Investment Professionals


Inflation and stretched valuations shine light on precious metals


With inflation running at its highest level in decades and the global economy getting hotter than anticipated, investors are wondering what to do.

Bonds offer slim returns. As inflation has jolted higher, and central banks keep interest rates low, the real returns on bonds in rich countries have hovered below zero.

AQR's Forecast Real Returns (5-10Y)


Source: AQR, Q1 2021, Capital Market Assumptions for Major Asset Classes

Shares seem little better. The valuations of major share market gauges around the world are above their long-term averages. In Australia, the trailing price-to-earnings ratio of the ASX 200 is at all-time highs. While the PE ratio of the S&P 500 in the US is re-approaching the heights of the dotcom era.

Stretched valuations and low yields suggest returns for conventional portfolios will be lower than in previous eras. AQR, the investment group, predicts that a traditional US portfolio made up 60/40 of shares and bonds could return as little as 1.4% after adjusting for inflation in the coming years--significantly below the 5% average since 1900.

This challenging environment has sent investors looking for alternatives, which may offer higher returns and protection from inflation. One alternative that is gaining increasing traction is precious metals. These most famously include gold and silver, but also include lesser-known elements like platinum and palladium. As today’s environment challenges conventional portfolio-building techniques, precious metals are having their moment.

Precious metals outperform when inflation rises

As a general rule, when inflation rises, most assets fare badly. A recent study led by Campbell Harvey, professor of finance at Duke University, found that the returns for most mainstream asset classes were negative when inflation spikes. Shares were especially precarious, with the S&P 500 almost unfailingly dropping when inflation shot up.

Asset classes in inflationary environments*


Source: *Defined as periods where the year over year realized inflation rate rises beyond 2%. Source: Neville, Henry and Draaisma, Teun and Funnell, Ben and Harvey, Campbell R. and van Hemert, Otto, The Best Strategies for Inflationary Times (May 25, 2021).

But the average returns for precious metals during periods of high inflation were in the double digits, the study found. Most interestingly the report found that gold, the foremost precious metal, did better than inflation-protected bonds (known as “TIPS”) when inflation rises. The reason seemed to be that precious metals can store real value in times of negative real rates. (When bonds and cash are guaranteed to lose real value). As such, the study concluded, precious metals may be appropriate as an inflation hedge.

Beyond their outperformance, rising inflation also challenges the traditional role of bonds in portfolios. And raises the question of whether precious metals can partly be taken in their place. For most investors, the core of a portfolio is made of shares, with bonds providing capital stability and thereby limiting drawdowns. Yet inflation undermines bonds’ ability to do this, as their value mechanically fall with rising inflation.

Precious metals vs important Australian asset classes*


Source: *AUD. 5 year annualised average total returns up to 2 June 2021. Global bonds = Bloomberg Barclays Global Aggregate Float Adjusted Total Return Index Hedged AU. Commodities = Bloomberg Commodity Index Total Return. Global shares = MSCI World Net Total Return USD Index. Aussie shares = ASX 200 Total Return Index. Precious Metals = ETPMPM. Aussie bonds = Bloomberg AusBond Composite 0+ Yr Index. Hedge funds = HFR Global Index.

As precious metals have no internal rate of return their prices are not guaranteed to fall when inflation rises. Their prices are instead set by supply and demand, which vary greatly between metals.

Palladium has more than 80% of its demand coming from the car industry, where it is used as a catalyst. Platinum has broad industrial uses including glass-making equipment, car catalysts, and dental equipment. Gold demand comes mostly from investors, such as central banks, who regard it as a safe haven and in jewellery. While silver, the best conductor of electricity, is used mostly in industry, such as in solar panels.

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