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The Role Of Gold In Your Portfolio

Feb 02, 2021

Executive Summary

  • Gold plays a critical role in preserving wealth and should be considered in a context beyond a securities portfolio.
  • The long-history of gold and correlation to real interest rates makes gold a sound proxy on the price of money.
  • Gold also serves a separate role in a diversified securities portfolio, outpacing risk assets during large declines in real interest rates.
  • Investors should consider "linking" or "backing" a percentage of net wealth in gold, in addition to the contributions the yellow metal can make to a diversified securities portfolio.
  • Long-term economic trends support gold in a securities portfolio with the potential roadblock of the zero-bound. Short-term trends favor higher real interest rates, which can weigh on the price of gold.

The Role Of Gold In Your Portfolio

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Gold has been an integral part of wealth management and a form of money for thousands of years. Gold can be a divisive topic, however, with a school of investors that hold a majority of their net wealth in gold-linked assets and another school of investors that consider gold nothing but a "pet rock." 

When discussing gold, the future outlook, and the role in a securities portfolio, it is worth breaking the conversation into two separate parts: the role in preserving net wealth and the role in a securities portfolio. Some investors can think of these two situations concurrently, but I personally use a "bucket" approach to managing my net wealth and think of these two scenarios separately, in separate buckets. 

When thinking about gold in the context of preserving net wealth, we are guarding against a major decline in the value of your home currency. This is a tail-risk scenario that happens with extremely low frequency but suddenly and repeated throughout history. The reason I consider this completely separately from the role of gold in a securities portfolio is so that I do not have to contemplate a hyperinflation tail-risk scenario while managing a securities portfolio with a 3-5 year outlook. 

In the context of a securities portfolio or a portfolio of assets that get marked to market, gold helps to provide stability and generally acts as the mirror image to real interest rates or the price of money. Gold is not necessarily a pure inflation hedge but rather a hedge against declining real interest rates. Gold has outperformed risk assets like stocks throughout various periods in history, even periods that are generally deemed "bull markets." 

First, we'll take a look at gold's role in preserving net wealth and how you may arrive at a personal gold-backing that makes sense for you. Secondly, we'll look at the long-term and shorter-term outlook for the price of gold in the context of a securities portfolio. 

Gold's Role In Preserving Net Wealth

For thousands of years, gold has served the role of money in the global economy, either explicitly or through various stages of "gold-backed" currencies. 

Even as the global economy moved to a fiat-based currency system, removing the explicit redeemable link to gold, the price of the metal has unique characteristics that still resemble the price of money. 

As noted above, the conversation about gold centers around two main issues. First is the highly feared "Minsky Moment" in which our debt-based system collapses, the value of the dollar declines rapidly as hyperinflation ensues, and the world looks to restabilize the system, with perhaps some new link to gold, multiples higher than the current price. This is a possible scenario, but one that is virtually impossible to time. Thus, a static, perpetual allocation to gold for this express purpose can be a valuable tool in wealth preservation. 

Gold tracks real interest rates, or the price of money, even during a hyperinflationary Minsky Moment scenario. Investors continually look for gold to break the link to real interest rates without realizing the hyperinflationary scenario still comes with rapidly declining real interest rates as the inflation rate rises faster than interest rates.

 As a reminder, the "real" interest rate is the nominal interest rate minus expected inflation. 

During a hyperinflationary scenario, the expected rate of inflation rises faster than actual inflation, leading to a continuous downward spiral in real interest rates, or the price of money. Thus, the price of gold rises rapidly, acting as "money"  and the opportunity cost of holding the prevailing real interest rate security, mostly commonly today an inflation-adjusted Treasury bond. 

For example, in Zimbabwe, the textbook example of hyperinflation, the overnight interest rate is roughly 40%, but consumer inflation is over 300% on an annual basis. Thus, the real interest rate is so deeply negative, it is impossible to raise overnight interest rates enough to create upward pressure on real interest rates, and thus the price of gold rose to hundreds of thousands of dollars an ounce in Zimbabwe dollars. 

I'd submit, in this type of scenario, one that is unlikely in the United States in the near-term, but not impossible on a perpetual time frame, that paper gold ETFs like (GLD) or any other sister ETF will not protect net wealth. Physical gold is likely required for this type of left-tail event. Given that this type of situation is unlikely and a low probability event on any 3-5 year time window, I view and protect against this situation entirely separately from my "securities portfolios" in which gaining exposure to the price of gold through paper ETFs is more than sufficient. 

