If there’s one thing that just about every investor seems to agree on right now, it’s that gold is going to be a winning investment under QE3.
As central banks debase their currencies, the thinking goes, hard assets should benefit. In the short term, the level of consensus around this theory might be an indicator that the price of gold could be in for a rougher go than many expect. But from a longer-term standpoint, this might be one of the rare cases where the conventional wisdom could actually prove accurate — although not necessarily for the reasons investors might expect.
Here’s why: The most favorable attribute of gold might not be its attractiveness relative to fiat currencies, but rather its relationship to other asset classes. Gold, in fact, is in a position to perform well in the years ahead regardless of whether various stimulus programs work.
The crux of this assertion is that central banks, by continuing to throw cash at a global economy that is no longer responding to monetary stimulus, are creating a deluge of cash that will instead find its way into financial assets.
The real question for investors is which financial assets will benefit now. And on this front, gold looks better than either stocks or bonds.
Gold Looking Better Than Ever
It might be hard to believe, but the fourth anniversary of the inception of QE1 is coming up on Nov. 25. In this era of stimulus, the process of excess liquidity working its way into the financial system (rather than fueling growth) has driven stocks to four-year highs, caused Treasury yields to plummet to all time lows, and led to massive rallies across the spread sectors of the bond market.
Gold, of course, also has moved higher during this time. SPDR Gold Shares (NYSE:GLD) stands at about $170 today, compared with a price of $73.30 two weeks before the first round of QE was officially announced.
But that isn’t the only thing different between the world of 2008 and today. Corporate profit margins, rather than being depressed as they were then, are now at all-time highs (indicating that there is less room for improvement). In addition, the yield on the S&P 500 is now about half what it was then.
The landscape in the bond market is much different as well. The 10-year Treasury note — which offered a yield of 3.75% on Nov. 14, 2008 — now sits more than 2 full percentage points lower at 1.71%. Yields on iShares iBoxx $ InvesTop Investment Grade Corp. Bond Fund (NYSE:LQD) and iShares iBoxx $ High Yield Corporate Bond (NYSE:HYG) — then at about 7.7% and 15.4%, respectively — are now at 2.96% and 5.72%.* This indicates that although gold is much higher today than it was four years ago, there also is much less opportunity cost to holding a non-dividend paying asset.
Gold therefore might be more attractive today on a relative basis today than it was four years ago — even at a price that’s 130% higher.
Gold Better Off Than Stocks in a Weak Economy
The other key benefit of gold over other asset classes is that it less sensitive to larger economic forces.
The best evidence that central bankers might be pushing on a string is corporate earnings estimates. On Sept. 24, Bespoke Investment Group published a chart (viewable here) showing that third-quarter earnings estimates have fallen from +3.9% (year-over-year) in early July to -2% now. During this time, the United States, Europe, China and Japan have all announced policies designed to fight slowing growth. While the weak economic environment can hold back stocks by depressing earnings, its effect on gold is much more limited because of the continued demand from the investors and central banks.
It’s true that weaker economic growth in China and India has depressed physical gold demand in those countries. Still, this table from gold.org shows that the dollar value of total investment demand rose 11% in the first half of 2012 versus the same period a year earlier, while central bank demand increased by 43.9%. Both should continue to rise in an environment of protracted QE, meaning that any increase in physical demand off the current low base would provide a powerful engine for the gold price, irrespective of the growth picture.
Even if it doesn’t, investment and central bank demand should help maintain stability in the overall supply-and-demand equation.
The Bottom Line
Gold is unique in that it can outperform in two scenarios. If the central banks are successful and the world economy moves into a mode of self-sustaining positive growth, that would be a positive for Asian gold demand. Alternatively, gold is uniquely positioned to attract capital over other asset classes if continued slow growth pushes money into financial assets rather than the real economy.
While gold prices might be shaky for a time as the market digests the gains of the past month, all the factors are in place to support long-term outperformance for gold.
*Yields quoted are 30-day SEC yields. Source: iShares.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.