When Will Life Return to Normal?

By David Glickman, CFA, Health Care Research Analyst | February 02, 2021

If we are honest with ourselves, it is a question that almost all of us, as investors and people, are probably wondering right about now. In this case, it took the form of the following note from a young colleague based in locked-down London directed to me and my fellow Health Care analyst as part of the daily, ongoing Research Information Group email discussion that has always comprised much of our meeting, brainstorm, and “water-cooler” time here at Harding Loevner.

Considering the challenges of [vaccine] manufacturing and distribution, what would be your best estimate for when developed economies will return to “normality”? I.e., people in developed economies are allowed—and feel safe enough—to live a life more like 2019. E.g., Sept 2021? Jan 2022? Never?

Two male and one female co-workers meeting up before work and greeting each other with a kiss on the cheek and hug.

As I wrote to this analyst and the rest of the group, my honest answer is: it’s very hard to say at this point. Beyond the manufacturing and distribution challenges he references, the most troubling recent news involves the increasing prevalence of COVID-19 mutations such as the B.1.1.7 variant that first emerged in the UK and the B.1.351 that originated in South Africa. Since mid-January, there has been mounting concern that some of these variants, in addition to being more contagious, might also be more resistant to the vaccines that have already been developed. The latest study results for a pair of vaccines still awaiting approval—one from Novavax and another from our portfolio holding Johnson & Johnson (JNJ)—confirm that at least for the South African variant this is indeed the case, as both vaccines showed reduced efficacy in preventing infection in South Africa, where B.1.351 is dominant. For the Novavax trial, the reduction in infection rates in the UK was 89%, compared to just 60% in South Africa. For JNJ’s vaccine, the reduction in infection rates was 72% in the US versus just 57% in South Africa. In other words, these vaccine candidates are still capable of dramatically reducing severe COVID-19, but aren’t capable of reducing the viral load enough to lower infection rates as dramatically as we had come to expect from Pfizer and Moderna’s vaccines, whose blockbuster phase 3 trial results in late 2020 were for populations not yet exposed to B.1.351. While the follow-up data are still preliminary, expectations for how those vaccines perform against the variant probably now need to be lowered as well.

If you get a vaccine by the summer, you’ll be better protected, but my expectation is that the new and future variants will become the dominant strains in the coming months, and so you won’t be 95% protected, more like somewhere in the 50-60% protection range.

Getting much better distribution and administration of vaccines suddenly becomes more urgent. As health officials have emphasized, the more the virus is contained, the less opportunity that variants will have to replicate and gain a larger foothold in a population. Mask-wearing, handwashing, and social distancing take on similarly elevated importance in this game of viral Whack-a-Mole. It seems overly optimistic, however, to think that the variants won’t soon become more prevalent regardless, including in the US, and that we won’t just as soon need new tools to combat them. One big plus about many of the new vaccines is that they can be modified quickly, increasing manufacturers’ ability to issue booster shots specifically aimed at the variants. But can vaccine updates be issued quickly enough to prevent added waves of infection and forestall still more variants from popping up? Let’s hope.

Based on conference calls I’ve been on with the vaccine manufacturers, and research I’ve read about the nature of the virus, it is surprising, and, frankly, a bit alarming, that so many viable variants are out there this soon. The rationale given now by scientific experts is that uncontrolled spread for too long gave the virus more chances to find better ways of eluding our immune systems. RNA viruses replicate for speed and aren’t good at “checking their work,” so the vast majority of mutations are just mistakes that typically function to weaken the virus and thus immediately go extinct. However, there has always been a small probability that some of these copying errors would confer a benefit on the virus. It is akin to rolling dice and having them come up ones 10 times in a row—if you roll 1 trillion times instead of 100 billion, there’s a decently higher chance of that happening. Still, in the lifecycle of a virus such a pace of snake-eye streaks typically isn’t seen until after we apply more Darwinian pressure and the organism is forced to mutate to survive. It’s disappointing that we’re getting so many variants at this juncture, but it wouldn’t be surprising if the pattern continues. It is also possible we could have another burst of variants to contend with once the virus has finally been brought under control and feels truly cornered.

