The following is an edited extract from ABC Bullion's new book, “Gold for Australian Investors”
Discover the eight reasons why Australian investors should consider including physical gold in their investment portfolio. Here is number 2.
2. Gold is a natural holding in low “real” interest rate environments
One of the most commonly held myths regarding gold is that the price will fall when interest rates rise. This is false, as their have been several such periods in the past forty-plus years in which gold prices have risen strongly, alongside rising rates.
The reason for this is that it is not the nominal interest rate, nor its direction, that has typically counted when it comes to the likely direction of gold prices, but the “real” interest rate, which also accounts for the impact of inflation.
In simple terms, if we have a RBA cash rate of 5%, and inflation is running at 3%, then the “real” interest rate is just 2%. Note that one could use the average term-deposit rate or 90-day bank bills or some other kind of market rate of interest to calculate what “real” interest rates are in any given country, but the official cash rate is just as useful a figure.
That physical gold prices would tend to perform better in environments of low “real” interest rates is logical for two primary reasons. The first of these reasons is that low “real” interest rates are typically a central bank response to periods of lower economic growth, if not outright recession. They are also often used not only as an attempt to kick start growth, but also as a way of “papering over” potential risks in the financial system, with lower “real” rates improving debt serviceability for households, corporations and, indeed, sovereign states.
In these environments, not only is there a greater risk that returns on more traditional asset classes will be constrained, but volatility will often increase as well. Naturally this encourages investors to look for “safe haven” assets, which physical gold has demonstrated itself to be time and time again, and is one of the reasons why precious metals have performed as well as they have over the last fifteen years.
The second, and arguably most important, of the two reasons gold tends to perform so well in low “real” rate environments is that low “real” interest rates reduce the “opportunity cost” to an investor of taking money out of a bank account or term deposit, and purchasing physical bullion instead.
That investors would turn to gold in place of traditional cash investments during low “real” rate environments is entirely logical, for the investor is guaranteed a low, if not negative, “real” return by remaining in cash.
This is highly relevant for Australian investors today, with the RBA cutting the official cash rate in 2016 to an all-time record low of just 1.50%, essentially putting the “real” interest rate at zero in this country, with ABS and RBA data to end March 2016 measuring inflation excluding volatile items and trimmed mean inflation both putting annual prices increases at 1.70%.
This puts Australian savers in the same position as the vast majority of their global counterparts, with research published in early 2015 from Gluskin Sheff Economist David Rosenberg (using data from the IMF, Bloomberg and Haver Analytics) suggesting that a full 90% of the industrialized world now has “real” rates near or below zero.
Physical gold, whilst it does not pay a yield (unless lent), at least offers the opportunity for capital appreciation that can offset the loss of purchasing power that results from consumer price inflation.
Digressing for a moment from the argument regarding low “real” rates specifically, and it is worth briefly pointing out that over the long run, physical gold has proved itself to be the better long-term savings asset.
The following table highlights this, looking at returns on physical gold and cash over the 1 year, 10 years, 15 years and 44 years period ending December 2014, a time-span that has covered both high and low “real” rate environments.
Gold and Cash Returns to end December 2014 (%)
Source: Cor Capital, RBA, IRESS, Chant West, ABC Bullion
As you can see, gold has been a higher returning asset, with the outperformance growing since the start of 2015, owing to a gold price near AUD $1600 per troy ounce, and a cash rate now below 2%.
Returning to environments of low “real” rates, and it is worth mentioning that the likelihood of strong gold price returns in such environments was something that the Pacific Investment Management Company (PIMCO), the $1.52 trillion asset manager and fixed income specialist, explained back in January 2014.
In an article titled “Demystifying Gold Prices”, PIMCO gave an example that illustrated the way they thought about gold prices, and their likely direction, which focused on the importance of “real” rates, or “real” yields.
PIMCO stated (bolded emphasis mine);
“Pretend there was an asset that had no risk of default and a real – that is, inflation-adjusted – value that varied over time but did so around some constant level. In other words, this asset has no credit risk and in the long run maintains its purchasing power. How much would investors pay for it? Whatever the amount is, it would likely vary over time with the level of real yields available in very high quality, nearly “default-free” assets (such as U.S. Treasuries). That is, when real yields on other such assets are high, investors would likely want a bigger discount to the long-run estimated real value of the hypothetical asset. Conversely, when real yields are low, the opportunity cost of owning the asset drops and investors would likely be willing to pay a higher price relative to the assets long-run estimated real value.”
In other words, if “real” yields, either on bank accounts, or government bonds, which are nearly default free, are high, or at least trending higher, then the price investors are willing to pay for physical gold, the only highly liquid asset class entirely devoid of credit risk, is more likely to be lower, and vice versa.
Market history over the past four decades suggests PIMCO is right, for a study of returns over the entire period that gold prices have been free-floating validates their assertion that gold prices tend to prosper in low “real” rate environments.
From the end of 1970 to the end of 2014, there were twenty-four years in the United States when “real” interest rates were 2% or less. This includes almost the entirety of the 1970s, with low “real” rates a feature of that decade. There was also a period in the early 1990s when “real” interest rates fell below 2%, whilst many years since the turn of the century also fit into this category.
Gold in low ‘real rate’ environments: United States
Source: Federal Reserve Bank of St Louis, World Gold Council
Physical gold prices rose in eighteen of the twenty-four years when “real” interest rates were 2% or less, and recorded an average annual increase of 19.66%. This is illustrated in the table right.
The logic of investing in physical gold, and seeing it as a natural portfolio holding in low “real” interest rate environments, is not something limited to the United States, with broadly similar results to those highlighted above seen in Australia as well.
From the end of 1970 to the end of 2014, there have been twenty years where “real” interest rates in Australia were 2% or less for the year. Physical gold prices rose in 18 of those 20 years (i.e. 90% of the time), with an annual average gain of just under 23%.
Average Annual Returns when “real” rates are 2% or less: Australia
Source: RBA, IRESS, Cor Capital, returns cover period 1971 to 2014 inclusive, based on average RBA cash rates minus end of year inflation readings.
Not only was this clearly far superior to cash, but as the table below highlights, the average annual return on physical gold in these years of low “real” rates were also far superior to that of both the stock market and the bond market.
Less you think the table above suggests a period of high returns and growing wealth in low “real” rate environments, we’d point out that the returns contained in it are nominal, with inflation rates averaging close to 7% in the years “real” rates were 2% or less. Many of the years saw double-digit inflation rates. The stock and bond returns don’t look quite so attractive with that added perspective, with gold the only asset that protected and meaningfully increased real wealth.
Investors’ natural desire for a tangible “safe haven” asset in times of uncertainty, combined with the market leading returns of physical gold in periods of low “real” interest rates, are some of the primary reasons investors are allocating a portion of their portfolio to precious metals today.
This trend could well strengthen if there is further downside in the official cash rate in the years ahead, something many market commentators and analysts think is likely, with forecasts suggesting the RBA cash rate could fall at least as low as 1.00% in the coming 12 months.
Should this reduction in interest rates transpire alongside an increase in either core inflationary pressures or greater financial market volatility (or both), investor movement toward physical gold will only be strengthened.
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