The current political landscape in the United States has created a situation where the possibility of a government default is no longer dismissed as a crazy idea. The "risk-free rate" is an academic theory that is not applicable in reality.
With discussions underway to raise America's $31 trillion debt ceiling, investors are becoming increasingly concerned about protecting their investments in the event of a crisis. This discussion looks at some ideas to mitigate the risks associated with a potential U.S. government default. Specifically, I look at the importance of diversification and the appeal of gold as a safe-haven asset.
The importance of diversification
With all the uncertainty surrounding a potential U.S. government default, earlier in the year JPMorgan Wealth Management looked at the significance of diversification as a primary defense strategy. They recommend investors consider allocating their investments across a range of assets, including alternative currencies such as the Japanese yen and the Swiss franc, precious metals like gold and high-quality international equities. This diversified approach aims to reduce vulnerability to the repercussions of a default while maintaining a balanced portfolio.
Why gold?
Gold has long been an important part of the investment portfolios of wealthy families and other risk-averse investors. I remember doing a study a few years ago that showed adding some gold exposure to a portfolio consisting of large-cap equities improved that portfolio’s Sharpe ratio, or risk adjusted returns.
The commodity has been rallying recently because of market flows relating to the anxiety around a potential U.S. default. According to a recent survey by Bloomberg, gold is the preferred safety choice for both professional and retail investors, with 52% and 46% respectively selecting it as their top option.
Next was Treasury bonds, chosen by 14% and 15% of professional and retail investors. I think that is because the market is programmed to buy Treasury bonds in a risk-off environment. U.S. default is a risk-off event, so Treasuries could, counterintuitively, rally on a U.S. default.
Bitcoin ranked lower in the survey, trailing behind gold, the dollar, the yen and the Swiss franc.
The preference for gold highlights its enduring appeal as a reliable asset during times of crisis.
Implications for alternative currencies and cryptocurrencies
The preference for gold as a safe-haven asset highlights the fact the euro is not a good alternative to the dollar. It also shows bitcoin as an alternative to the traditional dollar-dominated financial system is not a respected idea among active investors. In my opinion, we should just forget about bitcoin and cryptocurrencies because they are arguably extremely problematic on many fronts.
The resurgence of gold
Some investors do not like gold due to its lack of yield. However, it seems like history is mean reverting to some extent. The precious metal has experienced a resurgence in recent years. Since 2016, the price of gold has doubled, reaching close to an all-time high (unadjusted for inflation) of nearly $2,100 per troy ounce in the current month.
There was a well-established formula for gold’s price movements: inverse movement against the dollar and real interest rates and also somewhat positively influenced by equity market volatility as represented by the VIX index. Interestingly, this relationship between gold prices and real yields has changed since early 2022.
Traditionally, investors turned to gold as an anti-inflation safety hedge. However, this recent breakdown in correlation, i.e., the strong gold price at the same time as a strong U.S. dollar, suggests gold has gained appeal as an alternative to the dollar and not just as an anti-dollar trade. This could be due to a shift from central banks diversifying their reserves away from the dollar due to geopolitical tensions and economic sanctions following the war in Ukraine, as reported by the World Gold Council’s latest gold demand trends report.
The growing acceptance of gold as part of a hedging strategy against a potential U.S. government default underscores its role as a barometer of both global instability and political dysfunction. As countries like China and Russia seek alternatives to the dollar-based order, gold gains even greater traction as a store of value. I also think the vast quantitative easing measures of the past 15 years have driven global inflation, which in turn has led investors of all types to favor gold.
Some investors are not too worried about their portfolios' Sharpe ratios, so gold becomes just a trade and not an investment. However, gold miners give investors access to both the gold price and the earnings power of mining operations.
Strong gold mining candidates
There are a number of good opportuities among gold mining companies.
One option is an exchange-traded fund such as VanEck Gold Miners ETF (GDX, Financial) to get exposure to a diversified basket of gold miners. I would prefer to be more selective, however.
As a defensive play, I would focus on the largest gold miners. Looking through the top 10 constituents of the FTSE Gold Mines Index, I found that only three had a GF Score of over 81.
Australia’s Northern Star Resources Ltd. (ASX:NST, Financial) came out on top with a GF Score of 95. Next was Canada’s B2Gold Corp. (BTG, Financial) with a GF Score of 91. In third place was Canada’s Agnico Eagle Mines Ltd. (AEM, Financial) with a GF Score of 87.
As such, these three stocks appear to have strong outperformance potential in their own right. Further, they give investors some defensive gold price exposure, which is embedded in their asset bases.
Conclusion
In conclusion, as investors grapple with risky U.S. government behavior, diversification and the inclusion of gold or miners in their investment portfolios come to the fore as a prudent strategy. The commodity's historical significance as a safe-haven asset, coupled with recent shifts in its trading patterns and central banks' buying behavior, supports its role as a barometer of global instability and hedge against it.
If a debt deal is reached, it will likely be a temporary solution, so gold's enduring appeal as a reliable asset remains intact, providing investors with a valuable tool to protect against the uncertainties of the investment landscape.
