Charles Morris
Charles Morris
28/01/2020

Expecting inflation to rise? Then buy gold.

The assassination of the Iranian general, Qasem Soleimani, has seen gold get off to a strong start this year. Temperatures have risen and the potential for retaliation and escalation has caused concern. The fear is less what Iran does to the US, but how the US retaliate when they do. Yet the recent move pales into insignificance when weighed against events of the past two decades. Almost none of gold’s return has come from geopolitical tensions, and almost all of it comes from lower long-term interest rates, with a modest spattering of inflation.

Since the beginning of this century, gold has returned 9.9% per annum in sterling terms, which means it has beaten gilts (7.1%), inflation linked gilts (7.8%), high yield bonds (7.1%), US equities (7.1%), Asian equities (8.7%) and even the Nasdaq (6.2%). That commendable result came about despite a savage bear market for gold between 2011 and 2015 and no income stream; something that proves to be a useful tailwind for financial assets over long
periods of time.

Gold remains the best performing mainstream asset of the 21st century, yet investors own a mere 82 million ounces (worth $128 billion) between them via the exchange traded funds.

That might sound like a substantial holding, but it isn’t. With global exchange traded funds worth over $5 trillion, the implication is that the average portfolio has a mere 2% allocation to gold. Academic studies range in their conclusions, but they all suggest the optimised allocation should be greater than zero. I’ve often felt that 8% makes sense for a balanced portfolio and 15% to 25% for an all-weather total return fund.

But before you mindlessly add a shiny piece of metal into the mix, it is worth asking why you would want to own it? Most see gold as a hedge against inflation, yet it has been the best asset in a low inflation era. That’s not difficult to understand because gold is an asset, just like equities, bonds and property. For two decades, asset prices have risen markedly, not so
much because the economy grew, but because monetary policy became easier. Lower long-term interest rates have boosted the price of everything, and gold is no exception.

In addition to gold being revalued by easy money, investors came to realise that it was deeply undervalued 20 years ago. It was trading at $255 per ounce when it should probably not have fallen much below $410. When we look at gold’s attribution since, it has performed in line with the long bond, with an additional bonus from being undervalued to begin with. Yet unlike the long bond, it has the advantage that it can carry on performing when inflation starts to rise. In fact, that’s when things start to get interesting.

Bonds loathe inflation as we saw during the 1970s, and equities don’t like it that much either. The UK gilt market turned £100 invested in 1970 into £66 by 1980 in real terms and including dividends. For UK equities, which are though to be inflation proof, £100 was turned into £79. That is a brutal experience for financial assets which came about as bond yields and inflation soared. Yet over the same period, £100 invested in gold became worth £722 in real terms which is quite a difference. It starts to become clear why an allocation to gold makes sense as it is the only asset that can withstand monetary debasement. You might suggest inflation linked gilts, but they will deliver a real return of -2.4% as prices are too high. When inflation comes, gold will stay a step ahead.

It seems a tad simplistic, but gold bull markets have tended to coincide with dollar bear markets, and one is long overdue. Recall that a strong dollar isn’t the norm, and it slumped by a third between the 2000 stockmarket bubble and the credit crisis. Dollar strength only came about thereafter, as the US had higher real interest rates than elsewhere. It’s all about real rates, which have been falling for two decades, and have boosted asset prices in the process.

We can be confident of that link because there have been three meaningful spikes in real rates since the year 2000, and each of them has ended badly. The first came in 2008 and coincided with the financial crisis, where asset prices collapsed, and the dollar surged. The second came about in 2013 during the taper tantrum, which led to another surge in the dollar and subsequent mayhem in the emerging markets in 2015. Then more recently in late 2018, the Fed hiked rates for the last time, pushing the real rate back above 1%. They probably waited too long because global equities collapsed by 25% in short order.

It stands to reason that real rates will need to keep on falling for the system to keep on giving. With around $17 trillion of negatively yielding European bonds seen last year, there is little left for the bond market to give. That means for real rates to keep on falling, inflation must rise. The past decade has seen just 19% inflation in the US and 33% in the UK. The higher number in the UK reflects a weak currency, and when that rolls over to the US, inflation will start to rise there too. Normally change occurs when the status quo is deeply embedded in group think. There is a widespread view that demographics and debt will hold inflation down, and that cheap money will continue indefinitely. But don’t count your chickens.

With large fiscal spending programmes coming to a bridge near you, funded by deficits, it would be more surprising if inflation stayed low than if it didn’t. I don’t have a crystal ball for inflation in the 2020s, but the bond market does. It thinks the answer will be 19%; precisely what it was last decade. I am 100% sure that it won’t be 19%. Whether it’s oil prices, deficits, higher wages, trade wars or policy, inflation will rise. And you don’t need to believe me because the rising gold price is telling you that. Gold can sniff out inflation just as pigs can sniff out truffles. A six-year high in the gold price shouldn’t be ignored, even if the short- term fear premium unwinds.

My last point is how high gold could move when inflation comes? It has already been the best performing asset of the century without inflation, but we already know much of that is due to repricing. With rates so low, a gold bull market can only be driven by rising inflation, with a speculative premium adding some icing on top. But those two factors alone will see
gold soar.

Consider that if US inflation were to rise to 4% by 2030 from the current 2%, and the market believed it was structural rather than cyclical, then gold would be worth approximately twice as much as it is today. If you then compound 4% for ten years, you get to add on another 48%. And when the crowd notices that gold is doing so well, they hop aboard and send it to a 50% premium above fair value. We last saw that in 2011, when gold was all the rage. And back in 1980, the gold bubble of bubbles, it must have been at least that. Putting all of this together, it’s not difficult to see that gold could trade four times higher a decade from now. And that’s with only 4% inflation by 2030.

The compelling part is that if inflation remains low, then it doesn’t matter much as gold will merely plod on. With bond yields so low, the income stream you are missing out on isn’t much to write home about anyway. And if the economy cools, gold will prove to be resilient while equities fall. Adding gold to a portfolio will make it more resilient and protect it when
the ugly beast of inflation returns. If ever there was a time to think differently, it’s now.