As a healthy male in my early-40s, I’m less concerned about severe disease and hospitalization once I get vaccinated, but I am concerned about the risk of being a “long hauler,” one of the estimated 10% of COVID-19 patients who experience debilitating symptoms for months or potentially years (or longer—we just don’t know) after the initial infection has run its course. I’ve met two long haulers in the last month and they are both in the 45–55 age range. We have no idea yet, for any of these vaccines, what the reduction in risk of being a long hauler is.

So, as for life returning to “2019”? I don’t think that’s going to happen this year. If you get vaccinated by the summer, you’ll be better protected, but my expectation is that the new and future variants will become the dominant strains in the coming months, and so you won’t be 95% protected, more like somewhere in the 50–60% protection range, although with much higher protection against severe disease. To me, that’s still definitely not enough to return to greeting someone outside my family with a European faux kiss on the cheek.

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Big Health vs. Big Tech: A Fight over the Future of US Health Care

By Igor Tishin, PhD, Analyst, Information Technology and Patrick Todd, CFA, Analyst, Health Care and Real Estate | June 22, 2021

The $4 trillion US health care system represents both the best and worst of health care globally, responsible for the vast majority of leading-edge treatments and providers as well as high rates of uninsured, a staggering $11,000 in annual expenditures per person, and among the worst levels of infant mortality and life expectancy in the developed world. The system’s structure—a hodgepodge of private employer-subsidized, public, and quasi-public insurers, for-profit and not-for-profit networks and unaffiliated providers—famously incentivizes some providers to ring up higher volumes of procedures while inflating fees to cover the huge overhead required to administer the complexity.

Source: Our World In Data

Igor Tishin, PhD, an Information Technology analyst at Harding Loevner, refers to US health care as a “rust heap.” Tishin frequently shares his view that some of the companies under his coverage are in a better position than traditional health care firms to deliver the sort of disruptive change the US health care system so obviously needs. This view puts him at odds with Patrick Todd, CFA, one of our Health Care analysts, who covers a number of high-quality durable-growth insurance, pharma, and diagnostics companies. In responding to Tishin, Todd acknowledges US health care’s need for reform yet is adamant that Tishin’s description of Big Tech’s bonafides is wildly overstated. Tishin paints this as the kind of apologist thinking that has tolerated US$60,000 C-sections.

Hostilities between our brown-bag combatants flared following the January announcement that Haven, a consortium formed to much fanfare several years ago between Amazon, JP Morgan, and Berkshire Hathaway—the most high-profile effort to date by powerful outsiders to develop a better model for delivering higher-quality, more cost-effective care—was disbanding. The following exchange was excerpted from Tishin’s and Todd’s recent internal research postings. We should note that the pair, avid skiers and hikers who regularly compare notes on their families’ outdoor adventures, are perfectly friendly. Often as not on topics not related to US health care, they find their views aligned.

Patrick Todd: Many in the media have concluded that the entrenched powers of private insurers, doctors, and major hospital systems caused Haven’s demise. It makes a good headline, but it’s inaccurate. I think Haven’s demise has more to do with Amazon’s ambition. Amazon has been developing similar offerings to those of Haven. For example, Amazon Care, the primary care and prescription plan for Amazon employees that is now being expanded to the public, is very similar to the former Haven platform for Amazon, JPM, and Berkshire employees. Amazon also just opened its own online pharmacy, building on the acquisition of Pill Pack several years ago. None of these are revolutionary ideas, but I just think Amazon realized they don’t need JPM and Berkshire in the mix.

While Haven has been in the news, I think the more important recent development is the more-or-less unnoticed expansion of the Affordable Care Act (i.e., Obamacare) tucked into the last COVID-19 relief bill. I see this as a sign the Biden administration will continue to expand government’s role in health care, including Medicaid but more importantly Medicare Advantage (MA), which very much benefits UnitedHealth, the market share leader. What’s also interesting is how UnitedHealth is moving more towards an integrated model like hospital network Kaiser Permanente. Through their Optum unit, UnitedHealth is buying up facilities and investing heavily in tech to create a more effective and efficient delivery model that lowers the cost of care. So, you’re seeing best-of-breed providers and insurers becoming more similar.

And so any attempts to fix the system are fruitless because the current setup is a decent compromise and the incumbents are generally doing a fine job. What a pathetic conclusion!

