Last week we looked at interest rates and how low interest rates affect savers. In the past (during the 60s-90s) investors were able to generate better risk-free rates of return than today. Historically, savers and and investors have turned to the stock market to generate higher than average returns.
However, in a time where many stocks are extremely overvalued, generating “good” returns can be challenging. Due to this risk of buying overvalued companies we have seen people take routes less traveled to get investment returns.
In the last two years, we have seen a significant increase in the price of gold. On September 1, 2018 gold futures closed as $1,256. As of the time of writing, gold is sitting at around $1,990. That’s a return of more than 58%. Just for reference, the S&P 500 over that same time period is up just over 11%.
Looking back over the last 100 years, gold has never been this high. It seems as though people are seeing the value in gold. Part of this value comes in the way of it’s immunity to inflation.
Fiat currencies are what people today would just call money. Historically, government currencies like the American dollar were backed by a physical commodity, usually gold.
When currencies were backed by gold, it was called the Gold Standard. The gold standard meant that the dollar was fixed to the price of gold. A country could only print, issue, and circulate as much money as they had in their gold reserves. To read more on the recession of the ’70s and the end of the gold standard, click here.
By having currencies linked to the price of gold, it acted as a way to prevent “artificial” inflation. However, the Gold standard ended in 1971. Since then, currencies have not been backed by anything. This has essentially given government and central banks the ability to print money without any immediate and noticeable ramifications.
We have talked about inflation quite frequently. Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over some period of time.
Inflation is generally classified into 3 types: Demand-Pull, Cost-Push, and Built-In.
Demand-pull inflation occurs when the overall demand for goods and services in an economy increase more rapidly than the economy’s production capacity.
This type of inflation can occur by cuts to supply, like when oil-producing countries decided to cut oil production. Or, it can happen by an increase in demand for a particular product or service. For instance, a place with mild winters suddenly has a really harsh winter, the demand for winter tires will probably increase (this is a small example but I think you get the point).
Cost-Push inflation is the result of the increase in the price to produce goods or services. This may happen by an increase in labor costs or raw materials costs. In order to maintain their profit margins, companies must increase the cost to the end-user.
Built-In inflation links to adaptive expectations. As the price of goods and services increase, consumers require more money to maintain purchasing power. In turn, employers and businesses are forced to increases wages. This increases their cost of production which consequently increases the price of the end product or service. This cycle continues as one factor induces the other.
Increasing the supply of money in an economy leads to demand-pull inflation. As more money is issued and available to individuals, it leads to increased spending. Consequently, the increase in demand leads to higher prices.
The money supply can be increased in two ways. The monetary authorities can 1) print and give away money to individuals, or 2) they can devalue their currency.
Currently, we are seeing the first one, printing and giving away money directly to individuals. The huge stimulus packages issued by the central banks and governments have given millions of people, billions of dollars that they normally wouldn’t have had. If it hasn’t already, this will lead to the debasement of the fiat currencies.
Debasement – refers to lowering the value of a currency.
People seem to be realizing that this type of monetary policy isn’t sustainable. Printing money, handing it out, and increasing your government debt to levels no one can even comprehend. This has caused people to have apprehensions towards fiat currencies.
A worsening labor market would generally be an indicator of a deflationary time. However, since government spending has increased dramatically due to the recent bailouts and stimulus packages, the fear of severe future inflation is very real.
The debt cannot just disappear. Because of this, once the economy stabilizes, there is an incentive for central banks and governments to let inflation rise. Higher inflation will allow for an easier time servicing and paying off the debt that they have accumulated. However, higher inflation is not a good thing for the general public and especially savers.
People can now see that a fiat currency, like the US Dollar, that can be devalued or inflated at a whim, is not a true store of value. This is where alternatives like gold and cryptocurrencies come into play.
Gold and Crypto
Due to the fact that governments and central banks now have free reign on money printing, it is causing people to take pause. They are realizing that the 100 dollars they have today, will not be as valuable tomorrow if the government continues to issue more money.
This is why we are seeing the run to safe havens like precious metals and some cryptocurrencies.
Why are these people flocking to precious metals and cryptos?
The Value of Gold
Unlike the Canadian or US dollar (or any fiat currency), the amount of gold in circulation can not be manipulated. Dollars can easily be printed with a few keystrokes and click of a mouse. The process to mine, refine, and produce gold is not that simple and is extremely cost-intensive. Gold also can’t be synthetically created, although many alchemists in history have tried.
In addition, there is a fixed amount of gold. Once all the gold has been mined, more gold will not magically appear. As gold continues to get mined, the cost of mining will likely continue to increase. This is because the un-mined gold will be in more remote and harder to access places and further under ground.
Because gold production and supply is limited, as currencies (specifically USD as the world reserve currency) lose value due to inflation, gold tends to get more expensive. Lets look at an example of an investor holding cash vs. an investor holding gold.
Let’s assume there is $1,000 in circulation, and Investor A owns 10% ($100). Let’s assume that there is 1000 Oz of gold (each Oz is worth $1), and Investor B owns 10% (100 Oz).
Now let’s assume that in year two, the central bank decides to print $500 more. There is now $1,500 in circulation and Investor A now owns 6.66% of all the money. However, since gold production is limited, only an additional 50 oz of gold was produced. Investor B now owns 9.5% of all gold in circulation.
Since there is now $1,500 in circulation and only 1050 oz of gold the price of each oz of gold has increased. Each oz of gold is now worth $1.42 ($1,500 / 1050 = $1.42). This means that the person with the $100 can now only purchase 70 oz of gold. However, the person that had the 100 Oz of gold can now sell them for $142.
Crypto’s Are The New Gold
A lot of crypto’s have similar characteristics to gold: many have a finite amount of coins available; the supply of crypto’s is not controlled by a central figure (i.e., government or banks); As more is mined, the remaining un-mined becomes more costly to mine.
Additionally, just as it is hard to steal physical gold, counterfeit it, or otherwise corrupt it, the same is true with many cryptocurrencies.
Let’s take Bitcoin (BTC) as an example. It is one of the original cryptocurrencies that has some attractive characteristics as an alternative to fiat currencies.
- Bitcoin is mathematically finite. The maximum amount of Bitcoin that can ever exist is 21,000,000.
- Bitcoin is divisible into hundreds of millionths, meaning you can buy, hold, and transact very small amounts.
- Bitcoin is cryptographic code hosted on a distributed ledger, making it impossible to replicate, forge, hack, or increase total amount of bitcoin in any way.
- A distributed ledger takes computing power and energy to operate and maintain, meaning there is a cost to provide the network infrastructure.
The distributed ledger is really the defining factor of bitcoin. A distributed ledger means there are hundreds of thousands of computers all over the world hosting, verifying, and updating an identical copy of transaction history.
Every time a new transaction is entered into the bitcoin network, computer terminals around the world check over the string of encrypted code, verify that it is legit and belongs on the public ledger (or blockchain), and then update the copy of the public ledger held by all terminals on the network.
The distributed ledger takes the traditional concept of money, removes the ability of any government to devalue it, and provides a fully public system of trust where no one can fraudulently create more bitcoin.
As mentioned above, we have seen the price of gold increase markedly over the last two years. As more and more people realize that there dollar denominated assets are not safe from inflation, more people will move towards safe havens.
Due to a striking amount of similarities between gold and some cryptocurrencies, it is not hard to imagine a future where more people move towards digital assets in some form. This doesn’t even take into account the tech advancements and innovation that would accompany wide spread blockchain and crypto adoption.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy