Key Points
• History suggests we are at a point in the
market cycle from which gold will outperform stocks in the coming years.
• Gold’s outperformance relative to stocks has
averaged over 50% in the five years following previous yield curve
inversions.
• Nominal returns on cash and bonds, as well
as inflation rates, are lower today than recorded levels at previous yield
curve inversions.
• Equity valuations are higher today compared
to all previous yield curve inversions except for February 2000.
Global bond markets dominated the attention of investors and financial
market commentators last week, with yields on some developed market
government bonds falling to record lows. In Australia, 10 year government
bonds dropped to all time record lows around 1.75% at one point.
Attention has particularly focused on the US, where the yield curve has
inverted for the first time in more than a decade. The last time this
phenomenon occurred was just before the start of the Global Financial Crisis
(GFC).
What does yield curve inversion mean?
For those unfamiliar with the phrase ’yield curve inversion’, it is simply
a circumstance where short term bonds, for example a two year government
bond, have a higher return than a longer term bond, for example a 10 year
government bond.
Note that yield curve inversion doesn’t have to refer to two year and 10
year bonds exclusively. Indeed right now it’s one year and 10 year bonds that
have inverted.
Irrespective of which bonds you’re specifically referring too, typically
you’d expect longer term bonds to have higher yields than shorter term bonds.
There are a number of reasons for this including the need to compensate
investors for taking on greater risks in a longer term loan, as well as them
having a greater opportunity cost in terms of investment they’ll have to
forego. This is because it will take longer for them to get their money back
in a long term bond, relative to a short term bond.
As such, yield curve inversions do not occur all that frequently in
financial markets, and when they do, they are typically seen as a bad omen in
terms of what is likely to happen in the economy in the years that follow. As
one market analyst, Jeffrey Halley, stated to Bloomberg earlier this week: “Bond markets globally,
along with dovish central banks, have been telling us a slowdown is on the
way.”
Yield curve inversions often, though not always, precede recessions, or
outright falls in total economic output. This is why market analysts,
economic commentators and policy makers are concerned with present day
developments, and the inversion that is taking place today.
What has happened to markets in the past?
Over the past 40 years in the US there have been four previous periods
where the yield curve has inverted, with a US two year government bond having
a higher yield than a US 10 year government bond. These occurred in August
1978, a decade later in December 1988, again in February 2000, and most
recently in December 2005 (please see end of article for our data sources
and inversion methodology).
The chart below highlights what happened to the price of gold, and the
price of the S&P 500*, in the one, three, and five year periods that
followed those four previous yield curve inversions, with all returns expressed
in percentages.
Note that the data in the chart below represents the average return across
all four periods, with a more granular and highly detailed breakdown of the
returns generated by gold and stocks following each individual yield curve
inversion provided at the end of this article.
*The S&P 500 is widely regarded as the best single gauge of large
cap US equities.
As you can see, on average, gold prices have strongly outperformed
equities in the one, three and five year periods following on from previous
yield curve inversions, with a positive performance differential that gets
larger over time.
Over one year, the average performance of gold at just over 16% is almost
double that of equities, whilst over three years, the average return for gold
is more than 45% higher, with equities actually suffering a minor decline in
value.
Extend the analysis out to five years and the average return of gold is
more than 50% higher than equity markets historically delivered, with gold
prices up almost 80%.
Were a similar scenario to play out in the years ahead, it would not be
unreasonable to expect the gold price to be trading at almost USD 2,400 per
oz by 2024, based on the gold price today, which is trading just below USD
1,300 per oz.
As the more granular data at the end of this article will highlight, the
above chart doesn’t mean that gold outperformed each and every time the yield
curve inverted, and indeed in the one, three and five years that followed the
1988 inversion, stocks turned out to be a more profitable place to invest
than gold.
Is gold guaranteed to outperform?
In a word, no.
There is a good reason why fund managers and the like must disclose the
fact that past performance is no guarantee of future returns, or results.
Gold for one didn’t outperform in all prior periods of curve inversion, with
the years following the 1988 yield curve inversion far kinder to stock
markets than bullion investors.
There are also some obvious differences between the current scenario we
are facing in markets, and historical periods where the curve inverted.
Inflation for one is far lower today than the 1970s and 1980s, while central
bank activity in the bond market over the last few years may have impacted
the effectiveness of yield curve inversion as a recession risk warning.
While US, and indeed global growth rates are slowing, the US economy is
still expanding, growing at an annualised rate of 2.6% in the last quarter of
2018 (the latest available data). We are likely some time away from a
recession, should it eventuate at all.
Be that as it may the data presented above, and below in the more granular
breakdown of each period below, is clear. If history is any guide, there is a
good chance that gold bullion will outperform financial assets in the years
ahead.
This argument is further supported not only by the rich valuations in
stock markets today, but the very low real yields on offer in traditional
defensive assets, including the almost USD 10 trillion in negative yielding sovereign debt.
At the very least, prudent investors will be looking at gold as a way of
protecting capital in what may turn out to be a challenging period for the
global economy and financial markets.
