3 reasons why gold stocks can outperform if inflation starts to rise

The fiscal and monetary ‘bazookas’ fired by governments and central banks to combat the COVID-19 pandemic has left economists divided on what the fallout will be.

Inflation fears are rising in some quarters, while other experts reckon the economic shock will drag on the outlook for growth.

But no matter the outcome, gold prices are still positioned to hold their gains in the second half of the year says Jordan Eliseo, investment research manager at the Perth Mint.

Gold’s rally has been well documented and many junior explorers have benefited, with almost 70 of the 141 gold stocks tracked by Stockhead posting a gain in the 12 months to June 12.

READ: Gold Digger: Investing in gold stocks is good business

Speaking with Stockhead, Eliseo said the policy response across major western economies “does raise the spectre” of higher inflation down the track.

To illustrate the scale of recent support measures, he compared the COVID-19 liquidity injection to what took place after the 2008 global financial crisis (GFC).

“In the aftermath of the GFC it took almost seven years for the Federal Reserve’s balance sheet to grow by $US3.5 trillion (~$5tn) to a pre COVID-19 high of $US4.52tn (~$6.45tn),” Eliseo explained.

“This time around, the Fed has added more than $US3tn (~$4.3tn) to their balance sheet in just over three months.”

Meanwhile, “on the fiscal side, deficits as a percentage of GDP are likely going to be twice as large in 2020 as they were in 2009”.

Over the medium to long-term, such unprecedented spending measures are likely to “fuel concerns about the potential for higher inflation”, Eliseo said.

That said, the inflation outlook is always a topic of hot debate. And billionaire investor Howard Marks probably described it best in a recent memo when he wrote the factors that create inflation were “truly mysterious“.

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If it does return that may not bode well for equities, but Eliseo said there’s a good chance gold investors will be still be smiling. He outlined three core reasons why gold typically outperforms when inflation rises:

1. There’s no other asset that has anywhere near the track record that gold has in terms of maintaining its purchasing power.

2. No other asset class is either large enough (in terms of market size) or accessible enough to a wide pool of investors seeking a hedge against inflation.

3. There is no other liquid asset that has the inflation-protecting qualities of gold. Cash and bonds for example are liquid, but they represent an exposure to currency units that are designed to lose value over time.

If inflation does return, it will probably accompany a stronger rebound in economic activity than what central banks and governments are currently predicting.

But if the exit from the ongoing health crisis proves to be more complex, Eliseo said gold also provided a strong portfolio option during increased levels of volatility caused by economic downturns.

He pointed to gold’s performance in the wake of the three main economic shocks of the 21st century — the 9/11 terrorist attacks, the GFC and COVID-19. Over that time period, the price of gold has risen by more than 500 per cent.

“Each of these events have led to heightened equity market volatility and reinforced the need for uncorrelated safe haven assets,” Eliseo said.

“In terms of average returns, gold has outperformed all other asset classes in periods where equity markets sell off. So in my view it’s no surprise it has prospered throughout this era, even if official inflationary pressures have remained benign.”