Igor Tishin: And so any attempts to fix the system are fruitless because the current setup is a decent compromise and the incumbents are generally doing a fine job. What a pathetic conclusion! The only thing that Haven’s failure proves to me is that they were not audacious enough and it will take a true outsider to bring simplicity, competition, and accountability to the health care industry’s parasitic relationship with vested interests in Washington and other parts of the economy. It’s going to take an entity with a “call option” mindset (i.e., little to lose, much to gain) and credible capabilities to expose the rot and hopefully fix the problem before the political will is hijacked. Fortunately, there is such a company with the ambition and a good deal of the ingredients in place to offer a data-driven health care system. I gather you’ve heard of Apple?

PT: I think we can both agree that there are inefficiencies in health care delivery, but “parasitic” is a bit extreme even for you, don’t you think? The US does spend more and fares worse on adult and infant mortality metrics. It also has higher rates of poverty and teen pregnancy, much higher levels of obesity, and higher car crash and gun deaths. A lot of the inefficiencies also have to do with how fragmented our payment systems are among Medicare, Medicaid, a fully nationalized program like the Veterans Administration, commercial insurance, insurance purchased on exchanges, etc. How is Apple supposed to fix the payments structure? Unless you’re suggesting we move to a cash system of some kind where the customer pays directly, which not a single other developed country has ever seriously considered doing, and in which case you’ve become even more disconnected from reality than when I last checked.

IT: Sunlight is a great disinfectant! Yes, fragmentation is a huge problem, and of course some policy changes would be required, but let’s look at some of the other parts of the system that are broken: the party receiving the service is not responsible for the payment; the party providing the service decides on the volume of consumption; the party that pays does not really care about the outcome as much as about the cost; and the outcomes and costs are extremely difficult to objectively compare across entities.

Introducing a comprehensive and coherent data platform to streamline treatment administration, track costs and outcomes, and fight balkanization can be a powerful step to expose each of the flaws in the current arrangement, clarify the vision for alternatives, and thus help unite political will for the policy change. Apple with its world-class personal data management platform, credibility with over one billion customers, and data privacy leadership (obviously critical in making such a system work) has a unique set of assets to tackle the issues.

PT: That is a list of blanket statements. Certain areas within health care do encourage volume, that’s true, but others do not. Medicare and some insurance pay hospitals a fixed fee for inpatient care regardless of how much it costs. If a hospital can deliver care more efficiently, they make more money. Conversely, if they do a poor job with the patient and costs are higher than expected, the hospital loses money. I also disagree that insurance companies aren’t incentivized to keep you healthy and keep their own costs low. As for the difficulty in tracking outcomes and costs, this is getting better, in my opinion—without the help of Apple. Doctors’ offices were still using fax machines not too long ago. But with the implementation of the 2009 HITECH Act, we now have electronic health records, and health systems and health care information technology companies are starting to make sense of all this data to improve outcomes and costs. You are starting to see some artificial intelligence applications as well.

IT: Every reform you mention would be enormously enhanced if deployed on a more robust and thorough data platform. The problem is hospitals and insurance companies have neither the expertise nor incentives to scale this up.

Take some of the cultural issues you mentioned contributing to the overall poor health of the US population. The US system is more “sick care” than health care; many more resources are devoted to fixing than preventing. Well, the only way to change that is to introduce personal accountability by rewarding the desired behavior. The Apple Watch can collect some basic but relevant personal data over long periods of time in a very efficient and economical manner. If the insurers really cared about the well-being of their customers, they would all cover putting a basic version of Apple Watch on people’s wrists and use this data to give them a break on their insurance premiums. Once the platform is out there and open to third-party developers, there would be no shortage of creative models for how to foster healthier living through such incentives. A portion of the insurers’ savings could also flow back to Apple and the app developers.

The biometrics on the Apple Watch are still pretty rudimentary, but the company has all sorts of other patents pending for blood pressure sensors, sweat analysis of blood sugar and blood alcohol content, and different types of motion detectors. The other major tech players clearly have a role to play as well. Apple stands out for its expertise in hardware solutions and the strength of its operating system, but Google probably has the strongest AI and data analytics capabilities to process all this data and help patients and their providers make smarter decisions. Amazon is still king of e-commerce and logistics, which will be key in closing the loop between those smart decisions and implementation in the real world through things like low-cost drug refills, mail-in tests and telemedicine, and more transparent pricing between vendors.

