Hedging against a market downturn with gold

Hedging against a market downturn with gold

Investors with a sense of value are beginning to worry about the durability of the momentum that has taken equity markets to new record highs and government bond yields to probably the lowest ever seen. And well they might worry: six years of zero interest rates have failed to generate the global economic recovery expected and the financial system is still fragile.

The truth is the cycle of bull and bear markets has more to do with money flows than actual business prospects. Money pumped into the system through lower interest rates and quantitative easing goes into stocks and bonds first, long before companies and their banks feel confident enough to finance investment in plant and equipment.

In a conventional credit cycle this marks the peak in markets, because the economic recovery that eventually follows leads to higher consumer prices and higher interest rates. This cycle, we have the added burden of a legacy of debt too great to bear when interest rates rise more than a few per cent. So if economies recover and interest rates rise, markets will not only fall but a modest interest rate increase will be enough to bankrupt large sections of the global economy. Alternatively, if economies fall back into recession, investment risk is likely to rise, and again markets will fall. Put another way, from here on investors are relying solely on continuing momentum.

The value investor should consider gold as a hedge against these risks, but it is important to consider why gold might protect a portfolio. Essentially gold is a store of value separate from currencies and the markets that depend on them. If the purchasing power of a currency falls, other things being equal gold and its various derivatives offer protection. Physical bullion and coins held outside the financial system offer protection against systemic risk, because no one wants to find that the bank holding gold on their behalf goes bust. So it is important to consider which of these risks matter and the likelihood that they will materialise.

In my view both these risks are significant and growing. The markets have seen a rapid expansion of narrow money since the Lehman crisis, yet are beginning to price in global deflation, with an unwinding of foreign currency positions back into the US dollar. There is tremendous gearing between the dollar and all other currencies as shown in the illustration below.

Gold Money

That was the position almost one year ago. Even if it’s not much worse today one can imagine given the numbers that capital flows back into the dollar could rapidly become destabilising. The trigger for these flows is most likely to be a slump in somewhere like Europe, China or Japan, and there is mounting evidence that this is actually happening. It is worth noting that there is a stampede out of the yen and into the US dollar at the moment, while the euro is not very far behind.

These flows into the dollar also place strains on the banking system, which brings us to systemic risk. Banks are highly exposed to sovereign debt, and governments faced with recession will see their deficits increase sharply. So not only will there be increased debt to fund, but markets are likely to reassess bond risk. This being the case, Eurozone debt is badly mispriced, and yields on Spanish, Greek, Italian and Portuguese debt should rise sharply. Given the high balance sheet gearing of some of the large Eurozone banks that own this debt it could rapidly escalate into a banking crisis.

Of course, we cannot go about our daily business thinking banks and currencies are all going to collapse at any moment, but it does make sense to insure against it, and the insurance premium, the price of gold, is especially cheap at the moment. I personally insure against both currency and systemic risk by owning bullion and storing it away from the banking system entirely. Companies like GoldMoney are set up to provide this facility at low cost in a range of locations around the world.

Like any insurance policy, we hope that it will prove unnecessary. In which case, by retaining gold in market-recognised vaults, it will be easy to sell when the danger hopefully passes.

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Giving you convenient and economical access to precious metals. James Turk and his eldest son Geoff Turk founded GoldMoney in 2001. Both understand gold's usefulness as a financial asset and value its worldwide role as money. Their ambition has been to share their views on sound money with the wider public while using the internet to provide a new way to buy and store gold and silver. The opportunity to preserve purchasing power and diversify wealth with precious metals had previously been inconvenient and expensive. GoldMoney now offers the best way to buy gold, silver, platinum and palladium online and safely store these precious metals for you. It is GoldMoney’s vision that the benefits and dependability of gold and silver should be easily available to everyone, while providing its customers with assurances of integrity so they know their money is safe. GoldMoney offers the best way to buy gold, silver, platinum and palladium online and storage for all of these precious metals.

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