The Great Rotation… From bonds to GOLD?
DailyPfennig | Tim Smith
For the past few years, investors have talked about the possibility of a “great rotation,” whereby investors would move assets from bonds into equity funds. It never really came to fruition. But now, some analysts believe this could be happening.
Over the past six months, the yield on 10-year Treasury bonds has jumped from 1.5% to around 2.5%.1 As readers of the Daily Pfennig® newsletter know, yields and bond prices move in the opposite direction. With this recent jump in yield, bond prices have declined recently.
According to a January 11, 2017 article from Bloomberg, in total, bonds have lost about $2 trillion in value since the U.S. presidential election.2 With losses piling up, a lot of investors are rotating from bonds into stocks. Bank of America Merrill Lynch reports that $41.5 billion was pulled out of bond funds in the two months following Trump’s election win. While bond funds saw the largest redemptions since 2013, almost $70 billion flowed into U.S. equity funds.3
If bond yields continue to rise, this trend could continue. But, there’s another asset rotation nearly nobody is talking about. If inflation starts to get out of hand, we could also get a rotation from bonds into gold. Let me explain…
Inflation Has Been Surprising Analysts
Ever since the “Great Recession of 2008,” deflation has been the main concern for many investors. But now, inflation is quietly ticking higher across most of the world’s major economies. The global Citi Inflation Surprise Index measures inflation data relative to market expectations. This past December, the index turned positive. That means inflation data is now higher than what analysts were expecting. The index has also just reached its highest level in more than five years.4 This could be a sign that the era of low inflation is coming to an end.
Energy prices have stabilized. Prices for factory goods coming out of China are rising at the quickest pace in more than five years.5 And, with low unemployment in the U.S., we could soon see wage inflation. Meanwhile, central banks around the globe are in no hurry to withdraw stimulus. The U.S. Federal Reserve, for example, has said it will hike interest rates at a really slow pace. Fed Chairwoman Janet Yellen has even said they’re willing to let the economy run hot for a little while.6
Remember, Fed officials believe premature tightening of monetary policy played a key role in causing the Great Depression of the 1930s.7 They don’t want to risk making the same mistake again. For that reason, central banks could be unwilling to react to inflation until it’s clearly moving higher again. The problem is…that’s how inflation normally gets out of hand. Inflationary expectations could take hold much more quickly than central bankers expect.
If that happens, bond yields should continue to move higher, while bond prices will continue to underperform. That happens because longer-term interest rates tend to rise with inflation, as investors demand higher yields to compensate for the loss of purchasing power. The continued underperformance of fixed-income assets could trigger more outflows from bond funds. And, some of that money could end up in precious metals.
The Great Rotation…Into Gold?
An asset allocation survey by the U.S. Council of Institutional Investors shows that commodities in general account for only 1.8% of pension fund investments. That means only a fraction of that 1.8% is invested specifically in gold and silver.8 U.S. Treasury bonds are viewed as a “safe-haven” asset because of the perception that they have zero risk of default. The bond bull market that started in 1981 has also helped reinforce the idea that you can’t go wrong with bonds. But, if we enter into a more inflationary environment, bond investors will continue to lose money, and that could trigger an outflow of capital into assets that have historically worked as inflationary hedges. Those assets could include gold and silver.
In 1980, gold made up 2.74% of global financial assets. Today, it’s just 0.58%.9 In other words, there’s a lot of room for institutional investors to invest more heavily in gold. A great rotation from bonds into stocks may very well be under way. But, if inflation starts to get out of hand, we could also see some of that outflow from bond funds end up in gold. This asset allocation adjustment would just be another tailwind for gold.