Gold Rush 2020
We are all familiar with traditional stock and bond investments as they provide the nucleus for most of our investment portfolios. However, we often neglect other “alternative” investments that can provide key types of exposure during challenging investment periods. Gold, and other precious metals, is one such investment category that can act as a hedge against inflation and provide a safe haven in times of crisis. At Patina Wealth, we actively look for opportunities to deploy precious metals in portfolios and have added to the category in 2020 for most investors. We generally prefer using Gold over other precious metals as the former generally has lower price volatility.
So far in 2020, gold and silver have surged and now stand among the top performing investments year to date. From December 31st through August 31st, the exchange-traded-funds tracking gold and silver (GLD and SLV) are up 29.3% and 57.3% versus 8.3% for the S&P 500 Index and 6.8% for the aggregate bond market (as measured by AGG). It’s also noteworthy that precious metals tend to not be highly correlated with either stocks or bonds meaning they can enhance the risk-adjusted performance of portfolios.
Precious metals are part of an investment category known as commodities. Commodities generally refer to raw materials or agricultural products. The price of commodities, like most assets, is determined by supply and demand. When the price of a commodity is trending in a particular direction, it usually means there is an imbalance in supply and demand. So far in 2020, there has been a massive surge in demand for precious metals. Let’s explore why this imbalance has existed and where it may be headed from here.
Precious metals have a commercial use, however, this has had very little to do with the recent price surge. Rather, investors are piling into the category as a form of defense against the uncertainty of the current investment landscape. In general, precious metals prove to be great investments when certain conditions are present. These conditions include, (a) periods of high inflation, (b) an environment of socio-economic or currency instability and/or (c) negative “real” interest rates (i.e., interest rates net of inflation).
Currently, we have two of the above conditions present (i.e., negative real interest rates and currency instability). Moreover, while inflation is not currently present, many economists believe that we are headed for an inflationary period in the coming years given that central banks are aggressively seeking to kick-start economic activity with very accommodative policies which are inherently inflationary. It’s also noteworthy that the Federal Reserve targets 2% inflation, on average, as a matter of policy and has said they are comfortable letting it run above that target level in the near term. Still, targeting inflation and achieving it are two different things and many developed nations (e.g., Japan) have generally failed to achieve their inflation targets for over a decade.
Regarding the conditions that are present, let’s first look at negative real interest rates. Real interest rates are negative when the rate of inflation exceeds the rate of interest paid on a given fixed-income investment. Presently, it is estimated that over $15 trillion in bonds globally are paying a negative real interest rate (i.e., net of inflation, allocating money to these bonds would effectively cause your wealth to shrink over time). It’s noteworthy that we have never had such a high percentage of the global bond market effectively losing money net of inflation. In such an environment, gold becomes an attractive alternative to bonds because it is perceived to move more in line with inflation which, even if low, is perceived to be above zero. What is further fueling investors is the fact that central banks of developed nations are providing guidance that they have no intention of raising interest rates anytime soon and are aggressively looking to increase inflation. In other words, they are clearly and emphatically signaling that negative real rates are not likely to go away for a long time and, in fact, are likely to worsen.
Gold is also perceived as a potential remedy to currency instability. The amount of gold at any point in time is generally fixed. More can be mined but this doesn’t happen quickly. Currency, on the other hand, can be printed by central banks and can change dramatically from year to year. In fact, in 2020, we’ve seen a massive increase in the money supply in the United States and other developed countries. This is a further tailwind to gold as the dollar price of gold stands to gain as more “fiat” (i.e., paper) currency is created. Moreover, as fears are stoked about the credibility of a currency investors can pile into gold as a form of shelter. Although we’re a long way from destroying the credibility of the American dollar, the rampant money printing globally is causing uncertainly and contributing to gold demand.
As we look to the future, one would expect some pull-back in the prices of precious metals. The prices have risen so far and so fast that some consolidation would be expected. However, the medium to long-term case for precious metals, and for gold in particular, remains bullish. Regarding the money printing by central banks, it’s hard to see an end in sight. COVID-19 has caused substantial unemployment and central banks are aggressively providing support which is dramatically increasing the money supply. Moreover, things are likely to get more accommodative from here. For example, any prolonged economic downturn is going to mean a prolonged period of government assistance. Moreover, in the mid to long-term it’s hard to see how all of our “unfunded” obligations like social security and state pensions are going to be met without further money printing. Perhaps the strongest argument for a continued rise in gold demand is the expected real interest rate forecast. It’s tough to find an economist who thinks we’re going to see positive real rates in the next few years. Gold feels like a good bet because centrals banks, like the US Federal Reserve, have indicated that they intend to keep short-term rates at zero and target inflation at 2%. In other words, their goal for the foreseeable future is to target -2% real short-term interest rates which would keep the vast majority of the bond market in negative territory. As always, we will continue to monitor the situation and look to make adjustments as more information becomes available.
