Hakuna Matata! What a wonderful phrase
Hakuna Matata! Ain’t no passing craze
It means no worries for the rest of your days
It’s our problem-free philosophy…
“The Lion King” Lyrics –Tim Rice
My family and I have recently returned from a wonderful trip to Southern Africa and the experiences will be treasured memories for a lifetime.
One of those experiences was visiting Robben Island, where Nelson Mandela was imprisoned for 27 years. The guides we had for the tour are all former inmates of Robben Island and many of them still live there (this time out of choice).
One particular cell we visited had been occupied by Mandela’s fellow anti-apartheid colleague, Robert Sobukwe. As some of you know, I tend to like numbers (what was your first clue?). I could not help but notice a letter on the wall of his cell. It was addressed to his wife Veronica and dealt with the tuition needed for their children’s school in 1962.
What caught my eye was the amount of that tuition: 40 rand, or 80 pounds. Some quick math told me that one South African rand was worth two pounds then (which would have been about $6 CAD). Today there are 12 rand to the pound and almost 8 to the U.S. dollar.
So that means in a little under 50 years the rand has lost about 95% of its value when compared to currencies that have themselves experienced a significant amount of inflation.
And this massive depreciation in their currency pales in comparison to their northern neighbour, Zimbabwe, for example. Just before they completely suspended their currency, they issued bank notes below in the amount of 100 trillion that today could not buy a cup of coffee. Here is a copy of one I bought for $2 on the street in Victoria Falls (and apparently I overpaid).
Yet when we met people in South Africa, Swaziland and Zimbabwe, there was a certain feeling of Hakuna Matata (roughly translated as “no worries”) when it came to how they viewed themselves and life in general.
Even the Zimbabweans did not seem overly concerned about inflation. (Of course now they do not have their own currency.)
So why all of this talk about African inflation? Since 2008, most governments have borrowed huge amounts of money which many people believe will eventually lead to uncontrolled inflation for the rich world. If that happens then the following should also occur:
- Gold prices will soar.
- Anyone holding bonds will have the value of their assets evaporate (especially long maturities).
- Real assets will be the only store of value.
- Buying canned goods, learning how to shoot, and moving to a cabin 100 km from civilization will be de rigeur.
Or perhaps not.
It is this connection between inflation, paper (or fiat) money, gold and bonds that intrigues me.
The last 100 years or so has been the most inflationary century in history based on all sources I have been able to find. The level of inflation depends on the country you are in, but, by way of example, to replace $100 from 1914 (the beginning of World War I) in 2010 would take about $2,500 in both the U.S. and Canada. In England, to replace £100 would require a staggering £8,600 today.
Those numbers are huge in absolute terms but a little less daunting when looked at on a yearly basis. They represent annual inflation rates of about 3.3% and 5% respectively. Not that large year by year – much like the proverbial frog in the pot of boiling water, we have adapted to the inexorable devaluation of our currencies.
Interestingly, it was not always so. In the 100 years before the start of WWI (1815-1914), there was no inflation in England. The century of Pax Britannica that began with the defeat of Napoleon at Waterloo ended with the onset of WWI, with prices falling 22% for 100 years. The government of Britain could borrow as much money as it required at rates of 2.5% for indefinite periods of time. (British Consols, as they were called, had no maturity dates. This meant the government never had to repay the principal, just the interest).
No doubt gold advocates will say that this is primarily due to the fact that the pound was backed by gold and therefore a “hard” currency. They would continue to say that when we removed paper currencies from that standard, we doomed them to constant depreciation. Therefore, don’t own paper currencies and don’t lend money to governments (or arguably anyone else). Just buy gold to protect yourself against the ravages of inflation.
On the surface, the gold bugs seem to have the facts to back them up:
- In 1914, 1oz. of gold was worth $20 US.
- In 2010, the price has fluctuated around $1,200/oz (an increase of 6000%).
- In “real” (inflation-adjusted) terms, gold would have to be at $500/oz to have kept pace with inflation.
Clearly gold has done what it was supposed to and maintained its store of value plus a health profit. The return over the last century for gold was 4.3% per year with inflation averaging 3.4% (U.S. CPI 1914-2010). So that makes the real return just under 1% per year.
How does that stack up with paper (fiat) currencies?
Does that mean gold is always better than paper money that governments can print when ever they need cash to pay their bills? The answer is yes and no, but mostly no.
In fact, we can show that (as far as we can tell) the paper money of all countries who have not actually defaulted on their debt has outperformed gold as an investment for the last 100 years. How is this possible given gold’s stellar performance during this last century?
The answer is interest; specifically, compound interest (the eighth wonder of the world, according to Einstein).
In order to do this research properly, we referred to a book called A History of Interest Rates (by Sidney Homer and Richard Sylla) which allows one to find out what merchants in Babylon were charging their friends and neighbours for carpet or camel loans (between 20% and 33% so one can assume collections might have been difficult).
Our focus lies with the interest rates of three countries in particular – Great Britain, U.S. and Canada.
