Take everything you think you know about gold and toss it out the window, because there's a very real possibility that physical gold can continue to rise even as the Federal Reserve moves forward with its monetary tightening.
Forget what you think you know about gold
Generally speaking, higher interest rates are the enemy of physical gold, and it all ties into opportunity cost.
Gold itself offers no dividend yield, so it relies on a number of external factors, which we're going to get to a bit later, to drive investor demand. One of those factors is interest rates and yields on interest-bearing assets. If yields on bonds, bank CDs, and savings accounts, are relatively low, then some investors may be willing to give up a small, but safe, nominal gain in favor of buying gold, which could offer a bigger return. Conversely, if yields rise on these safer assets, it makes less sense from the standpoint of investors to give up these guaranteed gains and buy gold, thus hurting demand for the physical metal and sending its spot price lower.
On paper, the current tightening the Fed is conducting should be bad news for gold. Since Dec. 2015, the Fed has increased its federal funds target rate by 75 basis-points to a range of 0.75% to 1%. Though that's still historically very low, the Fed has a long-term fed funds target rate of 3% that it's aiming for. This very well could put U.S. Treasuries and bank CDs back in the 3% to 4% range, making them quite attractive to risk-averse investors.
Yes, gold can rise in value as the Fed raises rates
But, as I've learned over my nearly 20-year investing career, things don't always happen as they should on paper. Gold and gold stocks could very well wind up pushing higher even as interest rates rise another 50, 100, or even 200 basis points in the next two to three years. Here are three reasons you'd be smart to consider gold and gold stocks for your portfolio despite what the textbooks may tell you.
1. Inflation acts as a natural check
Arguably the biggest reason to consider being a bull on gold despite rising rates is the push-pull mechanism known as inflation. Inflation measures the rising price of a predetermined basket of goods and services.
Typically, the higher inflation goes (i.e., the quicker prices are rising), the more attractive gold becomes. The reason is simple: inflation is usually correlative to economic expansion. When the economy is growing, the Fed is often expanding the money supply, which dilutes the value of existing dollars in the marketplace and makes it more expensive to buy assets that have a perceived store of value, such as gold. Yet, the Fed also raises its fed funds target rate when the economy starts to heat up. Thus, higher inflation rates can help counteract the adverse impact of higher interest rates in a growing economy.
According to the Bureau of Labor Statistics' February inflation data, the Consumer Price Index for All Urban Consumers (CPI-U) grew by 2.7%, implying that inflation is heating up for the first time in more than three years. That's good news for gold.
2. Supply and demand play an important role
Once again, we have to remember as investors that the Fed isn't going to be tightening monetary policy if the economy isn't expanding. Therefore, if the Fed is tightening, then there's a pretty good likelihood that the demand for commodities, including gold, is growing as well.
According to data aggregated from the World Gold Council, demand for gold increased by nearly 93 tons to 4,309 tons in 2016 compared to 2015. Although we witnessed a decline in jewelry demand, likely a result of weaker gold demand in India where jewelry is a source of wealth preservation, there was a 660 tons increase in demand from electronic-traded funds and other investment vehicles. If the U.S. and global economies continue to expand, then gold's uses in jewelry and technology could see a boon.
At the same time, it's important to recognize that gold miners have mostly kept a lid on their production capacity. Faced with more than four years of falling prices, most gold miners pared back their capital expenditures and focused on only their highest ore grade mines. What we're left with are gold miners that are profitable at much lower spot prices, and somewhat stagnant supply. Slow supply growth and increasing demand is a textbook scenario that traditionally calls for higher prices.
3. Uncertainty, uncertainty, uncertainty!
Last, but not least, don't forget about the yellow metal's best friend: uncertainty.
The tough thing about uncertainty is there isn't anything that helps us quantify it (and no, the VIX is a silly short-term example, in my opinion). But, there are very clear global concerns on the horizon that could work in gold's favor.
For example, Britain recently triggered Article 50, meaning it's committed to leaving the European Union within the next two years. Leaving the EU means Britain has to forge new trade deals, which may not go as smoothly as the country has suggested it would. Some pundits believe that the separation of the UK and the EU could lead to a recession for the UK and perhaps even the EU, which is still struggling with the high debt loads of Italy, Spain, and Greece. Long story short, Europe is still somewhat a mess, and as long as its future remains clouded, gold has a bit of an extra luster to it.
Likewise, President Trump is a complete X-factor for the United States. The U.S. stock market has factored in the strong potential for individual and corporate tax reform, with the assumption that lowering tax rates will mean greater consumer consumption and faster business growth rates. But, what if these reforms don't come to fruition? Trump and congressional Republicans have already failed to repeal and replace the Affordable Care Act, signifying that change may be tougher than once realized.
Gold continues to offer investors an intriguing place to park their money while these uncertainties play out.
Two interesting gold stocks worth considering
However, if this Fool were given the choice of owning physical gold or buying gold stocks, I'd suggest investors steer toward gold stocks. With gold stocks you have the potential to receive a dividend, you'll be able to take advantage of management's decision-making, and there's more useful fundamental data to pore over than with physical gold.
One intriguing gold stock that's arguably more leveraged to gold than any other gold company is Royal Gold (RGLD 0.41%). Royal Gold is a royalty and streaming company that provides large amounts of upfront capital so other mining companies can expand or develop a mine. In return, Royal Gold receives a fixed percentage of production for a long period of time, or life-of-mine, at a well-below-market rate.
Based on the company's preliminary third-quarter production results, released last week, its cost of sales was just $356 per gold ounce, meaning it has an approximate $900 per gold ounce margin at the moment. Since Royal Gold operates with such massive margins, any increase or decline in spot gold directly impacts its profitability and valuation.
The other gold stock that investors may want to get on their radars is Barrick Gold (GOLD 0.03%). The reason Barrick is so attractive is the company's exceptionally low all-in sustaining costs (AISC). AISC is about as encompassing a cost measure as you can get with a mining company. Barrick wound up lowering its full-year AISC forecast three times last year, and in 2017 it's forecasting an AISC of between $720 and $770, which at the midpoint provides more than $500 in margin between the current spot price of gold.
Barrick has also made excellent strides in improving its financial flexibility. In a two-year span the company has reduced its total debt from $13.1 billion to roughly $8 billion, and it has an intermediate-term goal of pushing its debt down to just $5 billion. Lower debt levels mean more flexibility and less in interest expenses for Barrick.
If gold bucks what the textbooks suggest it'll do as interest rates rise, Royal Gold and Barrick Gold will probably be beneficiaries.