I do not make any recommendations regarding how to buy gold, how much to buy, how to store it, or the other challenges that come with holding the metal in its physical form because this is not my area of expertise, and this is outside the scope of EPB Macro Research as a macro-economic research service with a model "securities" portfolio. 

How much gold or what percentage of your net wealth you feel is necessary to hedge against this situation can be determined by how high you feel the price of gold may rise in hyperinflation or uncontrolled inflation scenario. 

If the price of gold rises from $2,000 per ounce to $20,000 per ounce, linking 10% of your net wealth to the price of gold would result in 100% protection against a Minky Moment. If the price of gold rises from $2,000 per ounce to $50,000 per ounce, a 25-fold increase, then a 4% allocation will provide 100% protection. 

I personally find the 5%-10% range a reasonable level, but your personal "gold-backing" depends entirely on your personal situation and views on the price of gold during a Minky Moment. 

 I prefer not to cloud the judgment of a securities portfolio with a rolling multi-year time horizon with fears of a collapse in the currency. This tail event can be hedged quite easily by linking a portion of your net wealth to the physical metal. Therefore, when dealing with your securities portfolio, you can avoid the questions regarding hyperinflation and "the end game," the hundreds of pages of terms and conditions outlined in various gold ETF prospectuses and focus on the structural, long-term economic trends and shorter-term cyclicality in the rate of growth and inflation. 

You may consider finding a level of gold exposure that works for you and "set it and forget it."

Now, we can think of gold, purely in the form of price direction, without the burden of mixing wealth preservation from a tail-event with the goals of a mark-to-market securities portfolio.

Gold In A Securities Portfolio

Gold is money and acts inversely to the direction of real interest rates. That is the current benchmark interest rate minus expected inflation. Gold tends to hold the strongest correlation around the 10-year real interest rate maturity, so that is the default when discussing real interest rates. 

Importantly, as with all economic data we analyze at EPB Macro Research, it is not the level of real interest rate that is important, but rather the direction. 

If you were to read about a country called "XYZ" and you learned the real interest rate was -10%, you would lack information about the recent direction of gold prices. If the real interest rate in XYZ just moved from -20% to -10%, gold prices would fall sharply as the real interest rate is rising

Conversely, if the real interest rate was completing a move from 0% to -10%, gold prices would be screaming higher on the basis of real interest rates declining.

The chart below shows the recent correlation between the real interest rate and gold. The 10-year real interest rate is graphed inversely on the chart below. 

Real Interest Rates & Gold:Source: FRED, EPB Macro Research

Gold is based on real interest rates, not the US Dollar "USD" as it is commonly taught. 

To solidify this point, in the last three months, the USD, proxied via popular ETF (UUP), declined concurrently with the price of gold, falling 3.2% and 4.02%, respectively. 

In other words, a falling USD proved to offer little support to the price of gold because it is real interest rates that remain the most important fundamental consideration. 

Money supply growth will only impact the price of gold to the extent that rising money supply is inflationary, and we know through a careful review that the link between money supply and inflation is loose at best. 

US Dollar & Gold Price:Source: YCharts

Real interest rates can move for a variety of reasons because there are two independent legs to the inflation-linked Treasury security, namely the nominal interest rate and the expected rate of inflation.

The closest proxy for the direction of real interest rates will be real economic growth. 

Real Economic Growth & Real Interest Rates:Source: FRED, EPB Macro Research

There has been ample research to support that higher levels of public and private debt lead to lower rates of real GDP growth.

The chart below shows the total public and private debt to GDP, as well as a lower threshold and an upper threshold at which debt starts to reduce economic growth relative to trend potential. 

 These thresholds have been replicated dozens of times across many research papers with differing techniques. 

These thresholds were aggregated from the BIS paper "The Real Effects of Debt," the IMF paper "Too Much Finance," the IMF paper "Public Debt and Growth," the Journal of Economic Perspectives paper "Public Debt Overhangs," and the American Economic Review paper "Growth in a Time of Debt."

The lower threshold takes the low end of the debt to GDP range outlined for all sectors of the economy (government, business, household, and financial), and the upper threshold takes the high end of the range set out in the papers mentioned. 

Total Debt To GDP Thresholds:Source: BIS, IMF, Journal of Economic Perspectives, American Economic Review, Federal Reserve, BEA, EPB Macro Research

In the IMF paper, "Too Much Finance," the authors outline the nonlinear relationship between higher debt to GDP and economic growth. 