Not everyone is a biohacker trying to optimize their output. As a health care IT executive once told me, “Silicon Valley tends to overestimate the health curiosity of the individual.”

PT: It seems obvious that if the people in the US ate less and worked out more our health outcomes would be better. But not everyone is a biohacker trying to optimize their output. As a health care IT executive once told me, “Silicon Valley tends to overestimate the health curiosity of the individual.”

We are already seeing a big move towards value-based reimbursement models that encourage savings, and the health care system is investing heavily in developing the technology and contracts to make it work. In my view, a company like UnitedHealth is just way better positioned to drive these changes. In addition to their traditional insurance operation and growing portfolio of primary and urgent care facilities, they own OptumInsight, which is a leading data and analytics platform used by 9 out of 10 US hospitals. It spends almost US$4 billion a year on tech and innovation and has products designed to tackle waste in the system. In places where OptumHealth, UnitedHealth’s soup-to-nuts data-driven insurance and provider offering, has been in the market for a while, their cost of care is already 30% lower than comparable fee-for-service Medicare.

When you reference the transition away from sick care, what you are really getting at is population health management. Again, this is already happening, and the change is coming from inside the system. Optum, as an example, helps with biometric solutions and on-site services and wellness coaching. Just giving people data on an Apple Watch doesn’t really do anything. Measuring your steps and heart rate only helps at the margin. You need outreach to make it work.

IT: Who is better at outreach than Amazon? Amazon Prime has nearly 150 million US subscribers. Every time they check out of their cart is another opportunity to serve them a reminder about better choices they could be making about their health.

PT: I’m not saying the tech companies aren’t part of the solution, but I see them more as data suppliers and an alternative distribution source than the ones really instigating change. I thought it was interesting that Amazon’s own chief medical officer, TV medical pundit Vin Gupta, recently just about acknowledged as much. Speaking of which, the most direct way to lower costs and improve outcomes is detecting disease early. I’m personally very excited about all the innovation in “liquid biopsies” that scan the body for circulating cancer cells and other very early signs of disease. GRAIL, a company now in the process of being reacquired by Illumina, has shown some impressive data and I expect their Galleri test to become a routine part of the annual bloodwork ordered by physicians. The more and better tests of this kind that are administered, the better the insights will be that come from all your Big Tech big data analysis.

IT: Yes, and I would expect GRAIL to eventually develop a mail-in version of the test and sell it on Amazon.

Patrick, if I didn’t know better, I would say we are approaching a consensus over what needs to be done, and at this point mainly haggling over who does it and in what order. I think change will accelerate when the Big Tech companies can make wearables and other related technologies widely available enough to unlock the data flow in a more powerful way, creating new incentives and behaviors from many of the same actors—hospitals, pharma, and insurers. It’s like the same cast of characters playing a historical drama instead of a horror movie. The result will be savings to patients and their employers, savings to insurers and providers, and a cut of those savings flowing back to the tech companies. As you know, for years “health care TBD” has been part of my long-term valuation model for Apple. I should thank you for helping me understand now how that will play out.

PT: You’re welcome, I guess. Except I’m skeptical that Big Tech really wants to disrupt health care. They want the consumer data, and they want access to that gigantic profit pool. Saying they are “bending the cost curve” is just part of their sales pitch. Let’s be honest, what does real disruption in US health care look like? It’s called single-payer health insurance, aka Medicare For All, but I’m not holding my breath waiting for that to happen.

IT: And if you do (hold your breath) be sure to download Apple Watch’s new Blood Oxygen app first. It’s really cool!

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Down the Rabbit Hole

By Peter Baughan, CFA | December 15, 2020

In trying to make sense of the state of things today, I found myself thinking of snippets I’ve heard from Lewis Carroll’s Alice in Wonderland. Until recently, however, I had never actually read the story. So, I went to Amazon.com and ordered a copy of the entire Alice in Wonderland Collection (Alice’s Adventures Underground, Alice’s Adventures in Wonderland, Alice Through the Looking Glass, and The Hunting of the Snark). While I was underwhelmed by the character development in these stories, I did find some takeaways that seem relevant today. Still, perhaps the most provocative line from Alice that I came across is one that was written not by Lewis Carroll but by Czech film director Jan Švankmajer for his 1988 film Alice.

