The Return on Gold!

Gold is headline news again.

Over the last 3 months, gold has outperformed all other ‘asset classes’ with a 27% and 18% increase in the Rand and US dollar prices respectively over this period. The yellow metal’s return over the last year boasts equally impressive gains of 38% and 30% in Rand and US dollar terms respectively.

The rise has drawn considerable media attention with pundits worldwide weighing in on the value of the ‘barbarous relic’. Over the past few decades, amid the frenzy of illusory paper wealth increases in financial asset prices, gold has been largely ignored by asset managers and the professional investment industry.

Economist Mike Shüssler’s Moneyweb article this week analysed long-term return data, highlighting that gold has, in fact, outperformed all other South African asset classes over the medium to long term (it actually did so in the short term as well, but his analysis relied on outdated short term data).

In this week’s article, we delve a little deeper into gold as an ‘asset class’ within the context of investment returns and popular opinion among investment pundits.

Gold is Money

Gold is often, but erroneously grouped together and compared with financial assets that earn an income stream, such as equities and bonds. The first step to understanding the true role (and hence value) of gold in the economy, is to recognise gold for what it is and for what it has been used throughout history – gold as money.

As we outlined in our debut article, gold possesses unique physical properties that cannot be artificially replicated – it is one of the 118 elements in the periodic table. These properties have endowed gold with the unique physical ability to store value across time. Due to its key monetary properties, gold has been used as money for millennia, dating back to the ancient Egyptian times.

Over the ages, many other forms of money were also tried, but all of these experiments ultimately failed. The most recent experiment in monetary history has been that of fiat paper currencies (read: unbacked by gold). This experiment is behind the illusory paper wealth that has masqueraded as value appreciation across stock markets worldwide..

A key damning feature of modern State-issued paper currencies is the lack of the key physical monetary characteristics for storing value. The continual loss of purchasing power in all fiat currencies since gold-backing was removed – the Rand has lost 99.9% of its value and the dollar 98% – bears testimony to this and has rendered them fairly useless as a store of value (read: savings mechanism). As such, we believe this experiment will ultimately prove to be exactly that.

Gold as an Asset Class

So when we understand the true role of gold in society, we can fairly compare gold to others ostensibly designed in this role – for use as money – and thus juxtapose the ‘returns’ of gold against that of the Rand, Dollar, Pound and so on.

Needless to say, there is no comparison – gold has vastly outperformed them all across any period of time, maintaining where its ‘cohorts’ have lost the majority of theirs.

But for interest’s sake, let’s compare apples to oranges. How has gold performed when compared to income yielding financial assets. The below table shows the comparison in Rand terms (we updated Moneyweb’s analysis with the most recent gold price data).

Number of years Total gross return JSE SA bonds real yield 91-day money market yield Total gross house return Gold in Rand
Last 50 years 3.94 2.08 0.75 1.05 5.16
Last 25 years 4.80 3.93 2.72 3.49 5.59
Last 15 years 6.03 2.49 1.05 1.43 9.98
Last 12 years -0.04 2.44 0.63 -1.84 7.30
Last 10 years 4.31 3.17 0.85 -0.15 5.50
Last 5 years -3.41 3.88 1.51 -0.15 3.82
Last 3 years -2.14 4.30 1.83 -0.79 1.27
Last 1 year -4.07 4.63 2.00 -0.77 32.49

Gold is the clear winner across all time horizons.

Time Preference

Gold, however, can earn a yield. For us to understand this statement, let’s set the stage for the term interest rate.

A fundamental truth about people is that we prefer to achieve our goals and objectives in the shortest possible time – the sooner it arrives, the better. This preference results from the very natural fact that our time is limited (we haven’t yet figured out how to make more time) and, as such, it needs to be economised.

So, with any given objective, the shorter the period of action to attain said objective, the more preferable. This universal fact is called time preference. Our time preference for consuming in the present is the obvious factor that holds us back from investing more capital to produce for the future. If we did not prefer consuming now vs next {insert timeframe}, we would never consume and simply invest in the production of future goods (which is absurd, since the ultimate purpose of all production is consumption).

As a basic example, let’s illustrate this principle in the context of our island economy as detailed in an earlier article.

