Gold: An investment to compete with the best

Often thought of as a relatively pedestrian real asset, returns generated by gold over the long term are anything but, according to Edison Investment Research.

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Portents of economic weakness

Following the United States Federal Reserve's dramatic shift in position, endings its asset-reduction programme in March 2019, Edison Investment Research has released its most recent gold report.

The forecasts look at gold in four different ways, relative to the US monetary base, relative to its correlation with US currency in circulation, US interest rates and US inflation, predicting a 75% chance of a dovish outcome and an average price close to $1,800/oz next year and to peak at just over $2,000/oz.

Historical returns – exploding myths

Gold is often thought of as a relatively pedestrian real asset, the returns from which are equally conservative. In fact, while there are periods in which this may be true, over the long term, gold has proved itself an investment to compete with the best. While the Dow Jones Industrials Average increased by 25.8x from 1967 to 2018, for example, the price of gold has increased by 36.3x. Of course, in the normal course of events, gold would not be expected to derive an income for its investor, while the Dow Jones would, in the form of dividends.

In annual percentage terms however, the returns from gold over the period are equivalent to 9.6% per year, while those from the Dow Jones are equivalent to 6.6% per year – the three percentage point disparity between the two approximating the average dividend yield over the period for the index. That is a pretty impressive performance for an asset that is often characterised as a portfolio diversifier or insurance policy.

Fed's erstwhile asset-reduction plan unsustainable

At the time of our last report on gold in November 2017, 'normalisation' of monetary policy was the mantra of both policy makers and financial markets. After a decade of ultra-loose monetary policy, interest rates were on a tightening cycle and the US Federal Reserve had just begun a plan to reduce its balance sheet by an unprecedented US$1.48 trillion over five years.

Given this background, our historical analogue for gold forecasting was the early 1980s, when Paul Volcker's Fed was similarly embarked on a tightening cycle.

After several quarters of moderating economic data, however, in March the Fed performed an abrupt about face, when it announced it would end its asset-reduction programme in September, thereby leaving the total US monetary base 37% higher than our previous expectations. Simultaneously, the markets' erstwhile expectations of interest rate hikes have given way to expectations (and now the reality) of cuts.

Add in trade tensions (eg US-China), geopolitical uncertainty (eg in the Persian Gulf) and suddenly the better historical analogue for 2019 appears to be the late 1970s, with at least one more round of monetary easing in prospect before any sense of a return to 'normality'.

Analysis

Gold's relationship with US inflation

Since 1945, gold can be seen to have undergone at least two completed bull and two completed bear markets: 

• A bear market between 1945 and 1967 (a period that was characterised by inflation and positive real interest rates).  
• A bull market between 1968 and 1980 (a period of financial crisis, negative real interest rates and/or unconventional monetary policy).
• A bear market from 1980 to 2001 (positive real interest rates).
• A bull market again from 2001 to 2012 (again characterised by financial crisis, negative real interest rates and unconventional monetary policy).
• A bear market from 2012 to the present that Edison contends has been characterised by the expectation of a resumption of positive real interest rates – an expectation that is currently being tested seriously by the markets for probably the first time since 2012. Note however that, as of 2018, the price of gold (as measured by its annual average) has been on an upward trend for three years since 2015 – albeit modestly in the case of the last two years

Gold's relationship with total US monetary base

In addition to its relationship with inflation, however, gold also exhibits a very close, statistically significant relationship with the US total monetary base. Since 1967, the relationship between the two elicits a Pearson product-moment correlation coefficient (PPMC) of 0.909, implying that there is less than a 5% chance that the relationship occurred by chance. 

This may be rationalised as the value of US gold holdings having a very close correlation with the total US monetary base (also with a PPMC of 0.909 since 1967), which reduces to the gold price having a very close correlation with the total US monetary base, given that the gold tonnage held by the Fed as a reserve asset has remained effectively unchanged since 1979 (and, to all intents and purposes, since 1972).

On the basis of the historical correlation between the two:

• The current gold price (US$1,485/oz at the time of writing) discounts a total US monetary base of US$3,844 billion (cf US$3,400 billion at end-2018). 
• The end-2018 total US monetary base of US$3,400 billion implies a gold price of US$1,337/oz.

Gold's relationship with currency in circulation

Relative to currency in circulation, the gold price can be said to have reverted rapidly from the premiums that were typical of bull market conditions in 2006–12 to those that are typical of bear market conditions in 2014–18.

Once again, there are two obvious historical analogues for the level of the gold price in 2018 relative to the positioning of the US economy within its post-crisis cycle – the first is the 1980s and the second is 1976.

Either way, investors should note that, as at 2018, at a factor of 0.83x, gold was trading below its long-term average level of 0.96x its predicted level. 

On the basis of the historical correlation between the two, we can make the following observations: 

• The current gold price (US$1,485/oz at the time of writing) discounts currency in circulation of US$1,657 billion (ie 3.0% below end-2018 currency in circulation of US$1,709 billion). 
• At the current time, end-2018 US currency in circulation of US$1,709 billion implies a gold price of US$1,528/oz (note that currency in circulation increased in 2015, 2016 and 2018 in contrast to negative movements in the total monetary base).

Two possible scenarios

Doves favour another round of monetary easing

With the underlying economy at something of a crossroads, gold could follow quite different paths. Supporting the Fed's increasingly 'dovish' outlook, the price of gold is approximately (or even slightly above) where we would expect it to be in the event of another round of accommodative monetary policy.

If this continues, then we believe it could appreciate by c US$300/oz vs spot by the end of 2020 and test its erstwhile record of US$1,689/oz (annual average) set in 2012.

Normalisation

However, if the assumption that the economy has just embarked on another round of monetary easing proves wrong and, in fact, a return to a 'hawkish' tightening is in store (as was the case until recently), then we would expect the gold price to fall by c US$300/oz in the next 12–24 months. Rarely has the outlook been so uncertain.

Edison's gold price forecasts for equity valuations

Given the Fed's recent overtures, for the purposes of our equity valuations we have decided to weight our forecasts based on a 75% chance of a dovish outcome and a 25% chance of a hawkish outcome over the next three years and to adopt a flat real gold price of US$1,350/oz thereafter. Among other things, this has the advantage of aligning developers' technical study costs with the approximate gold price environment in which those costs were calculated.

This article is based on Edison Investment Research's full report, 'Portents of economic weakness, Gold- Doves in the ascent' published August 2019.

Edison Investment Research is a third-party supplier and not part of interactive investor. Neither Edison or interactive investor will be responsible for any losses that may be incurred as a result of a trading idea. 

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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