Gold and Cyclical Inflationary Pressure

April 21, 2016

Gold and Cyclical Inflationary Pressure Photo

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Last week, we undertook some research on the expected return for equities, as represented by the S&P 500 Index, over the next 10 years. Based on the current low risk-free rate and high stock valuations, our expected return for equities is much lower than the historical return. The research also showed that many of our larger peers are expecting lower returns for the next 7-10 years.

This low-return world has been driven by low inflation, low growth and the current high valuations of stocks. It is common for some subset of financial assets to be overvalued, but it is rare for almost all assets to be richly priced, as they are right now.

Because the future expected return for equities is low, and volatility tends to be higher in a slow economy, it is valuable to add some non-correlated assets into a portfolio to reduce the portfolio volatility and better protect the capital. After five years of disappointing returns, a lot of hedge funds are now using low correlation as their selling point instead of outstanding risk-adjusted returns. In my opinion, gold is a better and cheaper way to diversify a portfolio.

If you look at this week’s chart, the correlation between gold and the S&P 500 Index tends to be negative in a crisis, but, during a bull market, it averages a correlation around 0.4. This low/negative correlation helps to demonstrate the diversification benefits of gold.

Low correlation is not the only reason to buy gold. In an environment where secular stagnation has almost become mainstream, the only cheap assets are inflation hedges. Everyone sees the secular headwinds for inflation: Demographics, technology innovation and overcapacity in industrial productions. The demand for an inflation hedge is low, and that makes it attractive compared to other assets.

It is very hard to argue against these secular trends as they are very real. However, if the business cycle is not completely managed away by the Federal Reserve, we should see some wage pressure and eventually some cyclical inflation. Usually, towards the late stage of a business cycle, demand increases, labor markets tighten, and we usually see the highest wage pressure at this point. Given how low the productivity has been growing in this recovery cycle (about 0.5% on average compared to 2% historically), a lot of new labor will be needed to meet marginal demands. Eventually, we should see this reflected in the Consumer Price Index (CPI), Personal Consumption Expenditures (PCE) and average hourly earnings reports.

Key Takeaway: Gold can be a good and inexpensive way to add diversification to a portfolio. The recent stock market rally has been led by energy, metal/minings and emerging markets. This is a sign that the market is pricing out the deflation risk and slowly pricing in some inflation risk. The upcoming data about inflation will tell us if the cyclical inflationary or secular deflationary force is winning. If inflation pressure increases, that will be a negative for both equities and bonds.

Attachment: Chart of the Week

Tags: Chart of the Week | Inflation | S&P 500 | Correlation | Gold | Non-correlated assets

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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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