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Hedging against inflationary money

Hedging against inflationary money
Profile photo of Thorsten Polleit

US interest rates have been held fairly low for quite some time now. The Federal Reserve (Fed) last raised its rate by 0.25 to 0.50 percent on 16 December 2015, but that was but a temporary reprieve. Rates’ long-term backslide has since resumed.

graph1

US short- and long-term interest rates in percent

Source: Bloomberg.

The situation in the USA is emblematic of interest rates in many currency areas these days. Borrowing costs have hit rock bottom or close to it. Ten-year government bond yields in Germany and Japan, for example, recently plunged into negative territory.

graph2

Selected 10-year gov’t bond yields in percent

Source: Bloomberg.

Consequences

The global decline in interest rates has consequences. For one, it drives up asset prices. Take, for instance, the stock market. Future cash flows are being discounted at a lower rate, thereby pushing up firms’ present value and thus their stock prices.

graph3

10-year US gov’t bond yield in percent and S&P 500

Source: Bloomberg.

What’s more, lower interest rates reduce firms’ borrowing costs. For leveraged firms, this means higher profits, and their stock prices should benefit strongly: Higher cash flows are discounted at lower interest rates.

Extremely low interest rates have another very important consequence: Traditional bank deposits look to be a far less appealing place to park money, which makes gold an even more attractive option.

In recent decades, people could most of the time earn positive, inflation-adjusted yields on demand, time or savings deposits. This gave secured bank deposits a competitive edge over gold and silver.

Now that interest rates on bank deposits have all but evaporated, gold and silver are real rivals for time and savings deposits, representing relatively liquid assets typically held for the medium-to-long term.

These deposits have a credit or counterparty risk, while physical gold does not. By definition, gold cannot default. What’s more, politically expedient machinations cannot undermine gold’s buying power.

Beyond that, gold (and to some extent also silver) are a low-cost insurance for investors looking for a hedge against the evils of unbacked paper money: In extreme circumstance, the latter’s purchasing power can drop to zero, but this won’t be the case with gold.

Low rates here to stay

How long will interest rates remain in the cellar? Is zero percent even economically feasible for any prolonged period? Precious metals investors need answers to these key questions about low and nonexistent interest rates.

Central banks around the world have slashed their official rates to rock-bottom levels, dragging long-term bond yields and other borrowing costs down as well. But there is more to this than meets the eye.

Most central banks have started buying long-term bonds against issuing new base money. By doing so, they essentially control long-term yields. If a central bank is willing to purchase a bond at, say, US$ 100, the bond’s market price moves to exactly US$ 100.

For no one would sell the bond at a price less than US$ 100 – for he can sell it for US$ 100 to the central bank. In other words: Central banks have been implementing a minimum price policy for bonds, that is a policy for capping market interest rates.

Take, for instance, the European Central Bank (ECB). It ramps up its balance sheet volume by buying up all sorts of bonds, and these purchases are funded by issuing new euro deposits created out of thin air.

graph4

10-year German gov’t bond yield in percent and balance sheet volume of the Eurosystem in billion euros

Source: Thomson Financial. *National central banks plus ECB.

As the graph illustrates nicely, the rise in the ECB’s rising balance sheet volume is accompanied by a marked decline in bond yields. This drop in yields doesn’t come naturally, as was explained earlier on, it is a politically engineered outcome.

Gold and stocks

Debt levels are fairly high in practically all major economies around the world, so it seems unlikely that central banks will be willing or able to abandon their extreme low interest rate policies anytime soon—if ever.

Again, if monetary policy is to suppress interest rates, the (base) money supply has to be increased. And that bodes well for the gold price further down the line: A rise in the quantity of money reduces, and necessarily so, the purchasing power of money.

Over the long term, the gold price is largely driven by the quantity of money: The more unbacked paper money there is sloshing around relative to a given quantity of gold, the higher the latter’s exchange value should be against unbacked paper money.

In view of the inflationary consequences caused by central banks’ policies, however, the savvy investor would also want – in addition to holding the gold currency – to earn a return on capital that exceeds inflation. For this makes his capital to go up over time in real terms.

The investor could consider holding shares in companies that have inflation-resistant business models: Companies that can cope with high inflation by passing higher input costs (energy, wages, etc.) onto their product prices, earning positive inflation-adjusted returns on capital.

Inflation-resistant companies tend to be ‘asset light’: They operate with little fixed capital, so they do not suffer from soaring replacement costs once inflation takes off. And being remote from capital intensive production, these firms’ operations are less affected by boom and bust.

If the investor manages to buy stocks of inflation-resistant companies at prices substantially lower than their intrinsic value, he enjoys a ‘margin of safety’ that keeps the investment risk in check; the margin of safety protects against poor decisions.

There is little reason to assume that the investor can forecast stock prices. What he can do, however, is to make sure that the companies he owns have sound businesses. For if this is the case, the stock price will track the company’s operative success sooner or later.

From where we stand, gold and stocks of good companies – and quite a few are out there in the market place – seem to be sound ingredients for a portfolio aimed to weather the storm caused by central banks’ monetary follies, to hedge against inflationary money.

Articles
Profile photo of Thorsten Polleit

Dr. Thorsten Polleit, Chief Economist of Degussa, Honorary Professor at the University of Bayreuth, and Partner of Polleit & Riechert Investment Management.

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