The film opens with Alice saying, in part, “But, I nearly forgot, you must close your eyes otherwise you won’t see anything.” After all, Alice would never have experienced Wonderland or journeyed through the looking glass if she had not closed her eyes. And we’d have no Mad Hatter, no March Hare, and, of course, no Red Queen.

I ask myself: If I close my eyes, what do I see…in the markets? What I see is determined by my sense of what ought to be. I think of my introductory college philosophy course and Plato’s famous Forms. For Plato, everything has an absolute form, a universal ”right answer.” What we see on Earth are imperfect replicas of each thing’s true essence or Form. What would the Platonic Ideal look like for valuing a high-growth stock such as Shopify or, closer to our own portfolios, Amazon? When I close my eyes, I see a traditional multi-stage discounted cash flow model with a rapid growth period, a fade rate, and a rationally derived terminal value all discounted to the present using what I’ll call a traditionally derived cost of equity.

Other investors in the market today may see something quite different when they close their eyes. If, say, a Robinhood day trader closes his eyes, what does he see? Or if any of the numerous momentum fund managers close their eyes, what do they see? They may see relative price-to-sales driven by the second derivative of the revenue growth rate or some other relative forward 12-month or forward 3-month ratio as the key variable determining valuation. Or, perhaps today, all that many see are charts and price momentum amid the haze of Fedspeak that seems to devalue much of traditional investment thought. Perhaps investors today don’t see anything to do with ”terminal value” at all.

What do value investors see when they close their eyes? A number of us at Harding Loevner were struck by a recent Wall Street Journal article about famed value investor Ted Aronson’s decision to dissolve his longstanding $10 billion investment fund and return the cash to investors. Aronson, a previously very successful value-based quant manager, said: “It can all work for years, for decades, until or except when the not-so-invisible hand comes down and slaps you and says, ‘That’s what worked in the past, but it’s not going to work now, nope, not anymore.’”

I wonder what ways of seeing are being hard-wired into investors today. Who really speaks today of any of the valuation insights found in Benjamin Graham’s The Intelligent Investor, which was once seen as hallowed ground? I think it’s fair to say that very few market participants see the valuation structure advocated in Graham’s work when they close their eyes today. High price-to-sales seems to have replaced high price-to-earnings as the new normal. So-called modern monetary theory also looms—a new or non-standard to replace whatever fading monetary policy/interest rate standards once existed.

For Aronson, what’s up is down and what’s down is up. What he sees when he closes his eyes, what ought to be, well, it just ain’t so in the markets, and hasn’t been so for years. Aronson is a smart guy. As some of my colleagues noted in a recent client letter, there is no guarantee that what’s become true for him can’t become true one day for Harding Loevner. We don’t think we are any smarter than Aronson, or many other such value managers. We are considerably more fortunate at the moment as the global policy direction in recent years has smiled upon ”growth” while frowning upon ”value.” But further change may be coming.

All of this brings to mind a poem by Rainer Maria Rilke published in 1905:

I live my life in widening circles
that reach out across the world.
I may not ever complete the last one,
but I give myself to it.

I circle around God, that primordial tower.
I have been circling for thousands of years,
and I still don’t know: am I a falcon,
a storm, or a great song?

“I live my life in widening circles that reach out across the world”—not a bad description of investing amid ever more accommodative global monetary policy with its ripples spreading around the world. Or of investing amid a pandemic with the COVID-19 virus reaching out across the world in widening circles. I have the same ultimate question in 2020 that Rilke had in 1905. How’s all this end?

