The traditional view is that gold is a safe-haven asset. Safe-haven assets are important because investors want the value of their portfolio protected during times of stock market distress. Is the traditional view correct?
The Congressional Budget Office recently warned that its projections showed that the U.S. federal government debt is on a path from 97% of GDP last year to 116% by 2034—higher even than in World War II. Under current policies, it will eventually reach 200%.
The actual outlook is likely even worse because, from tax revenue to defense spending and interest rates, the CBO forecasts released earlier this year are underpinned by rosy assumptions (Trump’s 2017 tax cuts expire in 2025 and the CBO follows the legislation in its forecasts). Plug in the market’s current view on interest rates, and the debt-to-GDP ratio rises to 123% in 2034. Then assume—as most in Washington do—that ex-President Donald Trump’s tax cuts mainly stay in place, and the burden gets even higher.
Election Risks
Unfortunately, regardless of which side of the political spectrum you are on there are risks from the proposed policies of both candidates. With a Trump victory, there may be an increase in tariffs (which risks retaliation) including the potential imposition of 60% tariff on Chinese goods (up from 20%-25% currently); the repeal of the corporate AMT and buyback tax combined, a large increase in defense spending and full extension of TCJA tax cuts leading to even wider budget deficit. There is also the risk of militarized mass deportations negatively impacting labor force growth and wage inflation. Perhaps the greatest risk is that Trump has expressed the desire to influence Federal Reserve policy. Were this to happen—even the threat of it happening—it could create significant downside risks. The U.S. has long benefited from the dollar’s role as the world’s reserve currency. We have also benefited from our strong rule of law, having the deepest and most liquid capital markets and the freedom of capital. Any efforts to control the Fed could undermine the dollar and lead to an increase in the risk premium associated with U.S. debt instruments, raising the cost of our debt and negatively impacting our ability to fund the massive deficits we have accumulated.
With a Biden victory, there are the risks of multitrillion-dollar tax increases (half corporate, half high net worth) to support a multitrillion safety net expansion, widening the deficit as tax collections undershoot estimates while spending exceeds them.
The problem is that under either a Trump or a Biden presidency it is likely that the U.S. will continue to have a huge spending problem, with expenses running way above revenues. Eventually, lenders may no longer be willing to finance the deficits. If spending is not cut, the alternative solution would be to raise taxes to European levels. However, the result would be European-type low growth rates, which would have negative consequences for equities.
Given these risks, it’s no surprise that investor interest in gold has increased. Three main reasons dominate the heightened interest.
- Gold provides a hedge against currency risk;
- Gold acts as a haven of safety in bad times; and
- Gold is an excellent hedge against inflation.
Are these points valid? As always, we look to the empirical research evidence to provide answers.
In their June 2012 study, The Golden Dilemma, Claude Erb and Campbell Harvey examined those issues. In terms of being a currency hedge, they found that the change in the real price of gold was largely independent of the change in currency values—gold is not a good hedge against currency risk.
As for gold serving as a safe haven, meaning it is stable during bear markets in stocks, Erb and Harvey found gold isn’t quite the safe haven some might think. Seventeen percent of monthly stock returns fell into the category where gold dropped while stocks posted negative returns. If gold acts as a true safe haven, we would expect very few, if any, such observations. Still, 83% of the time on the right side isn’t a bad record. With that said, even the safe-haven hypothesis was tarnished, as gold prices declined over 30% during the worst of the financial crisis. When the hedge was needed most, it failed. In 2022 when stocks and bonds produced double-digit losses, even though gold outperformed stocks and bonds, it failed to provide a true hedge, as it fell slightly, closing at $1,824 in 2022 after closing at $1,829 in 2021.
In terms of gold’s value as an inflation hedge, the following example should help…
Read More: Is Gold Always a Safe-Haven Asset?