Gold is making headlines again as the price of bullion and gold mining companies have moved sharply higher over the last three months. Since the start of the year, bullion is up about 19% in USD terms, while the Canadian gold mining ETF “XGD” is up a whopping 43%. Now before you consider cashing everything in and joining the gold rush, let’s try to understand why gold has moved so far so fast.
One popular story is that gold offers good protection from volatility in the stock market. This one is quite easy to debunk: price history shows no reliable relationship between gold and equities. Sometimes it does go up during market panics, but other times it does not. There must be another reason behind gold’s rise.
Some people suggest there is a link between the price of gold and negative interest rates around the world, but that’s only half true. Interest rates alone are not to blame. It goes one level deeper, to something called the “real” interest rate.
“Real” interest rates are a mix of fact and opinion that try to approximate the cost of lending or borrowing money, after inflation. We can calculate the “real’ rate by taking the yield on a long term risk-free bond (like a US government bond), and subtracting from it the level of inflation in the economy. While the yield on a long term government bond is easy to find, inflation is more of a guess -- a highly refined guess, but a guess nonetheless.
Going back to economics 101, the theory goes that a positive real interest rate is bad for gold, while a negative real interest rate is good. I’ll explain why.
If you have a government bond yielding 3.5%, and inflation is 2%, then an investor holding that risk-free bond would receive a real interest rate of 1.5% per year (3.5% bond yield minus 2% inflation = 1.5%). So after inflation, the investor would have 1.5% more money one year from today. That beats gold, which pays no interest rate whatsoever. But if that same government bond yielded instead 1.0%, and inflation was still 2%, then an investor would receive a real interest rate of -1% (1% bond yield minus 2% inflation = -1%). That means that after inflation, it’s costing that investor 1% per year to hold the bond. Naturally the bond investor, not wanting to lose the value of their capital, would look for other options…
Those options might include other high quality cash-flowing investments that still yield more than inflation, or hard assets such as gold and other storable commodities. Since a bar of gold stays a bar of gold regardless of what’s happening around it, the bar acts as a store of value when other sources of safety like government bonds cost investors money to hold. In other words, the price of gold represents the perceived opportunity cost of investor safety.
During the recent stock market decline, US government bonds were in high demand as investors flocked to safety. This time around, investors bid up the price of government bonds to such a high degree that they began to yield less than inflation. Hence, we find ourselves today in a situation of negative real interest rates. With bonds expensive to hold, gold became an attractive option.
So as investors today, should we count on negative real interest rates persisting, and gold continuing to move higher?
That depends on your views of economic growth and inflation. If economic growth is still viable, then government bond yields should moderate higher to normal levels, above inflation, and hence we return to positive real rates. In my opinion the balance of rational expectations points towards continuing, maybe low but still continuing, long term economic growth. After centuries of human progress, betting against economic growth is not something that helps me sleep well at night.
But if you believe that economic growth is wishful thinking, or you believe inflation will move higher than normal, then negative real rates might encourage you to hold gold or miners.
The truth is that accurately and reliably forecasting these kinds of economic factors is very hard. And since gold and gold mining companies exhibit far more volatility than your average company, being wrong could be a very expensive mistake. That is to say I believe dealing in gold is more akin to speculation than investing – relying on one’s prediction of changes of future economic variables is very different than simply buying a company with a long-standing history of ample cash flow and operational success.
Outside of gold miners, not all companies are fit for negative real rates, but some are. Sticking to high quality cashflow businesses that can continue to generate cash at a rate above inflation creates real economic benefit regardless of what gold or bonds are doing. The best part is they work in positive real rate environments as well.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.