The declining credibility of central bankers across the world makes it a good idea for investors to increase their exposure to physical gold, according to Alastair Mundy of the Investec Cautious Managed fund. 
Gold has been one of the most out of favour asset classes over the past five years or so, but it has come back in a big way in 2016.
The price of the yellow metal peaked in 2011 at close to $1,900, but has been on a consistent downward trend since then, thanks to factors such as inflation staying stubbornly low, investors feeling more comfortable taking risk and the fact it offers no yield.
However, while the S&P GSCI Gold Spot index is still down 25 per cent since September of that year, a dovish outlook by the US Federal Reserve combined with negative interest rates in the likes of Japan – as well as considerable equity market volatility – have caused it to rally significantly since mid-December.
Performance of indices since December 2015
Source: FE Analytics
In fact, FE data shows that the gold price is up some 22.99 per cent since then compared with a 6.93 per cent rise in the MSCI AC World index.
However, with equity markets now showing some signs of stability, some analysts question whether gold will rally much further than its current price of $1,250.
Mundy, on the other hand, says he won’t be selling his exposure to gold any time soon. He says the recent rally in the metal’s price is a result of investors losing faith in central bankers and, given the state of economic fundamentals, he doesn’t expect that trend to reverse.
“In the last few months the amount of people betting on a happy ending has started to wane a little bit because seven or eight years after the financial crisis peaked, there is still a huge amount of debt and a worrying level of deflation,” Mundy (pictured) said.
“We have an even greater amount of deflation. More countries are in deflation now than were in 2009 and the amount of debt in the world as a percentage of GDP is even greater than then – but it’s all in the hands of governments instead of financial institutions. So, we have got absolutely nowhere in eight years.”
“With interest rates having been cut to almost zero, we are all out of those normal things and I think the next step is to move on into the extraordinary which could be policies like negative interest rates, moving money from people’s bank accounts, printing money to build hospitals and prisons or even dropping cash from helicopters.”
He admits the latter point is a little far-fetched, but at the same time, Mundy says it is a great concern that central bankers are running out of firepower to push the economy forward. Many others have warned about this threat to markets, such as Psigma’s Tom Becket.
“In the long term I have to confess to being very worried,” Becket told FE Trustnet recently. “First, Mario Draghi of the ECB made clear that he wants to loosen policy even further at the next ECB meeting in March. Interest rates could be cut down to even more negative territory.”
“Next up, the Federal Reserve changed their terminology at their latest meeting where unsurprisingly rates were left unchanged. There was no press conference this time around, but if there had been, Yellen would likely have said 'markets are freaking out, we're freaking out, won't somebody please think of the children'.”
As such, Mundy believes the world is heading for a ‘deflationary bust’ and he says this is highlighted by the extra-low government bond yields currently on offer.
Performance of indices over 1yr
Source: FE Analytics
“I believe whatever central banks feel compelled to do will be taken very badly by investors and as a result of that, investors will start worrying that central banks have lost the plot,” he said.
“Their credibility is already on its way down. It’s waning as a consequence of that so I think investors will start having great worries about holding cash and paper currency. That’s why I think therefore investors are starting to run to the likes of gold, silver and other precious metals.”
If deflation does rear its ugly head, though, Mundy says this would mean all the more reason to have exposure to gold bullion within a portfolio.
“If the world does head towards a deflationary bust, central banks are going to throw absolutely everything at it – the kitchen sink and a few other things,” Mundy said.
“We think the outcome of that could be inflation and even then central banks might be reluctant to do anything to stop it because inflation is what they want to create. Therefore, they are always going to be behind the curve of inflation and when you get behind the curve, history shows that makes it harder to control.”
“In that sort of scenario, it could be very testing for bonds”
As a result, Mundy runs a very different portfolio to many of his peers.
For example, while he holds close to 20 per cent of his Investec Cautious Managed fund in bonds, all of his weighting to the asset class is in index-linked government bonds which would benefit from higher inflation.
He also holds around 15 per cent in gold bullion and gold mining shares. While 50 per cent of the fund is held in equities, Mundy is also shorting the likes of the S&P 500 – an index he deems to be very overvalued.
This defensive positioning has meant the fund has largely struggled relative to its peers in the IA Mixed Investment 20%-60% Shares sector over the short to medium term, with the fund currently underperforming over three and five years by quite a considerable margin. It is a similar story with Mundy’s £1bn Investec UK Special Situations fund, as FE Trustnet recently highlighted.
That being said, his Cautious Managed fund has outperformed the peer group average – and done so with a better maximum drawdown and Sharpe ratio – since Mundy became manager in August 2002.
Performance of fund versus sector under Mundy
Source: FE Analytics
Mundy says that he is unlikely to add more to his equity weighting. Although he says traditional bonds will be hit the hardest if central banks create rampant inflation, the manager warns equites could also suffer given that ultra-loose monetary policy has pushed up valuations in certain parts of the market and forced down yields.
“History has shown that these can be bad asset classes to have exposure to, especially if you buy them at low starting yields – and that’s effectively what you’d be doing at the moment by building up a mixed portfolio of equities and bonds.”
He added: “We are still very, very wary. Obviously markets are all over the place at the moment, but in general we are very, very defensive on cautious managed, we’ve got a low equity exposure and we retain a high exposure to precious metals and cash.”