In our story, Adam forewent fishing for a day to build a net that enabled him to catch more than one fish a day. His friends, Bob and Charlie, wanted to borrow some of his fish to sustain them while they build their own nets. Adam charged them an interest rate for this privilege – they had to repay Bob 2 fish for the privilege of every 1 they borrowed.

In lending out his fish, Adam had to decide his preference for consuming the fish today versus receiving more fish in the future – Adam’s time preference. He decided to charge Bob and Charlie an interest rate of 100% (2 fish tomorrow, in return for 1 today). The interest rate is, therefore, fundamentally tied to time preference. (Please note that for this example, we assume no risk in Adam’s lending business).

Now let’s get back to real life..

In society, the medium for matching up investment and savings is money (it would be very difficult to coordinate these transactions in a barter economy). It is, thus, this function that money primarily facilitates. We take this obvious function so much for granted that we forget that interest rates in society are actually the expression of our combined time-preferences, which has its origin in our deferring consumption in the present for the future.

The intermediation of these matching transactions happens through banks. As a side note, this intermediation somewhat conceals the intrinsic link between interest and time-preference from us, as we falsely assume that we are not parting with our money by depositing it in a bank. We do, and a bank deposit is inherently nothing other than a loan to a bank, with the bank promising to honour this debt on our demand.

Gold and Interest

So when gold is used as money, it carries an inherent interest rate as time-preference obviously applies, as gold represents stored resources that are saved and not presently consumed. A saver lending his gold will expect it to be returned at the end of the loan period with an additional amount to reflect at a minimum his time-preference – on societal aggregate, gold’s interest rate.

Apart from isolated times of monetary debasement, this held true for millennia until the last century, when gold was gradually replaced as money by today’s paper currency system. Banks used to effectively lend out gold – as long as currency acted as a freely convertible gold substitute (a paper claim on physical gold), interest earned and paid on that currency was tied to the rate on gold. We have not discussed the above mechanics in a fractional reserve banking system of unbacked paper currency – a topic for a future article.

Gold is still being loaned out today, mostly between and among central banks and bullion banks. Today’s bullion market, dominated by the London Bullion Market, sets gold’s interest rate in the context of dollar interest rates. In London’s forward gold market, gold’s interest rate is termed its lease rate – the rate bullion banks lend gold to other bullion banks on a swap basis against US dollars.

Return: Gold vs Fiat

So now let’s return to the nexus of measuring against other asset classes.

Just like fiat currencies, when gold is used as money and loaned out, it attracts an interest rate. Furthermore, if someone wanted to borrow your gold, you would most likely require a greater return than the interest rate you would require when depositing your Rands at your local bank, not so? This is because of your gold’s relative scarcity to the paper.

What’s interesting is that interest rates on fiat paper currencies worldwide are at near zero levels. The calculation of time preference when it comes to fiat currency should take into account the fact that fiat currency is inflated (read: printed) without limitation, resulting in a loss of purchasing power. Naturally, one would be more eager to consume your Rands or Dollars today when you know it’s going to be worth less in future. The fact that this time preference is not reflected in interest rates we see worldwide is a reflection of the distortion of capital markets by this fiat paper currency system. 

Nonetheless, when we compare the return of gold as money to that of any other unbacked currency, past or present, gold is the winner by a country mile.

Return: Gold vs Financial Assets

Although the international price of gold naturally includes the return on gold leasing between bullion banks, when you and I own physical gold, we are not participating in the leasing of our physical gold to anyone (with paper gold, this may be a different story – but one for another time). As such, we do not expect an income stream from the physical gold.

Financial assets, on the other hand, necessarily earn an income stream (equities and bonds in the form of dividends and interest income respectively).

It is, thus, clear that pundits, in comparing gold to financial assets, are comparing apples to oranges, or more colloquially, fighting Connor McGregor against Floyd Mayweather in a boxing match!

But even despite this asymmetric analysis, gold still comes out on top (as shown in the above comparison table).

However, instead of celebrating the victory of one asset class over another, this data should induce earnest concern. It makes little sense for an investment that is designed to generate an income stream to be outperformed by an element that is designed to act as a store value and medium of exchange.

This fundamental disconnect speaks volumes of enormous distortions inherent in today’s global capital markets. We would argue that at the base of these distortions you will find the fiat paper currency system.

Hold on to your gold. We think it’s going to be a bumpy ride.

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