The current environment sometimes makes me think about the scene in the film Doctor Zhivago (sorry about the mixed references, but my eyes are still closed) when the good doctor returns to his family home one day to find it taken over by the workers’ committee. He is initially assigned to only one room and eventually is not allowed to enter at all. Standards changed, to say the least. More than at any time I can remember, I’d say the standards that underpin what passes for majority understanding and opinion, in the US anyway, are in flux. For example, would a proposition to reaffirm the US Constitution as written, if put to a popular vote today, win majority approval? I have my doubts. Would a proposition to reaffirm support for “free market capitalism,” if put to a popular vote today, win majority approval? I have my doubts. Would a proposition to reaffirm the principle of private ownership of land, if put to a popular vote today, win majority approval? I suspect this would still find majority support, but with a large vote against, and I’m not sure how the vote would turn out, say, five years from now. Yet the stock market has no such doubt. The best stocks in the market, by many country miles, are high-growth stocks where share prices reflect confidence in rapid earnings growth a decade or more from now—at least according to the arithmetic of discounted cash flows. Or perhaps that’s not how many investors look at it; they may only have confidence in sustained earnings momentum one to two quarters from now, not confidence in the state of things in, say, December 2030.

I did not find reading Alice’s Adventures in Wonderland and Through the Looking Glass to be a particularly satisfying experience. However, they were useful to read. As I reflect on it, the stories made me step back from my assumptions about how things should be, and left me open to considering other scenarios, in politics, in society, and in the financial markets. The meaning of the line “you must close your eyes or you won’t see anything” is not entirely clear to me. But it is perhaps the most provocative and potentially valuable investment insight I’ve come across in quite a while. While I ponder and watch, I plan to remain diversified and see just how prescient Alice’s upside-down world continues to be.

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Getting Real About Inflation … and Gold

By Edmund Bellord, Asset Allocation Strategist | January 08, 2021

As favorable vaccine news piles up, the winds of reflation are stirring. Early signs of an equity market style rotation in favor of cyclical value stocks, a weakening of the safe-haven US dollar, and a run-up in market-derived measures of inflation expectations all point to a resurgence of animal spirits despite a gloomy outlook for the economy. With our monetary maestros promising easy money into the distant future come what may, it is time to spare a thought for what the possible return of higher inflation might do to your portfolio. Inflation is viewed as the bane of fixed income investments, and rightfully so. But inflation can also wreak havoc on stocks. In theory, inflation should have no impact on equities provided companies are able to pass along higher input costs to their customers. In practice, equity valuations are highly sensitive to changes in the price level, tending to plummet when prices jump. No wonder investors are already casting about for inflation protection.

For a vociferous minority, the only bankable hedge for inflation is gold. For them, every spike in the gold price is reproof of government perfidy and foreshadows an inflationary surge. The evidence linking gold’s price and inflation, however, is curiously threadbare. If gold is an unreliable hedge against rising prices, what role, if any, should it play in a portfolio?

Gold as Currency

Gold, having shed its function as a means of exchange and unit of account, is still used as a store of value. Its inflation-hedging bona fides spring from the notion that, unlike other stores of value, it cannot be debased. Central bankers have the power to conjure fiat money at the stroke of a keyboard, but they are powerless when it comes to the quantity of gold. The price of gold may vary from day to day, but with a fixed supply on the order of 250,000 tons, of which one fifth remains lodged in the earth’s crust waiting to be mined, scarcity ensures that over long time spans its purchasing power remains intact. In 1934 an ounce of gold would have set you back US$26; had you buried it in the ground only to dig it up today, 86 years later, it would be worth almost US$2,000. Not a bad return when you consider that a paper dollar lost approximately 99% of its purchasing power in the interim.

But, of course, this simple illustration is dreadfully misleading. It is true that, had you let slip a dollar bill down the back of the couch while resting after burying your gold some 86 years ago, that dollar bill would buy you far fewer goods at the cash register today. Most dollars, however, are not left lying around to gather dust; they are deposited for safekeeping and, until recently, they earned interest. Fairer would be to evaluate gold relative to what you would have earned holding cash on deposit. According to Barro and Misra¹, the long-term compounded return on cash (T-Bills), after accounting for inflation, has been 1% per year, just shy of gold’s 1.1% real return. Gold may have won by a nose, but that extra 10 basis points came at the expense of frequent eye-watering price fluctuations and the occasional sleepless decade.

Echoes of the Gold Standard

It turns out that gold’s reputation as an inflation hedge is really founded on just two episodes: the end of the gold standard and the oil shock of 1979. Between 1971 and 1975 the price of gold quadrupled as the US severed the official link between the US dollar and gold. Again between 1977 and 1980 the price of gold tripled as the inflationary impact of the second oil shock rippled through the entire energy-dependent supply chain. Outside of these two peculiar instances, the relationship between gold and inflation largely falls apart. Remove just the years of 1974, 1979, and 1980, and as we can see the positive correlation between inflation and gold disappears entirely.

