July 2020 Macro Commentary

The price of gold has been grabbing the headlines recently, with the gold ETF GLD up 31% YTD compared to ~ 2% for the S&P 500 (as of the time of this writing).  It’s no surprise that investors would at least consider adding gold to their portfolios given the incredible increase in the money supply: the M2 money stock (a measure of the money supply that is readily available to be used in the near-term) has increased almost 20% over the course of less than six months.  Increasing the supply of money, holding all else equal, should in theory lead to an increase in monetary velocity; i.e. inflation.  Gold is the most obvious “hedge” to inflation, which is essentially a reduction in the value of paper money.

The U.S. experienced a similar situation following the financial crisis of 2008.  To combat inflation that was below their target, as well as GDP growth which was consistently lower than pre-2008 levels, the Federal Reserve embarked on multiple rounds of Quantitative Easing...effectively an increase in the money supply.  As a result of the expectation of runaway inflation, the gold price rallied significantly to over $1,800/oz by mid-2011.  But higher inflation was never realized, and in fact, inflation fell further below the Fed’s 2% target.  As a result, the gold price retraced a large portion of its gain, trading close to $1,000/oz by the end of 2015.

The same pattern is being realized today:  the substantial increase in the money supply is driving up the price of gold in anticipation of a sustained rise in its value relative to the U.S. dollar (and other fiat currencies).  This time may be different, however, when compared to the period of 2011 through 2015.  We see two major reasons why this gold rally is more sustainable, despite our anticipation of a near-term temporary pullback:  1) a shift in the Fed’s approach towards achieving its goal of 2% inflation; and 2) the unprecedented nature of the monetary and fiscal support provided by both the Fed and the U.S. government.

A New Inflation Targeting Regime

Prior to the pandemic, the Federal Reserve had been undertaking a review of its monetary policy tools and framework in specific relation to its inflation target.  This is a euphemistic way of saying that the Fed hadn’t been consistently meeting its inflation goals since 201`2 and they needed to talk about trying something different (the reasons as to why a 2% inflation target is so important is beyond the scope of this article).  This potential shift in the Fed’s inflation targeting regime was why we had made gold one of our biggest positions at the beginning of 2020.

The Fed’s review however was disrupted by the Covid-19 pandemic; but in Jerome Powell’s last press conference, he indicated the Fed is  back on track with its review and will “wrap up” discussions in the “near future”.

Now, the potential is clearly there for the Fed to come up with successful ways to drive inflation higher over the next economic cycle, but investors should in no way confuse this with the prospect for runaway inflation.  One of the most creative things the Fed has done over the past 10 years is implement new tools to quickly and effectively shrink the money supply (that do not rely on unloading massive chunks of Treasury securities).  The important point is that the Covid-19 pandemic will only serve to drive near-term realized inflation further below target, which will more strongly incentive the Fed to forcefully manage average inflation going forward.

The Unprecedented Policy Response

We are all aware of the magnitude of the trillions of dollars in fiscal stimulus, and I’ve written before on the size of the Fed’s liquidity and capital market support facilities.  But the single best chart, in my opinion, to display the unprecedented nature of the policy response is that of the personal savings rate (personal savings as a percentage of disposable personal income):

The savings rate peaked at almost 35% in April ’20; the savings rate in the prior two recessions aren’t even in the same zip code.  The drivers of the high savings rate in the current recession has to do with the concurrent implementation of massive fiscal and monetary stimulus:  direct checks to consumers, enhanced unemployment, and other government transfers payments funded by increased Treasury purchases from the Federal Reserve.  This support to incomes combined with a large temporary fall-off in consumer spending spiked the savings rate.

In a normal recession, consumer spending declines, savings increase and unemployment rises.  Due to the reduction in wages from high unemployment, net of unemployment insurance, the savings rate increase is generally much more modest.  In this recession however, personal incomes have actually gone up because the stimulus has been so large.  Now, we will see the savings rate continue to fall, exacerbated by any reduction in unemployment benefits; but it’s highly likely we will see sustained government stimulus with 17 million + unemployed and the virus still an issue...meaning the savings rate will remain very elevated compared to history.

The final, and most important, takeaway is that this high savings rate represents a tremendous amount of pent-up demand from consumers that has been funded by the printing of money.  In other words, because of  the massive increase in the money supply, those savings don’t have to be re-circulated back into Treasury securities to fund the huge government deficits...the Fed is funding the deficits, and at this point, has no other choice.

The high savings rate that has been effectively created by the indirect printing of U.S. dollars, combined with the inflation-targeting-regime-change coming from the Fed, are the reasons why the gold price rally this time around may be more sustainable.  In the near-term, the pandemic combined with election uncertainty should keep realized inflation low, and therefore a pause in the gold rally is plausible.  But if government stimulus payments keep rolling-in, the latency of the high savings rate could manifest in a massive flood of dollars in global currency markets, driving the U.S. dollar value of gold much higher.

Comment on Reserve Currencies

A less likely, but potentially very meaningful, driver of higher gold prices relative to the U.S. dollar is the role gold could play in global forex reserve portfolios, where the U.S. dollar has maintained prime reserve currency status.  What makes a currency valuable from a reserve standpoint (i.e. what currency is the most attractive in which to park capital) is geopolitical stability, consistent economic growth, stable inflation, and the currency’s role in global trade.

Investors should ask themselves how the U.S. economy and the U.S. dollar can be described both currently and in a forward looking sense relative to those factors...and i’ll leave it at that.

Gallatin Capital Management, LLC

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