Until next time…
Jordan Eliseo
1978 yield curve inversion
The following chart highlights the one year, three year and five year
performance for gold and the S&P 500 following on from the 1978 yield
curve inversion. The table that accompanies it highlights nominal two and 10
year yields, the gold price, CPI, the Federal Funds rate, and “real” cash and
bond rates. The table also shows both the price level of the S&P 500 and
the cyclically adjusted price to earnings ratio (CAPE) for the S&P 500 as
well, with these data points shown in the month the curve inverted, as well
as in the two years preceding inversion, and the three years after.
Highlights:
• Gold outperformed equities over one year,
three years and five years following on from the 1978 inversion
• Outperformance was most pronounced over
three years, with a differential of almost 80%
• While nominal cash and bond rates were high
in the 1970s (above 8%), so was inflation, which was on its way from under 6%
in 1976 to almost 12% by 1979
• From a valuation perspective, equities
remained “cheap” over this entire time period, with the CAPE ratio sitting
between eight and 12.
1988 yield curve inversion
The following chart highlights the one year, three year and five year
performance for gold and the S&P 500 following on from the 1988 yield
curve inversion. The table that accompanies it highlights nominal two and 10
year yields, the gold price, CPI, the Federal Funds rate, and “real” cash and
bond rates. The table also shows both the price level of the S&P 500 and
the cyclically adjusted price to earnings ratio (CAPE) for the S&P 500 as
well, with these data points shown in the month the curve inverted, as well
as in the two years preceding inversion, and the three years after.
Highlights:
• Gold underperformed equities over one year,
three years and five years following on from the 1988 inversion
• Underperformance was most pronounced over 5
years, with a differential of almost 70%
• Nominal cash and bond rates were high in the
late 1980s, whilst inflation was more subdued, with real yields of over 4%,
whilst equities were re-rated higher in the aftermath of the 1988 inversion,
with the CAPE ratio rising from 14.70 to 21.16 between 1988 and 1993
• This more positive environment for financial
assets helps in part to explains gold’s relatively poor performance in this
time period
2000 yield curve inversion
The following chart highlights the one year, three year
and five year performance for gold and the S&P 500 following on from the
year 2000 yield curve inversion. The table that accompanies it highlights
nominal two and 10 year yields, the gold price, CPI, the Federal Funds rate,
and “real” cash and bond rates. The table also shows both the price level of
the S&P 500 and the cyclically adjusted price to earnings ratio (CAPE)
for the S&P 500 as well, with these data points shown in the month the
curve inverted, as well as in the two years preceding inversion, and the
three years after.
Highlights:
• Gold and equities fell in the one year
following the February 2000 yield curve inversion
• Gold outperformed over three and five years,
beating equities by 60% over both timeframes
• Real cash and bond rates were still positive
(2.5%-3% depending on duration), giving investors multiple defensive options
for their portfolios
• Equities were incredibly expensive heading
into 2000, trading at over 40 times CAPE. This number fell dramatically in
the five years that followed, helping to explain the poor results for the
share market, and the strong returns delivered by gold
2005 yield curve inversion
The following chart highlights the one year, three year and five year
performance for gold and the S&P 500 following on from the 2005 yield
curve inversion. The table that accompanies it highlights nominal two and 10
year yields, the gold price, CPI, the Federal Funds rate, and “real” cash and
bond rates. The table also shows both the price level of the S&P 500 and
the cyclically adjusted price to earnings ratio (CAPE) for the S&P 500 as
well, with these data points shown in the month the curve inverted, as well
as in the two years preceding inversion and the three years after.
Highlights:
• Gold strongly outperformed equities over one
year, three years and five years following the 2005 inversion
• The most pronounced outperformance occurred
over five years, with gold up almost 175% whilst equities were largely flat
• This outperformance was driven by a handful
of factors, including the occurrence of negative real interest rates, and the
Federal Reserve undertaking Quantitative Easing in the aftermath of the GFC,
both of which limited the attractiveness of traditional defensive assets and
buoyed gold demand
• A sharp decline in equity valuations also
contributed to the outperformance of gold
Notes on data and calculations
Where possible, we have used monthly data points for calculations included
in this article, with much of that data sourced from Reuters. Inflation data
was sourced from the St Louis Federal Reserve, whilst S&P 500 data
(monthly prices and CAPE) was sourced from Robert Shiller/Yale, which is
available for public download from here
The article and the charts and tables used within it are based on our
classification of yield curve inversions as having occurred from the month
end that two year yields first closed above 10 year yields, provided two year
yields then remained above the 10 year yields for at least three months.
As an example, according to Reuters data, two year yields exceeded 10 year
yields at the end of June 1978, but not in July 1978. By end August 1978, two
year yields again exceeded 10 year yields, and did so until April 1980. Hence
we use August 1978 as the starting point for that yield curve inversion.
Using daily or weekly data points, a different data source, or a different
definition for yield curve inversion would generate different results to
those we have published.
Disclaimer
Past performance does not guarantee future results.
The information in this article and the links provided are for general
information only and should not be taken as constituting professional advice
from The Perth Mint. The Perth Mint is not a financial adviser. You should
consider seeking independent financial advice to check how the information in
this article relates to your unique circumstances.All data, including prices,
quotes, valuations and statistics included have been obtained from sources
The Perth Mint deems to be reliable, but we do not guarantee their accuracy
or completeness. The Perth Mint is not liable for any loss caused, whether
due to negligence or otherwise, arising from the use of, or reliance on, the
information provided directly or indirectly, by use of this article.
