Investment Strategies

Why gold makes sense for investors

There are times when the precious metal can play an important role in a diversified portfolio

May 22, 2016 @ 6:00 am

By Defred G. Folts III

+ Zoom

The price of gold rose more in the first quarter of 2016 than during any quarter since the third quarter of 1986. As a result, should advisers be educating their clients about including this rather unique commodity as part of their investing tool box, particularly now that a variety of gold ETFs are so readily available?

Gold doesn't pay a dividend or yield interest, nor does it convey partial ownership of an enterprise that may increase in value. However, there are times when gold can play an important role in a diversified portfolio. It can serve as a leading indicator of future inflation. It can be a defensive asset to hold during periods of economic and market anxiety. It can also act as a hedge against currency debasement since it could be thought of as an alternative form of money whose supply can't be increased at the whim of central banks.

The price of gold rose more in the first quarter of 2016 than during any quarter since the third quarter of 1986. As a result, should advisers be educating their clients about including this rather unique commodity as part of their investing tool box, particularly now that a variety of gold ETFs are so readily available?

Gold doesn't pay a dividend or yield interest, nor does it convey partial ownership of an enterprise that may increase in value. However, there are times when gold can play an important role in a diversified portfolio. It can serve as a leading indicator of future inflation. It can be a defensive asset to hold during periods of economic and market anxiety. It can also act as a hedge against currency debasement since it could be thought of as an alternative form of money whose supply can't be increased at the whim of central banks.

WHY HOLD GOLD?

The first quarter of 2016 was an excellent example of why it could make sense to include gold in an investor's portfolio. As the year began, the Federal Reserve was the only major central bank that had begun to raise interest rates, which it started last December. The Fed also presented a plan to raise rates four more times during 2016. Meanwhile, all other major central banks continued to ease their monetary policies. Consequently, investors expected this policy divergence would continue to increase the value of the U.S. dollar against the world's major currencies. However, the rising dollar eventually caused China to delink its currency. China's currency devaluation, coupled with the Fed's plans to tighten monetary policy throughout the year, helped lead to a steep decline in the global stock markets, with market pundits warning of a coming global recession. Then the Fed blinked! Once this happened, the heavily one-sided bet on the dollar began to unwind, providing relief to the gold market that had been under stress from the rising dollar.

The world's major central bankers are all seeking to generate greater economic growth and healthier levels of inflation by ensuring that the values of their respective currencies don't rise to the point where their exports become less competitive in a globally inter-connected world. As a result, the relative value of the world's major currencies continues to shift in value among one another.

Another consequence of these policies can be seen as the weakening of the value of all of the world's paper money or fiat currencies in absolute terms. This debasement of fiat currencies may be seen as at least one of the contributing factors in the run up in the price of gold thus far in 2016. If one were to consider all of the world's major currencies, not in relation to one another, but rather in terms of a different (fixed) type of currency such as gold (the anti-paper money), then what we experienced in the first quarter of 2016 is the value of all fiat currency declining in terms of gold. The consequence of this was the recent rise in the price of gold.

The price of gold could still go higher under the following scenario: If the limits to monetary stimulus become more apparent in the future, but at the same time global growth remains inadequate, then there could be increasing pressure on governments around the world to support economic growth by increasing fiscal spending. However, an increase in fiscal spending could easily lead to higher government debt levels, and the central banks would then be under pressure to monetize the debt, printing yet more money and further weakening their currencies.

Lastly, if one looks at the stock market back to the year 2000 — not in terms of U.S dollars, but rather in terms of the price of gold — then one sees that beginning in 2009 U.S. stocks had a dramatic move upward in U.S. dollar terms. But, priced in gold, the U.S. stock market is not even close to where it was in the year 2000.

If the Fed decides to raise short-term interest rates faster than the rate of inflation, then that could be negative for gold. Still, we believe that gold is an asset class that should be included in investors' toolboxes in the future.

Defred G. Folts III is chief investment strategist at 3EDGE Asset Management.

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