Figure 1: Correlation between change in Gold price vs. Inflation 1971-2020

If inflation isn’t driving the gold price, what is? The evidence suggests that a big part of what’s moving gold prices are real interest rates—or the difference between 10-year treasury yields and inflation—whose movements up or down are an important indicator of the underlying state of an economy and its expected growth. This inverse relationship between gold and real rates is born out in the next figure, which shows yearly changes in the price of gold and real interest rates from 1971 to 2020. The large increases in the gold price in 1974, 1979, and 1980, in addition to the price spikes of 2011 and 2020, all occurred against a backdrop of negative real rates. Correspondingly, the gold price declines of the early ’80s coincided with soaring real rates, a consequence of the tight monetary policy enacted during Paul Volker’s chairmanship of the US Federal Reserve.

This relationship between real rates and gold echoes the historical linkages between gold and the US dollar. Under a gold standard, because currency values in terms of gold were fixed, trade imbalances between countries were routinely resolved by a physical flow of gold. Gold would flow into countries that exported more than they imported and had high real exchange and interest rates, and out of countries where the opposite conditions held. But under a fiat system, where currency values in terms of gold are no longer fixed, real interest rates continue to exercise their pull, except now rebalancing occurs with a change in the price of gold instead of a flow. Perhaps because of its ongoing role as a central bank reserve asset and store of value, gold behaves like a shadow currency. A currency where, absent the prospect of a future cashflow, assessing how much to own comes down to what else you could be doing with that fraying dollar bill.

Hedging Inflation: It Depends

Just because gold has kept pace with the price of goods and services does not make it an effective inflation hedge in every scenario. And that’s because the alternate sources of expected inflation—diminished supply versus excess demand—have drastically different implications for real rates and hence for hedging strategies. If you think the world is in the thick of a deflationary or stagflationary bust that will depress real interest rates, then by all means buy gold. The current pandemic, like natural disasters more broadly, can certainly fit the pattern and to the extent it continues to depress consumption could still prove to be one of those kinds of periods. But if you are concerned about monetary excess, adding gold to a portfolio may turn out to be futile and may even magnify risks. If central bankers succeed in reviving inflation by stimulating demand growth, then we should also expect real rates to increase and the gold price to weaken. In that scenario, to hedge inflation you are better off buying TIPS and selling conventional bonds.

It’s only fair to point out that any notional horse race between gold and other assets assumes a functioning financial system nested in a stable society—not an unreasonable assumption for an optimist. But you don’t have to peer too far back in history to find examples of conflict, dispossession and collapse. Beyond keeping up with the price level, part of gold’s appeal lies in its tantalizing potential to ward off financial devastation. Although, if society deteriorates and its ability to function looks dicey, the risk of confiscation also shoots up and your chances of avoiding devastation by holding onto your lump of gold decline precipitously. This makes gold a bit like owning an out-of-the-money put option on social collapse underwritten by an ultimately insolvent counterparty. There is no chance of collecting, but at least its value should rise when people are fearful.

Endnotes

¹Robert Basra and Sanjay Misra, National Bureau of Economic Research, “Gold Returns,” NBER Working Paper Series (February 2013).

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Out of Our Minds

When Will Life Return to Normal?

Big Health vs. Big Tech: A Fight over the Future of US Health Care

Source: Our World In Data

Down the Rabbit Hole

Getting Real About Inflation … and Gold

Gold as Currency

Echoes of the Gold Standard

Figure 1: Correlation between change in Gold price vs. Inflation 1971-2020

Hedging Inflation: It Depends

Endnotes

Disclosures

Out of Our Minds

Big Health vs. Big Tech: A Fight over the Future of US Health Care

Source: Our World In Data

Down the Rabbit Hole

Getting Real About Inflation … and Gold

Gold as Currency

Echoes of the Gold Standard

Figure 1: Correlation between change in Gold price vs. Inflation 1971-2020

Hedging Inflation: It Depends

Endnotes

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Disclosures