Gold has entered into a new bull market despite the fact that the yellow metal’s performance has been muted quite recently, according to fund managers from Schroders.
Significant weakness in the US dollar and renewed geopolitical tension from the US and North Korea have failed to lead to strong gains for the metal, even though this would have been the expected response.
Over the past six months the gold price – represented by the S&P GSCI Gold Spot index – has actually declined as shown in the chart below.
Schroders’ James Luke, metals fund manager, and Mark Lacey, global energy fund manager, say gold has been held back by factors such as a rebound in real rates and increased stability in the Chinese yuan, which has dampened Chinese near-term investment demand for the metal.
Performance of gold index over 6 months
Source: FE Analytics
However, Luke and Lacey argue that factors such as this are short term in nature and do not change their view that gold has moved into a new bull market.
The managers cite four main reasons for this belief: global interest rates need to stay negative; broad equity valuations are extremely high and complacency stalks financial markets; the dollar might be entering a bear market; and Chinese demand for gold has the potential to surge.
“Right now it is the second of these factors which we think is particularly pertinent,” they added.
“At this time of heightened geopolitical risk, when Venezuela is on the brink of chaos and tensions are growing between North Korea and the US, there is the possibility of an event in the coming months which causes investors to seek to reduce their risk exposure.”
“In such circumstances, we strongly believe gold could turn out to be an under-owned and well-priced insurance policy.”
Luke and Lacey believe that the market has become too complacent in its outlook for corporate health, which could lead to an eventual correction.
Using the S&P 500 as an example, the managers noted that it reached an all-time high of 2,478 in July and has made a return of around 10 per cent in US dollar terms over 2017 to date.
However, they said the valuation of this index is expensive on a variety of measures. Simple price/book, trailing price/earnings or enterprise value/cashflow all show the index is trading on multiples that are 60 per cent to 100 per cent higher than the historical median over the last 90 years.
Performance of index over 2017
Source: FE Analytics
“Whichever your preferred metric, historical regression analysis suggests expected returns for equities, from today’s starting point, are very low,” the managers added.
“The latest justification for current high valuations include president Trump’s drive to cut corporate tax and the belief that companies’ cost of capital being at an all-time low supports future earnings growth.
“US companies may well receive a welcome reduction in the corporate tax rate, but the low cost of capital argument is flawed. Increasing interest rates are not supportive for equity valuations that are already high (versus history) as companies’ cost of capital increases. As unemployment continues to fall, inflation will start to pick up at the margin, regardless of the lag. Like it or not, we are firmly in a cycle of increasing nominal (not real) interest rates.”
If investors are too complacent about market valuations and the factors supporting them, then the managers said history suggests gold has the potential to perform very well if we are heading into a period of weakness.
Luke and Lacey said that the chart below, which shows the gold price and S&P 500 performance between 1961 and July 2017, illustrates that gold’s perceived ‘safe haven’ status is well-supported with hard evidence: gold price annual returns were positive (particularly during periods of high inflation) when stock market returns were negative.
“We see no reason why this relationship should not continue in the future; an argument for holding a minimum weighting in gold or gold equities in a well diversified portfolio,” they added. “It is important to remember, however, that past performance should not be used as a guide to future performance.”
Gold price vs S&P 500 performance – 10yr compound annual growth rate returns
Source: Bloomberg, Schroders
However, the managers said high equity valuations alone are not enough of a reason to expect the gold price to rise, but the risk/reward balance looks compelling when overall market complacency is high.
Furthermore, they noted that the VIX – which measures the implied volatility of the S&P500 over the next 30 days – is trading at a 27-year low. This suggest that investors currently expecting not only a stable pricing environment for the S&P 500 over the next few months, the managers said, but “basically the most benign risk environment in the history of the index”.
“To us, this is odd from many angles. Not least because current extreme equity valuations are set against the startling fact that global central banks are moving towards an attempt to reverse the most extreme set of policies in the history of monetary policy. More visceral external factors are also lurking in the background,” Luke and Lacey concluded.
“From our perspective, it is difficult to see how the market’s implied volatility does not pick up over the coming months as any external shocks will result in implied volatility increasing, given that valuations of broad equities appear overstretched. Not gold equities though; we believe they are cheap and our holdings are currently discounting gold prices of less than $1,200/oz. At the time of writing the gold price is $1,291.”