A small sample of data shows great potential
In my most recent article “A Return To Regular Order? (forbes.com), I explained how, given our current macroeconomic environment, a normal Fed would take its finger off the button. This should come as no surprise to anyone following the Fed closely, with some banks predicting up to 6 potential hikes in 2022 alone. during times of rising rates and why bonds continue to shed real rates (nominal yields minus current inflation) at historic lows Fed rate hike) is a precious metal (or, as we like to say, a “hard currency”). Although I pointed this out in my previous article, let’s dig deeper into the reason.
One of the best ways to try to predict the future is to look back and understand the past (using data from Bloomberg LP). Over the past 50 years, we have seen many rounds of Fed tightening. But in only 15 of a possible 200 quarters was a Fed-induced rate hike environment coupled with a “deflationary” regime (a quarter where GDP growth and inflation slowed based on a rate of variation). It is much more difficult to predict true recession deflation than to observe that when real GDP and inflation slow on a rate of change (ROC) basis, markets tend to smooth out deflation. It’s analogous to when we see positive increases in the rate of change in both metrics, the markets believe we’re going to grow forever (please tell me you recognize 2021 there). Although this quarter’s pattern is a little more confusing, it is inevitable that we will enter a deflationary period beginning in the second quarter of this year and likely longer.
In the 15 quarters we’ve seen the Fed tighten in times of ROC-Deflation, gold has averaged over 1.7% per quarter, versus the S&P just slightly below at less than 1, 2% per quarter. This data was, at the very least, reassuring enough to believe in gold as a hedge over the next few months. But a 50 basis point difference is nothing to get excited about…so I dug deeper.
Using proprietary valuation and slow-moving asset-flow models, we attempt to forecast returns for the next 10 years in all three major asset classes (stocks, bonds and gold). These models use a mix of forward-looking data and historical returns. We re-run these models at the start of each quarter to guide our asset allocation decisions. To start 2022, our equities are expected to be in the bottom quintile of expected returns, while gold is expected to be in the top quintile of expected returns.
Rather than looking at gold and equities only in times of Fed tightening and deflationary environments, I incorporated our proprietary models to also see how many of those quarters aligned with our top quintile of projected US returns. ‘gold. The result: 2 of the 15 quarters I highlighted above. So to put all of this in the larger context of the 50 year period we’re looking at, 1% of the time have we seen the Fed tighten in a slowing economy where our models would have projected gold to be in its highest quintile of expected returns. These two occurrences were Q3 2004 and Q4 2018. How did gold perform? +6.1% and +7.7%, respectively. The S&P500 on the other hand? -2.3% and -14.0%, respectively.
But what good is just a quarter of performance data when trying to build a portfolio? To better address this dilemma, I looked at the one-year forward period returns for Q3 2004 and Q4 2018. Gold returned +10.5% and +23.6 respectively. %, while, on the other hand, the S&P returned +4.4% and +2.2%, respectively. Finally, and because it’s important to note, I want to point out that silver was second only to gold (and a higher beta to play it), and also significantly outperformed stocks over the periods of one year for these 2 unique occurrences, return of +22.1% and +16.0%, respectively.
While all of this data is great, it’s important that before jumping to a conclusion, we take a step back and separate the numbers from the story. First, a sample size of two is ridiculously small. It tells you how unique the period we are entering can be. Second, shouldn’t the Fed rate hike kill an asset like gold, because real yields will go up? Yes, that’s the obvious answer, but there’s more to consider.
First, let me clarify that I don’t guarantee gold will have the kinds of returns we’ve seen in the two time periods described above. If Powell 2.0 turns into the second coming of Paul Volker in his zeal to stifle inflation, I imagine all non-cash assets will hurt. That said, I am confident that equities will be hit harder by Fed tightening than gold. Gold is already emerging from a year and a half of sluggishness, largely caused by anticipation of Fed hawkishness. Equities, on the other hand, have rarely been more expensive.
I also think it’s critical that I discuss the two ways I see this Fed cycle ultimately playing out. Scenario number one: The Fed is committed to raising rates until we return to the normal level of inflation of 2%, however long that may be and however severe the damage to the stock market. In this situation, I wouldn’t expect gold to be phenomenal, but still a great hedge for stocks.
Scenario number two: I highlighted this one in my last column. The Fed stops tightening monetary conditions early because they blink and can’t imagine the damage to the stock market and housing markets. What happens next? The resumption of money printing with real rates still historically low. That’s when I want gold… and lots of it.
We are about to enter largely uncharted waters over the coming quarters. That said, generally, when the sample size is small, the potential is large. But with my job of mitigating risk in portfolios, I like the setup of gold here as more than just a hedge against equities and I’m further confident that our research supports that notion. How much to own is a personal portfolio decision. When, and if, the Fed declares an early victory over inflation, I suggest you add to your gold holdings up to your personal limit.