A perfect storm is brewing in the markets. Western government bond yields are slumping to ever more pitiful levels (and prices rising) as confused investors seek safety, but in all the wrong places. Quantitative easing (QE) is keeping those government bond yields at ultra-low levels (another less polite description would be ‘rigging the market’).
Monstrously indebted Western governments are, in other words, coercing the more biddable institutions (namely banks and pension funds) through ‘financial repression’ to invest in their bonds. If you need any evidence of this, you might recall that a Dutch private-sector pension scheme last year was forced by the Dutch regulator to sell its holdings in gold and reinvest the proceeds in ‘safe’ assets – such as Dutch government bonds – although the regulator’s decision was later overturned on appeal.
It is difficult to overstate the problems facing underfunded pension schemes – particularly ones without the initiative to invest in ‘exotic’ assets such as gold. On the one hand, pension consultants Towers Watson estimates that UK schemes have liabilities of some £2trn compared with index-linked gilt supply (their natural liability-matching asset of choice) of only £0.5trn. It reckons that it will take until 2039 before the supply of index-linkers matches scheme liabilities.
On the other hand, British pension funds are sitting on what Bill Gross two years ago termed a pile of nitroglycerine – namely their exposure to fixed-income UK gilts. If the situation was dangerous then, it is worse now.
The Financial Times reported last week that UK pension funds are now holding more bonds than equities for the first time since the 1950s. So pension funds are now all-in in the bond market at its most expensive levels in history. What could possibly go wrong?
My single biggest concern over the near-to-medium term is that the government bond market goes bang. Whether this happens first in the US Treasury market or the UK’s gilt market (or some part of the ailing eurozone) may ultimately be somewhat moot. The point is: no market is an island. When interest rates start to spike higher in one part of the global capital infrastructure, they are likely to spike higher elsewhere.
A lurch higher in government bond yields is also consistent with a currency crisis, given that any developed country suddenly deemed unable to control its finances is likely to suffer a run on its currency too. The UK looks particularly vulnerable not least because it is effectively official government policy to devalue sterling in order to boost exports.
That the government has just extended its Zimbabwean economic policy in letting the Treasury grab interest payments from the Bank of England’s Asset Purchase Facility further weakens prospects for the pound. A 40-year experiment in unrestrained credit creation and unbacked fiat currency was always destined to end badly. Just how badly we are about to see.
So what can investors do to avoid being swept away in this looming monetary disaster? In the first instance, at the risk of sounding like a broken record, I think it makes perfect sense to hedge one’s currency exposure by owning the one currency that can’t be printed on demand, namely gold.
Gold is the optimal portfolio insurance because it is the one asset that is no one else’s liability. Bullion works. And so, in the interests of portfolio diversification and self-preservation, do high quality gold and silver mining companies, given that they still trade on a meaningful discount to the price of the physical.
Gold remains the most misunderstood asset in the world. Sceptics point back to the price of gold in 1999 (roughly $250 an ounce) and argue that at around $1,700 today, it’s expensive. But compared to what? How can you sensibly price an asset when the value of the denominator (the US dollar, for example) is being depreciated daily?
As one sensible investor once told me, it’s like trying to measure the width of a suit using an elastic tape measure. The only answer is to throw away the piece of elastic and wait until there’s a more sensible replacement.
Although the majority of my net worth is in the form of gold and silver, given the terrific uncertainties out there, I see merit in other investments too. High-quality defensive equities make sense, especially where good dividends are well covered by earnings. Although it’s something of a crowded trade, I particularly like prospects for Asian consumer-focused businesses trading on sensible valuations.
Real assets more generally make sense, too. That includes sensibly priced and productive real estate, farmland, and timber. But Western government bonds? Not for me, thank you. It’s time to take shelter from those.
• Tim Price is director of investment at PFP Wealth Management. He also writes The Price Report newsletter.