Small Data Sample Shows Big Potential

In my most recent article “A return to regular order” (A Return To Regular Order? (forbes.com), I outlined how, given our current macroeconomic backdrop, a normal Fed would take their finger off of the money printing button and begin to raise interest rates. This should come as no surprise to anyone who closely follows the Fed, with some banks projecting as many as 6 potential hikes to come in 2022 alone. It is now clear that the Fed is serious. I wrote about how equities have historically struggled during rate hiking periods and why bonds continue to leave me uninterested with real rates (nominal yields minus current inflation) at all-time lows. The one asset class that I continue to believe has significant upside (even in the face of the Fed raising rates) is precious metals (or as we like to say “hard currency”). While I highlighted this in my previous piece, let’s dive deeper into why.

One of the best ways to try and predict the future is to look back and understand the past (using data from Bloomberg LP). Over the last 50 years, we have seen plenty of Fed tightening cycles. But in only 15 of the possible 200 quarters has a Fed-induced rising rate environment been coupled with a “Deflationary” regime (a quarter where both GDP growth and inflation slowed on a rate-of-change basis). Predicting true recessionary deflation is much harder than observing that when real GDP and inflation slow on a rate-of-change basis (ROC) the markets tend to straight line the deflation. This is analogous to when we see rate-of-change positive increases in both measures, markets believe we will grow forever (please tell me you recognize 2021 there). While this quarter’s regime is a bit more muddied, it is inevitable that we enter a Deflationary period beginning in Q2 of this year and likely longer.

In those 15 quarters where we have seen the Fed tightening in times of ROC-Deflation, gold returned an average of over 1.7% a quarter, compared to the S&P just slightly below at under 1.2% a quarter. This data was, at the very least, reassuring enough to believe in gold as a hedge over the coming months. But a 50bps difference is nothing to write home about… so I dug deeper.

Using slow-moving proprietary models of valuation and asset flows we try to forecast the next 10 years of returns across the three major asset classes (equities, bonds, and gold). These models use a blend of forward looking and historical return data. We re-run these models at the beginning of each quarter to help guide us in our asset allocation decisions. To begin 2022, our equities are projected to be in the bottom quintile of expected returns, while gold is projected to be in the top quintile of expected returns.

Rather than looking at gold and equity solely in times of Fed tightening and Deflationary environments, I incorporated our proprietary models to also see how many of these quarters aligned with our top quintile of projected gold returns. The result: 2 out of the 15 quarters I highlighted above. So, to put it all in the broader context of the 50-year period that we are examining, 1% of the time have we seen the Fed tighten into 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 do? +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’s worth of return data when trying to construct a portfolio? To better deal with this dilemma, I looked at the one year forward period returns for both 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 is important to note, I want to call out that a close second to gold (and a higher beta way to play it) was silver, also significantly outperformed equities over the one-year periods for these 2 unique occurrences, returning +22.1% and +16.0%, respectively.

While all this data is great, it’s important that before jumping to any 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 might be. Second, shouldn’t the Fed raising rates kill an asset like gold, because real yields will rise? Yes, is the obvious answer, but there is more that needs to be considered.

First and foremost, let me be clear that I am not guaranteeing gold will have the types of returns we saw in the two periods detailed above. Should Powell 2.0 turn into the second coming of Paul Volker in his zeal to quell inflation, I imagine all assets ex-cash will do poorly.  That said, I am confident that equities will be hit harder by the Fed tightening than gold would. Gold is already coming off a year and a half sluggish period, largely caused by the anticipation of Fed hawkishness.  Equities, on the other hand, have rarely been more expensive.

I also think it is essential that I discuss the two ways that I see this Fed cycle ultimately playing out. Scenario number one: The Fed commits to raising rates until we return to the normal 2% level of inflation, however long that may be, and however bad the damage is to the equity market. In that situation, I would not expect gold to be phenomenal, but still a great hedge to equities.

Scenario number two: I highlighted this one in my last column. The Fed stops tightening monetary conditions early, because they blink and cannot fathom the damage endured by the equity market and housing markets. What happens next? The resumption of money printing with still historically low real rates. Now that is when I want gold… and lots of it.

We are about to enter largely unchartered waters over the next few quarters. That said, usually when the sample size is small the potential is big. But with my job being to mitigate risks in portfolios, I like gold’s setup here as more than just a hedge against equities and I feel further confident that our research supports this notion. How much to own is a personal portfolio decision. When, and if, the Fed declares a premature victory over inflation, I suggest that you add to your gold holdings up to your personal limit.