Gold is likely to benefit from the long-term expansion of central banks’ holdings, according to Troy Asset Management’s Charlotte Yonge, which continue to be driven by two key shifts in the global monetary landscape.
While traditionally seen as a ‘safe haven’ asset, gold should be approached with some caution and not be treated as just another commodity, said Yonge.
“Investing in gold is not a straightforward concept,” said the Personal Assets Trust and Trojan fund co-manager. “Gold is viewed by many as a commodity, even though the rules of supply & demand for industrial commodities do not apply.
“Demand drivers cannot be ascribed to normal patterns of economic growth or industrial activity. Instead, demand for gold is a function of perceived rather than a practical value.
“For those assessing gold as a commodity, this will no doubt appear unsatisfactory. The inability to neatly quantify the drivers of demand, and their basis in perception rather than utility, renders the analysis of gold too elusive for many investors.”
However, the yellow metal continues to play a vital role as a currency, particularly given the “fragility inherent in all fiat currencies”.
“The credibility of fiat currency depends upon the fiscal and monetary prudence of the issuing government,” the manager explained.
“It can be shattered overnight, as we have seen in the case of several emerging market currency devaluations, or it can be eroded gently, as looks likely to occur in much of the developed world.”
She added: “Any investor prepared to hold dollars, yen or Argentine pesos should also be prepared to hold gold.”
The precious metal exists outside of the financial system and has a long history of being used as a currency in various countries.
As such, the purchase of gold by central banks has been rising steadily in the decade since the global financial crisis.
Source: World Gold Council
Yonge said that demand from central banks has coincided with two major shifts in the global monetary landscape.
The first major shift identified by the Troy manager is fiat fragility and the “tacit acknowledgement by the US Federal Reserve of the impossibility of reversing quantitative easing”.
This was seen as Fed chairman Jerome Powell reversed course on normalisation, or raising, of interest rates earlier this year.
“Normalisation of monetary policy has failed,” she said. “Consequently, a potential resumption of central bank balance sheet expansion at some point in the future looks firmly back on the table, both in the US and elsewhere.”
It also comes at a time when unorthodox fiscal policy – such as so-called ‘modern monetary theory’ or ‘people’s QE’ – is gaining support, particularly in the US and UK despite record levels of unemployment.
“During the next downturn, further and more aggressive expansion in the supply of paper money looks inevitable,” she said.
“Driving this need for further expansion of the money supply is debt and the need to service it. It is also the reason why interest rates cannot rise any further.”
General government gross debt (per cent of GDP)
Source: IMF DataMapper
Levels of government debt-to-GDP have risen to multi-decade highs and can only be reversed by inflation.
As such, Yonge said the “inevitable devaluation” of paper currencies creates an urgency for investors looking to preserve the real value of their wealth.
Gold, therefore, offers an alternative given that it is “virtually indestructible” and there is a finite supply.
“These two characteristics render gold’s supply remarkably stable,” the fund manager said. “Contrast this with the expansion of central banks’ balance sheets over the past decade and gold’s merits as a supply-constrained currency are compelling.”
The second shift identified by Yonge relates to the US dollar’s status as a world reserve currency.
Such a status quo requires that the US maintains a trade deficit to ensure sufficient overseas supply of the currency, but this is incompatible with the Donald Trump administration is incompatible with this.
“As relationship turn more adversarial, it is unsurprising that countries such as Russia and China are increasingly prioritising gold, their holdings being up 102 per cent and 84 per cent respectively versus five years ago,” she said.
While the dollar is likely to remain its status for the time being, “a gradual shift away from dollar hegemony would likely have a significant impact”. 
Yonge (pictured) added: “Recent performance of the gold price has not, however, come at the expense of the dollar even though the two have tended to exhibit a negative correlation historically.”
“Their ordinarily inverse relationship is in part due to their interchangeability as reserve currencies, in part due to the gold price’s denomination in dollars – depreciation in the dollar renders gold more attractive in other currencies – as well as the fact that mining costs tend to be denominated in US dollars.”
The strong performance of the US economy has attracted investors to dollar assets at the same time that central banks and investors have recognised the merits of increasing reserve allocations towards gold, said the Troy manager.
“Thus, gold with its dollar denomination has provided a doubly valuable hedge against the depreciation of more febrile currencies,” she said.
“In sterling terms, gold has made a new all-time high over the past two months and has more than doubled over a decade.”
There is also historical data to support the yellow metal as a hedge against monetary uncertainty as well as a diversifying asset and hedge against risk assets.
“Gold’s role as a diversifier within portfolios has enormous scarcity value in a world where prospective returns from government bonds have diminished and one can no longer depend on their positive returns to offset equities in a bear market,” she said.
“The same decreased potential is true of the dollar today, both for the reasons we have mentioned as well as, for UK investors, its particular strength against sterling.”
As such, Troy has been building up gold exposure across their multi-asset mandates since 2003 and have doubled holdings to around 10 per cent of the net asset value since the global financial crisis.
Enough gold is held in the portfolios of Personal Assets Trust and the Trojan fund to provide sufficient downside protection, but too much can skew performance of the entire portfolio during periods of weakness for the precious metal.
“Owing to gold’s status as a currency, and consequently greater reliance upon perception, episodes of underperformance can be self-perpetuating, lasting longer than would be rational given the monetary environment.”
“We have recently emerged from one such period of purgatory for gold, powered by a hopeful expectation of monetary policy ‘normalisation’.”
Yonge concluded: “A return to world of ‘sound money’, without severely damaging assets prices is a hopeful vision of the future.
“With the supply of fiat currencies in flux, and more esoteric options for protection unproven, gold provides an alternative of substance, tested over centuries of investment history.”