The methodology we used was as follows:
- Sell 1oz of gold in 1914 and use it to buy the ten-year government bonds of each of the above countries ($20 US).
- Take the current value today of those bonds (with interest reinvested) and convert back to U.S. dollars to make all investments the same.
So what would that $20 US investment be worth today?
- UK Bonds grew at an average yield of 6.03%. $20 US (about £4 in 1914) would have grown to just over £1,150 today ($1,800 US). That is 50% more than gold.
- US Bonds returned 5.03% which made $20 in 10-year U.S. treasuries grow to $2,275 today. Almost double the price of gold.
- Canada is the real winner here. Our currency in U.S. dollars is now almost the same as it was in 1914 (near par). Our long-term bond rates have averaged 5.83% or almost 0.8% more than the U.S. That is enough (the Eighth Wonder) to make $20 CDN in 1914 grow to $4,450 today, or just under 4 times the value of gold.
Gold has shown an inflation-adjusted return of almost 1% per year, but that compares to 1.4% for UK Bonds, 1.6% for US bonds and a stellar 2.4% real return for Canadian bonds.
To paraphrase an old children’s game – paper wraps gold.
So if gold cannot outperform relatively safe bonds in a century when these currencies have dropped in value between 95% and 99%, perhaps it never will.
Of course if the country issuing the bonds or the currency defaults, then gold would indeed be precious (as I’m sure the citizens of Zimbabwe or Argentina would attest).
If government bonds outperform gold, then one might expect that the best results would come from owning the debt of “hard” currency countries (i.e.: currencies of countries that have very low inflation and that have appreciated consistently against the U.S. dollar). This would include the Swiss franc, Japanese yen and German mark (now part of the Euro). Since 1950 they have appreciated 312%, 320% and 160% respectively, while weaker currencies such as the pound, Australian dollar and South African rand have fallen -46%, -19% and -98% against the U.S. dollar.
Investors should have been better off as bondholders of strong vs. weak currencies. Unfortunately, the actual numbers do not support this conclusion. Countries with strong currencies can usually borrow money at lower rates than their weaker cousins.
Markets typically demand a premium in the form of higher interest rates from countries where inflation is relatively high or the country’s financial condition is not considered AAA.
Over the years, for example, both Canada and Australia have had to pay higher interest rates than the U.S. even though today both countries have far less government debt as a percentage of GDP than the U.S.
So the question is: do higher interest rates trump stronger currencies?
The table below compares currency and interest rates from eight countries between 1998 and 2010. In each case we have assumed the following:
1. Invest $100 in the local currency’s 10-year government bonds between 1998 and 2010.
2. Cash in those bonds today and convert the funds back into U.S. dollars at today’s exchange rate (August 2010).
The results are enlightening and, with explanation, somewhat logical.
Click image to enlarge.
- The “hard” currencies of Germany, Japan and Switzerland outperformed U.S. bonds when both interest rates and exchange rates are taken into account, but not by much.
- The weaker UK pound underperformed even though bond rates were slightly higher (Britain’s currency has dropped dramatically recently). If we redid these numbers as of January 2010, the UK bond investment would have performed as well as the “hard” currencies.
- Canada and Australia have outperformed U.S. bonds by a significant margin as their currencies have appreciated and their interest rates are either the same or higher than the U.S. An Australian investor is 60% better off than his American cousin. No doubt one major factor for both Canada and Australia since 1998 has been the significant rise in commodity prices and their relatively better fiscal performance.
- Perhaps the biggest surprise is South Africa, which has seen its currency drop by 36% in the last 12 years and, as stated earlier, 98% since 1950. Yet even with that, South African bonds have performed almost 30% better than US Bonds because of the fact that South Africa pays much higher interest rates (10.7% average 1998-2010 vs. 4.6% for the U.S.). This is more than enough to make up for the weaker currency.
The results are enlightening and, with explanation, somewhat logical.
So what can we learn from all of this:
- While Gold is a great store of value and has certainly maintained its purchasing power it is not an outstanding investment over the very long term. It is true that bullion prices have increase more than 400% in the last decade, but in the 20 years before that, gold prices dropped by more than 60%. Every asset class can experience a bubble. Gold may continue its performance of the last ten years for a while, but for me it is really a form of financial insurance and not a strategic asset.
- Governments have certainly devalued their currencies over the last century, but the same cannot be said for government debt. Unless a country defaults (and that has occurred with some frequency) the long-term interest on a country’s debt is higher than the long-term inflation rate. This means countries are not capable of inflating their way out of their debt obligations (absent default as noted above).
- Weaker currencies are not always a bad investment choice. Risk is always a factor, but higher yields can make up for that risk with countries in the same way it does with companies.
Perhaps we should not always have the problem-free philosophy of Hakuna Matata, but the fear that long bouts of inflation destroy wealth and standards of living also looks to be a bit overdone.
As long as it does not cost $100-trillion to buy a non-fat latte, we should be ok.