Alternative store-holds of wealth

The claim:

The long-run returns on many government and corporate bonds is likely to be below the rate of inflation. Better portfolio returns may be found in alternatives such as commodities, residential real estate and gold.

The rationale:

There is a well-established relationship between the forward P/E multiple on equities and their future returns over longer periods of time, albeit the link is less clear in the short-run. The current level (22x) would suggest that ten-year returns on US equities may be approaching zero. It is not a coincidence that this mirrors returns available in corporate credit, where the yield on a typical bond of the same maturity is effectively zero after deducting the expected level of inflation (but before accounting for default risk).

Chart: Yield on a BBB corporate bond less projected ten year inflation (derived from TIPs yield).

The evidence:

Let’s first look at commodities. Similar to its relationship to inflation (see: “The Long Term Story on Inflation”), growth in broad money is strongly associated with price returns in commodities. The chart below shows the nominal 10-year performance of a group of metals (weighted by value of 2019 production levels) alongside the growth in broad money (with 2021 using a run-rate projection).

Sources: Commodities real returns data via David Jacks (citation below); own calculations. Included in the chart are copper, lead, tin, nickel and zinc.

Clearly China has had increased bearing on the direction of commodity prices - as the largest single importer of metals and an increasing weight in global GDP and money supply. This is most visibly seen in the 2000-2010 commodity cycle — with it’s effect particularly pronounced after China’s entry to the WTO in 2001. So deciphering the monetary stance of China is critical for a complete assessment of commodities and this will be the subject of a future note.

But in addition to monetary dynamics, commodity cycles can also reflect the extent of built capacity where supply has long lead-times. The chart below shows levels of CapEx in extractive industries in the US (shown on an inverted scale) against future price returns in commodities.

Source: St Louis Federal Reserve. David Jacks (citation below). Own calculations. Commodity CapEx is relative to total fixed investment in the US.

Another alternative may be residential real estate. Home prices tend to at least hold their value in real terms over time. The chart below shows the long-term trend with the dark grey bars representing periods with inflation of 5%+ and the light grey bars for periods with inflation of 3%+.

Source: Robert J Shiller. Chart on log-scale to show growth rates.

While returns on housing tend to co-vary with the returns on equities, they tend to be less volatile and positive.

Source: The Rate of Return on Everything, 1870–2015. Federal Reserve Bank of San Francisco.

Lastly, gold tends to perform well in inflationary environments and has an improved return profile when (10-year) Treasuries yield less than 2.0% as they do currently. Moreover, since the Federal Reserve began operations in 1914, gold has had an annualized real return of 0.9% which exceeds what is currently available on US treasuries. 

The timing:

Clearly, house prices have increased appreciably in recent months. One key driver of this has been a lack of availability, where the change in housing inventories has some medium-term explanatory power for house prices (below). Inventories have since reverted toward historical levels (~6 months) and for long-term investors one would want to monitor this trend to see if supply over-reacts. However another positive driver is affordability — where transfer payments, a high savings rate and lower interest rates could enable individuals to take on more debt in the future. This could sustain prices above equilibrium for longer.

Performance of commodities tends to be highly cyclical. The chart below plots the 12 month performance of the Bloomberg Commodity Index (vs gold) against the 12 month change in a cyclical economic index (the ISM). Given the starting level for the latter (~66), one might look to gold (rather than a broad set of commodities) at this juncture as a way to manage a reversion lower in economic activity.

Appendix:

Citation: Jacks, D.S. (2019), “From Boom to Bust: A Typology of Real Commodity Prices in the Long Run.” Cliometrica 13(2), 202-220.

Note: Edited on 5 September to include timing section.