A doubleheader note today on big macro themes.
I’ve quietly grown more interested in gold for three reasons in recent months. The first is that it doesn’t seem to be an expensive hedge against volatility at the moment. The second cause for optimism is that volatility in the gold price has collapsed. Which could be a good contra-indicator. Lastly, although gold is seen as just one of many alternative assets and possible hedging options in the developed world, in much of the rest of the world, gold remains THE best hedge. Against currency collapse. Against chaos and war. And against unpredictable government’s. All of which I think pretty much brilliantly describes the current sorry state of much of the developing world.
Oh, and crypt-currencies – the supposed digital alternatives – aren’t looking quite so healthy at the moment.
So, gold looks a little more interesting than usual.
Quite the best note I’ve seen on the subject of the shiny precious metal is below. It’s by Jeremy Gatto, Investment Manager on Unigestion’s Multi-Asset Navigator fund and Florian Ielpo, Head of Macroeconomic Research. It’s well worth the long read.
And below this long note on gold, I’ve included a very short note and a great chart from Deutsche Asset Management, charting the ageing bull market and its remarkable longevity.
First though, gold. Here’s the Unigestion note on the precious metal….
Over the last few years, the price of gold has traded in a very tight range, often disappointing investors and leading some to question its use in portfolios as a diversifier and to preserve wealth. Despite heightened geopolitical risks, the so-called ‘Goldilocks’ scenario we experienced last year (i.e. solid growth, low inflation and low interest rates), where risky assets thrive, meant gold lost some of its appeal and delivered mixed returns along the way. With monetary policy normalisation by several key central banks underway, rising inflation and heightened market stress, gold is becoming ‘hot’ again and drawing investors back in. Will gold be a ‘free lunch’ over the next couple of years? We are doubtful, given current valuations. However, we believe gold will potentially offer great diversification properties as it will ultimately benefit from the changing monetary policy environment.
A couple of gold positives
After a long period of deflation, inflationary pressures are making their comeback. Looking at our World Inflation Nowcaster, which is a real-time synthetic measure that tracks inflation-surprise risk, there has been an impressive pick-up since mid-2016; and such risk currently remains elevated. Investors often associate the beginning of the ‘reflationary’ trade with Donald Trump’s election success.
However, according to our own measures, inflationary pressures started back around the late summer period of the same year (see Chart 1). Inflation is much more visible now, with Consumer Price Index (CPI) figures reaching higher grounds and the pricing of inflation having been revised upwards considerably by the market. The ability to use gold as an inflation hedge is often questioned; however when plotted against our Inflation Nowcaster, we can see that gold played its part with a positive correlation between the two, as illustrated in Chart 1. What appears quite clearly on the chart is that both indicators had a tendency to increase sharply around the same periods, such as in 2006-2007 or in 2011. Now, the recent pick-up has not yet been followed by an equivalent surge and we discuss a couple of potential explanations in the next section.
Going beyond this simple graph analysis, we examined the average performance of gold across four macro regimes: recession, inflation surprises, market stress and steady growth (see Chart 2). Looking back at the historical returns of gold between 1974 and 2017, gold delivered on average returns of 10% during periods of inflation, while during times of recession, gold returned the same performance as bonds. Whether one is worried about recession risk or inflation shock risk, based on our findings, gold seems to offer interesting hedging capabilities.
Inflationary pressures will comfort central banks in exiting their ultra-low level of monetary policy accommodation. The US Federal Reserve and Bank of Canada have started this process; other developed market central banks have made it clear that their next rate move will be up. With negative real rates still present in many countries, the risk of some central banks falling behind the curve is becoming a reality. If we look at the behaviour of gold during previous central bank tightening phases , it illustrates an interesting picture: the performance of gold over periods of rate hikes, both in developed markets (DM) and emerging markets (EM) is clearly much higher than over periods of no hikes. This relationship is true when considering returns and hikes in a coincidental way and when looking at the performance of gold the month that follows a hike. As such, hiking periods have been positive periods for gold and this is exactly where we think we are heading.
In our view, inflation and higher short-term rates are two supporting factors for gold over the medium term, but they are not the only ones. It is well-known that emerging markets have a large appetite for gold, with India and China being the largest consumers in the world. Emerging market demand is therefore important for the outlook of gold; this can be seen on the chart above by plotting the emerging market consumption component of our World Growth Nowcaster against gold returns. Currently, emerging market consumption is above potential, which could be interpreted as a possible positive catalyst for gold.
