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. Gold generally has lower price volatility than other precious metals.
Gold and silver have surged in 2020 and now stand among the top performing investments year to date. From December 31 through August 26, the exchange-traded-funds tracking gold and silver (GLD and SLV) are up 28.3% and 53.3% versus 7.7% for the S&P 500 Index and 6.8% for the aggregate bond market (as measured by AGG). Precious metals tend not to 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.
Precious metals have commercial uses, but, this has had very little to do with the recent price surge. Investors are piling into the category as a defense against the uncertainty of the investment landscape. When certain conditions are present, precious metals prove to be great investments. 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 these conditions present (negative real interest rates and currency instability). While inflation is not currently present, many economists believe that we are headed for an inflationary period in the coming years. Central banks are aggressively seeking to kick-start economic activity with very accommodative policies that are inherently inflationary. It’s also noteworthy that the Federal Reserve targets 2% inflation, on average, as a matter of policy. They say they are comfortable letting it run above that target level in the near term. Still, targeting a figure and achieving it are two different things, and many developed nations (e.g., Japan) have failed to achieve their inflation targets for over a decade.
Let’s 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. These bonds would effectively cause your wealth to shrink over time. We have never had such a high percentage of the global bond market effectively losing money net of inflation. 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. Further spurring investors is the fact that central banks of developed nations say that they have no intention of raising interest rates anytime soon and are aggressively looking to increase inflation. The clear and emphatic signal is 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 2020, we’ve seen a massive increase in the money supply in the United States and other developed countries. This is a tailwind for gold as the dollar price of gold stands to gain as more “fiat” (i.e., paper) currency is created. As fears are stoked about the credibility of a currency, investors pile into gold as a form of shelter. We’re a long way from destroying the credibility of the American dollar, but rampant money printing globally is causing uncertainty and contributing to gold demand.
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. Things are likely to get more accommodative from here. Any prolonged economic downturn is going to mean a prolonged period of government assistance. In the mid to long-term, it’s hard to see how all of our “unfunded” obligations such as social security and state pensions are going to be met without even more money printing.
Perhaps the strongest argument for a continued rise in gold demand is the real interest rate forecast. It’s tough to find an economist who thinks we’ll see positive real rates in the next few years. Centrals banks like the U.S. Federal Reserve have indicated that they intend to keep short-term rates at zero and target inflation at 2%, which would keep the vast majority of the bond market in negative territory.
Gold and other precious metals, like any other investment, are subject to potential losses. Be sure that they fit your overall investment objectives. This article isn’t meant to be a recommendation.
