Markets ponder the merits of following the yellow brick road

If one single chart helps to explain the turnaround in market sentiment from February’s despondency to March’s springy rally, it just might be this one. It shows US 5-year, 5-year forward inflation expectations. Since the middle of February, the market has gone from pricing in inflation of 1.42% five years hence to expecting 1.75% - a 23% change.

Inflation expectations are creeping up again in the USA

Source: FRED, St. Louis Federal Reserve Database

Staring a deflationary shock in the face, central banks have responded in a manner which has prompted some commentators to ask whether February’s G20 meeting in Shanghai was the site of some behind-the-scenes cooperation. This column doubts this, not least as central banks’ determination to talk down their currencies to drive their own exports higher is a beggar-thy-neighbour policy and one that smacks of everyone for themselves rather than the spirit of everyone being in this together.

Nevertheless, fresh moves from the European Central Bank and the People’s Bank of China, jawboning about deeper moves into negative interest rate territory from the Bank of Japan and an avowedly dovish Federal Reserve suggest the authorities accept they are far from winning their fight against inflation.

It also implies they will continue to experiment with the unorthodox, even if seven years of failure in the US, a couple in Europe and over two decades of huffing and puffing in Japan have made little or no great difference.

In addition, politicians are starting to pick apart the austerity narrative and reach for fiscal levers too. Japan’s Prime Minister, Shinzō Abe, is hinting at a deferral of a planned April 2017 consumption tax hike. His Canadian equivalent, Justin Trudeau, has unveiled a C$60 billion (£32 billion) infrastructure spending programme, while Italy’s Matteo Renzi is renewing his calls for an easing of the Eurozone’s fiscal deficit rules.

The prospect of fast and loose monetary policy coupled with fiscal easing may explain why one traditional inflation hedge has been a strong performer in 2016, following four years in the doldrums – namely gold. The precious metal has left all other major asset classes for dead so far this year, as the first quarter starts to draw to a close.

Gold has made a great start to 2016

Source: Thomson Reuters Datastream

Shiny happy people

The case for gold has three main thrusts.

  • One, it is a traditional safe haven during times of market stress. It roared higher during 2008 to 2011 as the effects of the financial crisis ripped around the world, as this price chart for gold since 2000 shows:

Gold has worked well during times of market stress this century

Source: Thomson Reuters Datastream

  • Two, it’s hard to find and produce, so supply only grows slowly. This is in contrast to paper money, which central banks can create at will at the flick of a switch. Gold is therefore a potential shield against central bank profligacy and any overshoot in their attempts to reach their 2% inflation targets.
  • Three, if interest rates go negative worldwide, you may have to pay to keep cash in the bank. Gold is therefore a potential alternative to cash under those circumstances.

Barbarous relic

The case against also comes in three forms:

  • One, it has limited industrial use, generates no yield or cash and thus has no intrinsic value at all.
  • Two, it’s not a cheap alternative to cash, as you have to pay to store and insure it, if you own the physical stuff.
  • Three, it tends to do best when everything else is doing badly, so if the markets believe that central banks will succeed in getting the economy back on track then gold may again look like a “barbarous relic” as former Chancellor of the Exchequer and Prime Minister Gordon Brown once described it. This next graphic takes gold back to 1970 and as you can see the dollar price has had some very bad runs as well as some very good ones.

Like all assets, gold has its good times and its bad

Source: Thomson Reuters Datastream

Watch what they do, not what they say

That chart of 5-year, 5-year inflation expectations could go a long way to influencing the metal’s performance, especially as the US Federal Reserve was so dovish in March. The Federal Open Markets Committee voted 8-1 against a March rate rise and took a less aggressive stance for the rest of the year, pruning back its planned four 0.25% rate hikes to just two.

This surprised many given that US inflation has started to show some signs of stirring. The headline consumer price index measure dropped back from 1.4% year-on-year to 1% in February but the Fed’s preferred measure, the so-called ‘core’ rate (which bizarrely excludes useful things like food and energy) actually blew past the central’s bank’s 2% target.

‘Core’ inflation is now exceeding the Fed’s target

Source: US Bureau of Labor Statistics

Chairwoman Yellen had previously flagged that 2% ‘core’ reading as a potential trigger for further interest rate increases. But then her predecessor Ben Bernanke had previously highlighted a drop in the unemployment rate below 6% as a key point and he did nothing either, so perhaps the Fed will talk a good game but continue to play it fast and loose with policy for a lot longer than it pretends and the market expects. At least that ties in with why inflation expectations are rising and gold is responding.

Portfolio options

Whether gold is right for a client’s portfolio will be down to their investment goals, target returns, time horizon and appetite for risk, as well as where they sit on the pros and cons for the metal outlined above.

If they do decide that central banks will continue to go all in with negative rates and more QE in their efforts to stoke inflation, then they may choose to follow the yellow brick road – and that’s a decision only you can make – there are three main ways to access to the metal.

  • First, clients can buy an Exchange-Traded Commodity (ETC), such as ETFS Physical Gold, which is designed to track movements in the underlying metal price and deliver performance, minus running costs. It is possible to buy versions which deliver performance in dollar or sterling terms, if clients are worried about currency movements. Some ETCs use physical or direct replication to provide performance (and thus own the gold) while others use synthetic or indirect replication and deliver gold’s price changes via derivative transactions:

Best performing precious metal ETCs over the past five years

Source: Morningstar, for the Commodities – Precious Metals category

  • Second, your clients can buy gold mining stocks - Randgold Resources is a member of the FTSE 100, for example. However, it is unlikely clients or advisers will have time for the intricacies of stock analysis or the appetite for stock-specific risk. As such, one option is to buy an Exchange-Traded Fund (ETF) which tracks a basket of gold mining stocks.

Only ETFS DAXglobal GoldMining GO ETF has a five-year history here and the annualised return has been an ugly -13.7% a year. Other alternatives include UBS Solactive Global Pure Gold Miners ETF, iShares Gold Producers ETF and then two tools which provide a choice between large caps and (even more operationally geared) small caps, namely Market Vectors Gold Miners ETF and Market Vectors Junior Gold Miners ETF.

Note that these ETFs have risen by between 55% and 78% year to date.

  • Third, also to manage stock-specific risk, clients can buy an actively run fund which specialises in precious metal miners. In return for a fee, they will gain access to a wide pool of gold miners, selected by an expert in the area. There are both open and closed-ended funds which operate in this area, although they may not be pure gold plays and will come with exposure to silver and possibly platinum and palladium, too. As such some research will be required to assess the exact exposures.

Best performing gold-mining exposed OEICs over the past five years

Source: Morningstar, for Sector Equity Precious Metals category.
Where more than one class of fund features only the best performer is listed.

Best performing gold-mining exposed investment companies over the past five years

Source: Morningstar, for the Sector Specialist: Commodities & Natural Resources category (excluding pure energy plays)

Silver lining

For any client who truly believes central banks will keep the pedal to the metal (as it were) there is a further option – silver. This can be accessed in all of the ways outlined above and may be of interest simply because the gold-silver ratio is near historic highs at around 80:1 (so one ounce of gold buys 80 ounces of silver).

Gold/silver ratio stands near historic highs

Source: Thomson Reuters Datastream

The average since 1970 is around 55 so it is possible that in the event of a break-out in inflationary expectations silver rises faster than gold. This final chart shows that silver is capable of sharp gains during times of inflation (but also sharp losses during periods of disinflation and financial market calm).

'The long-term silver price' or something similar

Source: Thomson Reuters Datastream

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

Top