investors should look to hold physical gold rather than paper gold, which is exposed to counter-party risk and is no different from fiat, in that there is often no collateral behind it. At some point, the correlation between physical and paper gold may break altogether.
If I had the temerity to forecast the future, I would take the view that the USD will do well all the way through to the next major recession, peaking in its early stages whilst it is still seen as a safe-haven asset. As and when the next recession starts to bite, I would envisage central banks and governments will take similar steps to those we saw in 2008, but that these measures will have limited impact. Having a very single minded Keynesian approach, the Fed and other central banks would likely continue such policies to the point that confidence is lost and a third party, like the IMF, needs to step in. At that point, the dollar would decline significantly and gold and silver would go higher. That, in my view, will likely mark the end of the dollar standard.
These are likely in my view to be very major moves and one should be prepared well in advance for them, but also not be too dogmatically biased, should it not play out as expected. Hence, we are overweight gold and are looking to add at favourable entry points.