The rising geopolitical instability has added a layer of risk to portfolio construction. Given the unpredictable nature of such events, hedging these has proven to be a difficult task. Gold, however, has helped as a useful diversifier against such events following increased demand for safe havens.
Investors’ interest in gold has risen in recent years, with total known exchange-traded funds of gold holdings rising 50% since their lows at the beginning of 2016. Gold futures-traded volumes have also been consistently rising over time, another indication that the demand for gold exposure is growing. Looking at the Commodity Futures Trading Commission (CFTC hereafter) weekly positioning report, gold is well below its historical highs, leaving room for long positions to build-up again. Monetary policy normalisation and heightened geopolitical risk should, in our view, result in higher volatility (or so-called market stress) for assets. Gold volatility is currently close to its historical lows, with three month implied volatility below 10%, making of it an affordable means of portfolio protection.
Risks to the outlook for gold
Top-down factors have largely driven gold returns in recent years. The US dollar has played a particularly significant role and we expect its direction will influence the outlook for gold.
The US dollar rally we have been experiencing since April is acting as an important headwind. The widening gap between US yields and those of the rest of the developed world boosts demand for the dollar as carry is becoming attractive. In the meantime, looking at the chart below, which represents the nominal GDP growth differential between the US and the eurozone, we see a clear outperformance of the US. If the European macro momentum continues to deteriorate while the US momentum remains firm, we could see the European Central Bank (ECB) delay its normalisation phase further. For now, however, the ECB has communicated that it views this as a temporary slowdown.
The chart below shows that the widening yield gap between 2-year rates and the Euro has reached new extremes. It remains to be seen in which way it converges, though the risk is that we see further US dollar appreciation. More importantly, we believe that one of the major risks to the gold story is its valuation: with inventories of gold remaining very high, valuation is a key element to consider when trying to anticipate the future of the price of gold. In a famous article from 2013, Erb and Harvey1 proposed a valuation metric for gold based on its theoretical connection to inflation: they theorised that the level of price of gold should somewhat be linearly related to the level of goods and services’ price indices. The last chart illustrates such a relationship that they named the “Golden constant”. From this perspective, gold is clearly over-valued. Furthermore, we believe that carry is another cross-asset reliable valuation metric. In the case of commodities, the roll yield is often used as a carry measure. Given the extremely contangoed future curve of gold, it also looks expensive: as for most markets, gold valuations are stretched and should be considered with caution.
In our view, two key macro factors are likely to drive gold over the coming months: the US dollar and the interest rates/inflation picture. This is good news for investors willing to sail the monetary policy normalisation phase that we foresee. We still have a tactical interest in the yellow metal, but we are also very aware that gold looks expensive from various perspectives and should, therefore, exhibit more limited reactions to inflation than in the past.
The Great Equity Bull Market
Deutsche Asset Management notes that since March 9, 2009, global share prices have risen without a fall of at least 20%, thus fulfilling the usual definition of a bull market.
“ After more than nine years, the question of the life expectancy of such a bull market naturally arises. current bull market is now competing with the previous record holder in terms of length. (This uses data for the S&P 500, going back to the bull market that started in May 1970. The picture looks similar for global indices.) According to the usual definition, the longest bull market to date lasted from October 11, 1990 to March 24, 2000, or 3452 days. There could soon be a new record holder. To be precise, the current bull market would have outlasted the previous on Wednesday, August 22, based on the assumption that we are not already in a bear market. That means, if the S&P 500 does not surpass 2873 index points, the bull market already ended back in January 26.
The chart below also shows that this may not only be the longest bull market, but that it has also performed well in terms of price development compared to its predecessors. This is all the more remarkable as economic growth in the current economic cycle, which also began in 2009, falls well short of previous cycles. However, the corporate sector has adapted better to the weak overall economic development than other sectors. Current share prices are underpinned by comparatively high corporate profits. That’s unlike the situation in the late 1990s. “
David Bianco, CIO Americas at DWS, notes, the 1990 bear market was at best a small bear with a decline of just under 20%. One could argue that the bull market of the 1990s began after the 1987 crash. According to this definition, we would have to be patient until June 2021 until the current bull market also sets this record.