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Shaken and stirred

The last time James Bond featured in VFTD was November 2012; too long ago for one of our favourite cinema heroes.

Goldfinger (1964) was the first Bond blockbuster, with a budget equal to that of the two preceding films combined. It was a huge commercial success, particularly in the US, where demand for the film was so high that the DeMille Cinema, in New York City, had to stay open twenty-four hours a day for fans to see the movie. In addition to both public and critical acclaim, Goldfinger was the first Bond film to win an Academy Award and the silver Aston Martin DB5, which played a starring role, arguably remains the most iconic car in cinematic history.

The story is based on a plot to manipulate the price of gold at a time when the US dollar, the world’s reserve currency, was ‘backed’ by the yellow metal; thus leading to economic chaos. The advent of ‘fiat’ money in 1971, which has underpinned the global monetary system ever since, significantly dates the story – or does it? Are we, once again, heading into an era where a reserve currency will be backed by gold?

The genesis of this question may be traced back to this time last year; Monday 26th March to be exact. On that day, China launched its yuan-denominated crude oil futures contract, thus challenging the petrodollar for dominance in the global oil market. Over the first trading session, 15.4 million barrels of crude for delivery in September 2018 changed hands. Exactly one week after launch, the volume of petro-yuan oil futures traded surpassed those on Brent Crude oil futures and its share of the market continues to grow. Some commentators believe March 26th 2018 will go down in history as a truly momentous day for both the US and China economies, as well as the status of their respective currencies.

As we know, the majority of global trade is conducted in US dollars and more than 60% of all foreign exchange reserves are currently held in this currency. The US financial system is at the core of the global economy and “the greenback” lies at the centre of it all. The world has accepted this model for decades, however, geopolitics and the sheer size of the ever-increasing US debt mountain have led to a growing number of interested parties questioning the long term sustainability of this model.

One particularly important cohort is the world’s central banks; for whom gold is a primary asset, today averaging 40% of G7 and 20% of G20 reserves. Their collective activity in the gold bullion market through 2018 was revealing. According to the World Gold Council, central banks added 651.5 tonnes to official gold reserves – the second highest yearly total on record. Net purchases climbed to their highest level since the end of US dollar convertibility into gold, as a greater pool of central banks turned to it as a diversifier. Those in central Europe were particularly active, with the Hungarian central bank taking its reserves to the highest level in 30 years, citing gold’s role as ‘a hedge against future structural changes in the international financial system, as well as its lack of counterparty or credit risk’ as reasons for the purchase.

Another very active purchaser was Russia, which has been on a path of ‘de-dollarising’ its reserves in recent years. In 2018, it bought 274.3 tonnes, funded by the almost total sale of its US Treasuries portfolio. This was the highest level of annual net purchases on record, the fourth consecutive year of +200 tonnes and the 13th consecutive year of rising gold reserves.

Unsurprisingly, Russia has been ever more willing to back the idea of global trade independent of the US dollar. In 2015, Gazprom decided to move away from the dollar towards the yuan and other Asian currencies. Iran followed suit the same year, accepting the yuan for payment of Iranian oil and Venezuela has subsequently done the same.

Why is all of this so noteworthy?

With major oil exporters, helped by China and its yuan-denominated oil futures contract, potentially moving towards a viable way to circumvent the petrodollar system, the US faces problems ahead. The value of the dollar is linked to its use as an oil trade medium; take this away and there are hundreds of billions of dollars in circulation that are no longer required. It is not unreasonable to think this would lead to a significantly weaker currency and a US economy facing a troubled future. In this context, the earlier quote from the Hungarian central bank makes great sense.

Like Russia, China has been building its central bank gold reserves and whilst it has far from de-dollarised its assets, the direction of travel looks very clear to many analysts. Is it only a matter of time before the yuan is pegged to gold and made fully convertible? 

Implications for portfolios?               

In the movie, Auric Goldfinger is surreptitiously attempting to corner the gold market. Today, some central banks are doing much the same thing but in plain sight. Despite this, few institutional investors or industry commentators appear concerned or interested. For many gold is still “a barbarous relic” (John Maynard Keynes), providing no utility, classified as an alternative and absent from portfolios. For others, including one of our managers – Ned Taylor-Leyland of Merian Global Investors – gold is now emerging from its ‘nuclear winter’, with benign inflation coupled with dovish central bank policies as key catalysts. At a recent conference we attended, Morgan Stanley forecast that 2019 would be a year for gold to shine. We believe it does have a growing role in portfolios, expressed through bullion or the equities of gold miners. Whilst we don’t anticipate the kind of returns you could have made from owning an Aston Martin DB5 – which today sell for over a $1million and a whopping $4.6million for one of the originals used in the film – we do believe that central banks are not the only ones who need to prepare for markets to be shaken and stirred!

Julia Warrander and Russell Waite

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