Gold as a hedge

Good morning. Yesterday’s good results from Target – a company that hasn’t performed perfectly recently – put another nail in the coffin of the “weakening American consumer” theory. There is a Target store in Jackson Hole, as it happens. Maybe Jay Powell should stop? Email us: [email protected] and [email protected].

Gold plating

How good is a hedge? What exactly does it cover and how?

Over the past 20 years or so, gold has performed much better than the other classic hedge of diversification for a portfolio of stocks, bonds:

Note, however, that gold is not a source of consistent returns. Look at the painful years 1997-2005 and 2012-2016, for example. If what you want from your non-equity allocation is stability, look elsewhere.

But maybe I don’t need my stock hedge to provide consistent gains. What I need is for it to perform particularly well when stocks are performing terribly. Gold has done well on this front recently. Here are the total returns for the S&P 500, gold, Treasuries and inflation-indexed Treasuries in four recent market spasms:

Gold was a better hedge than bonds in the great financial crisis at the end of 2018 and the inflation/rate rollout of 2022. Only in the dotcom bust were bonds superior and gold was still high then. Gold is a pretty good asset for risky times.

Only one thing bothers. In 2022, a big part of the market’s problem was inflation, the very thing that gold is most valued to protect against, and yet gold fell (less than bonds, but still).

This is an important point. In response to yesterday’s article, many readers argued that gold is a special kind of currency, a store of value that is not the responsibility of a blameless government. One commenter wrote that “the price of gold is not going up . . . (instead) all fiat currencies devalue relative to gold due to endless inflationary money printing profusion”; another said: “Hold (gold) to preserve your wealth while sterling and dollars are degraded year on year by M2 inflation.”

This is not quite right. Over decades, gold holds its value against inflation. But in a given year, or even over several years, it doesn’t correlate at all with inflation or anticipated inflation. There are a few ways to look at this. Here is the increase in the US M2 money supply and the increase in the price of gold:

The price of gold fluctuates wildly above and below the rate of money growth. In 2020, gold jumped when the money presses started humming – but then went sideways for a few years while the printing continued.

Here is a chart of the annual changes in the US CPI and the price of gold. I’ve used different axis values, zooming in on smaller CPI changes to make it easier to compare with gold price changes:

The price of gold clearly responds to inflation, but in a very inconsistent way. There are large price increases during periods of low inflation and vice versa. Over the long term, gold is a good store of value in the face of inflation. In the short to medium term, it’s often a pretty bad one.

Still, I’m gearing up for gold (though maybe not $2,500!).

The gold miners

Here’s a horrendous graphic:

This is an ETF that holds a diversified basket of gold miners relative to the price of gold. Since 2008 or so, miners have underperformed commodities very, very badly. Why is that? There seem to be two basic explanations here, one long-term and one short-term.

There is a stereotype about the types of people who operate mining companies. They are believed to be wildly optimistic, eager to start the next big project, and care little for the beauty of making shareholders richer. They end up digging a lot of big holes in the ground and generating poor profits.

Jon Hartsel of Donald Smith & Co believes the stereotype has had a lot of truth in recent decades. He points out that between 2011 and 2015, the five biggest gold miners took $80 billion in writedowns for mergers they overpaid for and projects with cost overruns. Investors won’t buy mining stocks until they’re sure the management teams aren’t up to their old tricks. Investors want free cash-flow, not more mines.

The North American shale oil industry used to have the same reputation for capital destruction as gold miners do now, but that has changed. So there is hope. And Hartsel points out that one company that has demonstrated disciplined capital management, Agnico Eagle, has managed to do quite well against gold:

Hartsel writes: “Agnico Eagle . . . trades at a premium valuation due to its excellent track record of capital allocation and operational execution. . . but the industry as a whole is allocating capital more rationally because it has learned from the mistakes of previous cycles.”

The shorter-term problem for miners, according to CIBC Capital Markets’ Anita Soni, was that operating cost inflation from 2020 to 2022 was higher than gold price inflation, causing margins to squeeze. She hopes the downturn could ease and believes the industry’s costs fell between the first and second quarters, even as the price of gold rose.

This is certainly visible in, for example, Barrick’s recent results. But it will take more than a quarter or two of expanding margins for the industry to regain investor confidence.

Salary report revisions

Yesterday, the Bureau of Labor Statistics revised down its hiring numbers from April 2023 to March 2024 by 818,000 jobs. One thing that stood out to us was the major downward revision in professional and business services – 358,000 jobs, or 44% of the total revision. I knew some consulting firms cut back on personality, but not this much!

Stephen Brown of Capital Economics offers an explanation. The reason the BLS revises its numbers each year is that its monthly results use business surveys, which do not capture changes in employment from the creation of new firms and the dissolution of old ones. To compensate in its monthly releases, the BLS uses what it calls a “birth-death model” to make estimates, which it can check a year later with information on jobless claims. From Stephen:

Although professional services account for only 15% of total wage employment, the BLS assumed that professional services accounted for a disproportionate 25% of job creation among new firms in the year through March. This. . . left room for wider downward revision if the birth-death model overestimates employment gains.

The BLS had reason to believe that professional services would punch above their weight—between 2012 and 2022, employment in professional services grew by 33%, behind only construction and transportation, driven in part by the creation of new companies. But the model was clearly too optimistic.

Have high interest rates somehow prevented white-collar professionals from starting new companies? Or is something else going on?

(Reiter)

A good read

Convention clothes.

FT Unhedged Podcast

Can’t get enough of Unhedged? Listen to our new podcast for a 15-minute dive into the latest market news and financial headlines, twice a week. Keep up to date with previous editions of the newsletter here.