Gold 2030

Gold has been the leading major asset class in the 21st century which surprises many professional investors and it has beaten the US treasuries, equities, developed market equities and emerging markets. USD 100 invested at the turn of the century has turned into USD 591. Gold doesn’t pay a yield, unless you lend it and therefore it’s believed that gold can’t be valued which is not true if you attribute gold’s great leap forward to the fall in US real interest rates (104%), realised inflation (52%), starting discount (55%) and, finally, the recent move to a 24% premium. These points are addressed in turn and then we look at the decade ahead.

The main driver has been falling real rates, that is, the US Treasury yield less the expected rate of inflation.This was over 4% in 2000 and has recently turned negative. It’s only understandable that gold is deemed to be more attractive when cash on deposit receives a negative real return, compared to those glorious days when you could earn a 4% real rate without taking any risk. Little wonder gold was trading so cheaply in 2000.

Gold started the period below fair value and crossed above in 2008. It then got ahead of itself at the 2011 peak, only to fall back into line for the next few years. Recently a premium has begun to re-emerge.

Many believe that gold is a safe haven which indeed it is, but only when real rates are falling. If the system freezes up, and there is a fear of deflation, then cash is king. Yet, gold has typically been quick to recover once the threat of deflation passes, a sign of asset quality.

Another observation is that, at the time of gold’s 2011 high, the US consumer price index brushed 3.9%. While gold soared, asset prices retreated, and the euro crisis was set in motion. Gold has a unique ability to sniff out inflation, and as soon as the threat passed, gold retreated, while general asset prices rallied.

In the run-up to the 2013 taper tantrum, the gold price sensed the impending spike in real interest rates. The premium peaked at nearly 50% (the gold price was 50% above fair value) in 2011 and started to decline 18 months ahead of the talk of rising interest rates. By the time of the taper tantrum, the premium was zero. It begs the question that if gold built a premium into a rising inflationary environment back then, and then anticipated its demise, it could be doing it again.

The gold premium seems to be a trending affair. The price rose from 2000 to 2005, yet the valuation gap failed to close. It was an era of a weak dollar, while gold was rising in US dollars, it was flat in most other currencies. It was only when gold started to show strength in the likes of the euro and the yen that the global buyers arrived, and the discount started to close.

The premium carried on rising into 2011, before narrowing ahead of the taper tantrum. Five years of inactivity followed, while gold patiently waited for general asset prices to trip. By late 2018, a new premium started to build, which brings us to the present day.

Given the trending nature of the premium, it is more likely to rise from here than reverse. That’s because gold is in a bull market and the forces driving it higher far outweigh the forces holding it back.

What we are seeing today is a surge in the money supply, which is being sent straight to the real economy. Prices are still falling because there has been a demand shock. The combination of closed businesses and high unemployment, much of which is hopefully temporary, has seen prices fall. But as the world economy re-emerges from the ashes, we could find ourselves facing a supply shock, with too much money chasing too few goods. It’s fair to assume that gold is, once again, a step ahead.

Gold compensates for realised inflation that has already happened. Yet, it also responds to real rates that reflect the cost of money. Those two inputs help us to anchor the price. However, as experienced investors are only too aware, the price will do what it wants to and the deviation from that price can differ significantly. The point of fair value is not to trade off, but to measure risk and reward. If gold is trading at a discount, it is possible to lose money, but hard to lose a lot of money, and vice versa.

In trying to determine where gold might find itself at the end of the decade, we need to make assumptions. It goes without saying that the future is unpredictable, but we can give it a try. Inflation will return and that alone is enough to consider a plausible scenario. In order to predict the gold price in 2030, we need to forecast realised inflation 2020 to 2030, real rates in 2030 and the premium to fair value.

This is the hardest question to answer, so we’ll keep it simple and forecast 4% as an average for the decade. Over the past 70 years, the average rate has been 3.5%, so we are going slightly higher. 4% compounded over ten years is 48%.

This is more scientific because we can use the valuation methodology and allow different inputs. What soon becomes clear is that real rates aren’t equal. That is, a 0% real yield can have 0% bond yield and 0% inflation, or it can have a 5% bond yield and 5% inflation. The former puts gold at $1,024, whereas the latter puts it at $2,716, a huge difference. This means that there’s more to it than real rates, because gold is more sensitive to inflation than the bond yield.

The huge gains in the 21st century have occurred in an environment with falling rates, while long-term inflation expectations have barely moved. With higher inflation on the horizon, things start to get interesting.
The gold premium touched 50% in 2011, the last time the animal spirits were raging wild. Assuming gold is in a bull market, it is fair to assume a similar premium will be seen at some point. Let’s stick with 50%. Given the current premium is 24%, there is 21% of upside to reach a 50% premium.

If inflation exceeds 4%, then expect a higher price and vice versa. If the bond yield blows out, then expect a lower price and vice versa. Finally, the premium could surge in 2025 and come back to zero or even below zero by 2030, should the Volcker moment come early. The point is that there is a rational framework from which you can understand the dynamics of the gold market. Owning gold does not mean you have to fly blind.

The current gold premium is telling us that higher inflation is coming. The implications for asset classes are immense. Higher inflation implies a weaker dollar, which implies higher commodity prices and a surge in emerging market equities. It will make bonds unattractive and potentially drive down equity valuations in the developed world. The last time we saw this was in the 1970s. Those that thrived, owned gold. Putting these together, the price impact from the current fair value of $1,400 is: Realised inflation 48%, Real rates 194% and Premium 21%.