Gold prices have risen year-to-date by roughly $200 an ounce, impressive at close to 20%, as investors repriced the risk of a negative tail event and increased the odds of a global recession. Along with the gold rally, we saw a sharp move lower in risky assets like equities and wider credit spreads. Will gold continue to shine?
Two years ago, I wrote about how to quantify gold’s value relative to other assets (“Demystifying Gold Prices”). The main point was gold maintains its real or inflation-adjusted value over long periods of time. Since the long-term value of gold should be fairly stable, its price today should move up and down in response to the movements of real yields (the nominal yield less inflation expectations) on high quality assets like U.S. Treasuries. Said another way, when real yields are higher, an investor should pay less for a zero-real-yield asset like gold, and vice versa when real yields are lower. We showed that over the last decade the market has traded gold like an asset with 27 years of real duration, so a 100-basis-points (bps) move lower in Treasury real yields on average translates to a 27% increase in the price of gold.
This year, real yields on U.S. Treasuries have moved lower by about 35 bps, which should be worth about a 10% increase in the price of gold. In addition, the value of the U.S. dollar index has declined by roughly 3% year-to-date, and given gold is denominated in dollar terms, this has also supported gold’s value since it takes more dollars to buy the same amount of gold. So a little over half of the increase in the price of gold is explained by quantifiable factors: gold’s long duration properties and the fact that it is denominated in dollars, making its current price rich to fundamentals in our opinion.
Figure 1 shows the price of gold (gold line), the long-term price of gold adjusted for the level of real yields on U.S. Treasuries (blue line), and the average real-yield-adjusted price of gold (green line). As the chart demonstrates, the price of gold after adjusting for real yields is at the highest level in more than two years and nearly 10% above its average level over the past three years.
While this chart’s valuation approach to gold is fairly quantitative, a more qualitative approach also should give investors some pause. In the past couple of weeks, equities have recovered nearly all of their year-to-date losses. In addition, commodities exposed to global and Chinese growth like oil, iron ore and copper are posting new year-to-date highs. And yet gold hasn’t given back any of its gains this year. We think there has been large buying from commodity trading advisors and trend funds as gold prices crossed major technical moving averages. There has also been large retail buying, with assets in exchange-traded funds like GLD rising sharply year-to-date. However, these flows tend to chase returns, and we don’t see them as a leading sign of future price moves. Rather, given current valuations, these flows permit tactical investors an opportunity to move into more attractively priced flight-to-quality
assets like U.S. TIPS or Treasuries.
Those buying gold as a flight-to-quality asset or as a tail hedge should be aware that it is primarily a long duration real asset. If long-term real yields continue to move lower, then gold will probably benefit; however, it likely will move less than U.S. Treasuries given its starting valuations. As such, we have recently been adding to short gold and long U.S. Treasury positions in some of our portfolios that allow commodity trades. In addition, investors who are wary of low yields should be equally attentive to gold’s price. Just look at how much gold prices fell during the “Taper Tantrum” of 2013.
For investors who want to own some precious metal as a store of value, we suggest platinum. We find it more attractive due to its higher cost of production and the fact that it is trading at about a $265 discount to gold, levels never seen before this year. While platinum might not keep up with gold in a major global recession, we believe it will do better across the full range of potential macro outcomes.
In short, be wary of gold prices at current levels as they look rich relative to other flight-to-quality assets.