A Case For Gold

• The Fed will tolerate higher inflation, which will lead to even more-negative real interest rates.
• I describe the implications of negative real interest rates for major asset classes: bonds, stocks, and gold.

In my previous article “The Fed Wants Inflation,” I argued that the Fed’s recent shift to targeting average inflation (rather than a simple 2% level) will likely lead to higher inflation and therefore to more-negative real (net of inflation) interest rates. Today, I focus on the implications of this for major asset classes.

Higher future inflation will have important implications for fixed-income investors, and for defensive and tactical strategies. Some bonds are not compensating investors even for current inflation of 1.7%. By investing in the 10-year Treasury, for example, investors commit to around a 1% loss in real terms (0.7%-1.7% rounded, see chart). Inflation-indexed Treasuries (TIPS) are also providing a real yield of -1% (see chart). That is, investors in both 10-year Treasury and TIPS would lose 1% of their purchasing power per year, with certainty.

Corporate bonds, with their slightly higher yields, are barely making up for inflation. If inflation rises, then all bond investors will lose in real terms. This loss will come over time (if bonds are held to maturity) or sooner on a market-value basis, if the Fed lets interest rates rise. Rising rates would be devastating given the enormous debt load – but that’s a separate discussion.

As I have written before, the recent rally has brought stocks to extremely overvalued levels. The S&P 500 is traded at 3.8 times its book value in mid-September – its highest since Jan-2001 (which preceded the 2001-02 bear market) and well above its 2007 and 2019 levels. In its 150-year history, Shiller’s P/E ratio has been higher only in 2018 and during the dot-com bubble of 1998-2001:

A popular argument for higher stock valuation has been that interest rates are lower. So, a hint of rising inflation and interest rates might be the pin that pricks the stock bubble. Recall that as the Fed was normalizing interest rates in 2018, the 10-year yield crossing above 3% in October-2018 was what initially triggered the selloff. This time, the threshold is likely much lower because of larger debt and near-zero (or negative) global interest rates.

If not stocks or bonds, then what? Some authors have written extensively about the attractiveness of gold as a store of value – I don’t have much to add to that. But we’re not “gold bugs” who like gold all the time – we think that the attractiveness of the metal depends on the specific environment. In 2013, for example, when inflation was below 2% and falling, and the 10-year Treasury yield jumped to 3%, gold lost 28%. Today, more investors are beginning to recognize the attractiveness of precious metals in the environment of trillions of added liquidity and zero interest rates. And the Fed’s most recent shift to potentially higher inflation makes gold even more attractive.

Gold price rallied this year to a new all-time high in early August, along with most precious and industrial metals. If we take a longer-term view, however, then gold’s 10-year total return almost exactly matches bonds (see chart) and well below the S&P 500’s 273 over-250% run. I wouldn’t be surprised if gold and stocks converge somewhere in the middle in the coming years. In the short term, our Gold model remains positive. The price correction since early August trimmed the year-to-date gain to 23% and makes an attractive entry point, in my view.

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