The Nonlinear Impact:

Source:  IMF: "Too Much Finance?"

This nonlinear relationship is mentioned many times in the cited papers above.

The empirical results suggest an inverse relationship between initial debt and subsequent growth, controlling for other determinants of growth: on average, a 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2 percentage points per year, with the impact being somewhat smaller in advanced economies. There is some evidence of nonlinearity with higher levels of initial debt having a proportionately larger negative effect on subsequent growth.

- IMF Paper "Public Debt and Growth"

Seldom do countries “grow” their way out of debts. The nonlinear response of growth to debt as debt grows towards historical boundaries is reminiscent of the “debt intolerance” phenomenon developed in Reinhart, Rogoff, and Savastano (2003).

- American Economic Review Paper "Growth in a Time of Debt"

The nonlinear impact on economic growth can be seen in the long-term chart of real GDP per capita. Real GDP per capita growth is the best proxy for the increase in the standard of living because it normalizes for inflation and population, resulting in the cleanest read on the new productive capacity created in the economy. 

The chart below chops off the major decline after the Great Depression and then the base effect 20 years later. 

We crossed the lower bound threshold of debt to GDP in the early 2000s and started to lose growth relative to the nation's long-term trend. 

Now, we have also crossed the upper thresholds of debt to GDP, so unless we change the economic system in which we operate, the host of available research implies that investment in the real economy will continue to suffer, and the growth rate of real GDP per capita will decline even more rapidly on a long-term basis, save for a large rebound after a sharp recession which is highly typical. 

The Nonlinear Relationship:Source: BEA, Maddison Project Database, EPB Macro Research

As a result, the real interest rate, should it continue to follow real economic growth lower, will result in higher gold prices as gold moves inversely to the price of money or the real interest rate.

Eventually, if the real interest rate moves low enough and inflation remains subdued, the nominal interest rate will be dragged into the zero-bound, which may or may not prove to be a hard floor. 

The BIS paper "Deleveraging? What Deleveraging?" discusses this phenomenon in which higher debt levels lead to lower real economic growth that can only be supported by ever lower real interest rates. 

This process continues unless a country is constrained by the zero-bound. 

Real Interest Rates In High Debt/Low Growth Economies:Source: BIS: "Deleveraging? What Deleveraging?"

Over time, on our current path, the real growth rate will continue to decline, and this will drag the real interest rate lower. This is highly supportive of gold prices through the lens of long-term trends. The zero-bound constraint is a potential roadblock to the secular tailwinds supporting an overweight allocation to gold in a securities portfolio. 

Since the United States started to show rapid declines in real GDP growth, which brought dramatic declines in real interest rates, gold has performed in-line or outperformed even stock prices depending on your chosen time frame. 

Pricing stocks in gold normalizes for inflation and declining real interest rates and measures how much stock prices can rise in real terms, without the benefit of falling interest rates. 

The answer since 1997 is not much, and this should continue to hold true as long as real economic growth continues to exhibit a declining trend. 

Risk Assets Vs. Gold Since 1995:

Source: YCharts

At EPB Macro Research, we always try to balance the long-term secular trends with the shorter-term cyclical trends. 

Based on the leading indicators of economic growth, discussed in more detail in the last [Quarterly Webcast], the bias for real GDP growth is higher over the next several quarters. 

Cyclical Leading Indicators:Source: ECRI, CRB, ISM, Federal Reserve, EPB Macro Research

Higher real economic growth is supportive of higher real interest rates, even if temporary, which should weigh on the price of gold. In other words, the ratio of stock prices to gold should rise while the leading indicators of growth are pointing the upside. 


Gold can serve many different roles in regards to protecting net wealth and also in a diversified securities portfolio. 

Investors worried about the potential for hyperinflation or a Minsky Moment may consider allocating a fixed percentage of net wealth to physical gold as paper gold ETFs are unlikely to protect wealth in such a left-tail shock. 

As a part of a diversified securities portfolio, the trend in gold will be predominantly determined by the direction of real interest rates. Long-term trends in economic growth support lower real interest rates and thus, higher gold prices. This process should continue unless the zero-bound proves to be a constraint on ever-lower real interest rates. 

In the short-term, a transitory rise in real economic growth supports higher real interest rates which can be a near-term drag on the price of gold.

As always, the decision to be overweight or underweight gold is a time-frame dependent decision. 

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