Gold in not in bubble territory
“It looks like a duck; it walks like a duck; it quacks like a duck. Maybe it is a duck? This saying comes to mind when looking at financial markets these days.
For instance, the valuation of government bond markets is ridiculously high. 10-year US Treasuries currently yield 1.13 per cent, which amounts to a priceearnings ratio of 88. In other words, if you bought the bond now, you would have to wait 88 years to recover your investment from receiving coupon payments. In the euro area, the composite of long-term government bonds trades at a negative yield, a rather grotesque situation.
Stock market multiples are also at very high levels, largely driven by the low interest rate environment created by central banks. Expected future profits are discounted with a rather low interest rate, which increases the present values of companies and thus their share prices. What is more, low interest rates reduce the cost of debt and thus benefit businesses’ profits, contributing to higher stock prices. In the low yield environment investors increasingly scramble for a “yield pick-up”, running into the stock market and boosting stock prices.
It is fair to assume that bond and stock markets are in “bubble territory”. But as experience shows, bubbles can persist for a quite a while. (They do not have to burst the moment you detected them!) In fact, a market correction appears to be relatively unlikely at the moment. Why is that? The answer is that central banks have tightened their grip on credit markets, fixing interest rates at very low levels.
Without raising interest rates, it is difficult to see how the price correction can, or will, kick in. If and when central banks continue their low interest rate and monetary expansion policies – which we believe is likely –, expectations that the inflationary effects will continue to drive up consumer goods and asset prices seem to be justified. In particular, prices in stock and housing markets stand a good chance of getting inflated further in what lies ahead.
What is more, there is reasonable doubt about the prospect that central banks will necessarily raise interest rates once consumer price inflation rears its ugly head. That is if it creeps above 2 per cent p.a. An important reason for this assumption is that governments favour higher inflation: With interest rates firmly suppressed, higher inflation means negative real funding yields.
Central banks will be reluctant to abandon their extremely expansionary monetary policy too soon. Because if they do, the debt pyramid is most likely to collapse, potentially causing a recession and mass unemployment on a grand scale. The US Federal Reserve (Fed) has already changed its inflation target accordingly:
In August 2020, the Fed announced that it will now aim for an “average” of 2% inflation, rather than maintaining 2% as a fixed goal. Against the backdrop of this assessment, at least two major risks for investors become apparent. First, the ongoing inflationary monetary policy will continue to fuel consumer and/or asset price inflation, in particular, driving asset valuations further into bubble territory. In other words: The purchasing power of money will decrease. Second, the bubble bursts earlier than is widely expected, deflating runaway asset valuations and sending the economies into a tailspin.
Both risks are undoubtedly challenging from an investor point of view. Holding gold (as portion of the portfolio liquidity) could be part of the solution. In the medium to long term, the purchasing power of gold cannot be debased by central banks running the electronic printing presses. And gold does not carry a default risk (other than, for example, bank deposits) – an important characteristic especially in view of the “bursting bubble” scenario.
As things stand, we think that gold isn’t in bubble territory. At its current price, we consider gold a “buy”, offering considerable upside potential for investors with an investment horizon of, say, three or five years; the yellow metal has an attractive risk-reward profile from our point of view, which becomes even more attractive should the price of gold suffer a short-term set-back.
Thorsten Polleit. Chief Economist at Degussa