By Ellen Hazen, CFA®, Chief Market Strategist

October Takeaways:

• Economic surprises in October were uniformly positive. Starting with the shockingly strong September payrolls number (254,000 vs. expectations of 150,000), data consistently indicate a strong economy. The unemployment rate decreased from 4.2% to 4.1%. Monthly retail sales growth was expected to be 0.1% month-over-month and was reported at 0.5%, while the Citigroup Economic Surprise index spiked from 0 at the beginning of the month to near 40 by month end
• Inflation continued to be higher than expected. The headline Consumer Price Index (CPI) was expected to increase by 2.3% year-over-year (Y/Y) and came in at 2.4%. Similarly, the Personal Consumption Expenditure (PCE) deflator was expected to be 2.6%, and was reported at 2.7%
• US medium-term and long-term interest rates increased. Following the string of unexpectedly positive economic data and higher-than-expected inflation, interest rates across most of the yield curve increased substantially during the month of October. The 2-year Treasury yield increased from 3.64% at the beginning of the month to 4.17% at the end of the month, an increase of 53 basis points (0.53%), while the 10-year Treasury yield increased by 50 basis points from 3.78% to 4.28%
• Higher interest rates drove negative bond returns. The Bloomberg Intermediate Government/Credit Index declined by 1.6% during the month, responding to the higher interest rates. This drove year-to-date returns for that index down from 4.7% at the end of September to only 3.0% by the end of October
• US corporate earnings also reflected a stronger-than-expected economy. With two-thirds of large-capitalization companies having reported third-quarter earnings by the end of the month, earnings growth was 8% Y/Y, well ahead of the 3-4% expected earlier in the month. The average surprise for earnings reported for the third quarter has been 7%. Consensus is looking for Q4 earnings growth of 8%, bringing full-year earnings growth to 8.2%. Next year, analysts are looking for 13%
• Most asset classes declined in value in October. In addition to the 1.6% decline in the intermediate bond index, large-capitalization equities declined by 0.9%, mid-sized equities declined by 0.7%, small equities declined by 2.6%, and international developed equities declined by 5.4%. Most commodities declined as well, with the iPath Bloomberg Commodity Index declining by 1.5%. This may have been driven by higher interest rates, or may simply reflect a pause after strong year-to-date returns across most asset classes
• Gold has been very strong. Bucking the commodity trend, the spot price of gold increased sharply, from $2,634 to $2,743, or by 4%
• Growth equities outperformed value equities with the Russell 1000 Growth Index declining by 0.3% while the Russell 1000 Value Index declined by 1.1%. This continues the trend for most of the year
• The September China spike faded. China stock market performance moderated after having spiked in late September and was down 3% for the month

What We Are Watching In November:

• Fed meeting Nov 7. The market is currently pricing in a 97% chance of a 0.25% interest rate cut in November, followed by one more cut in December and a further 0.75% reduction in 2025. Fed officials will be watching both the labor market and inflation
• Q3 GDP was reported at 2.8%, well above economists’ expectations of 2.1%. Currently, the Atlanta Federal Reserve’s GDPNow indicator is predicting Q4 GDP to decelerate to 2.4%
• CPI will be reported November 13 (consensus is 3.3% Y/Y), while PCE will be reported November 27

Gold is notoriously hard to value, because it has no cash flows. For many years, gold tracked real interest rates very closely. This is because the opportunity cost of owning gold increases with a higher real interest rate.

We can see from the first chart below that for most of the past 20 years, gold and the 10-year Treasury real yield have had a near-perfect inverse correlation. When the 10-year Treasury real yield (the stated yield less investors’ inflation expectation over the same timeframe) declines, gold increases, and vice versa. This is because both gold and US Treasurys have historically been perceived as safe assets. In times of risk, investors flock to both. Conversely, in a risk-on environment, both are weak, as investors use both as a source of funds to invest in riskier assets, such as equities.

Given that the S&P 500 is up over 20% year to date, we would view recent months as a risk-on environment. Yet, gold has materially appreciated this year (33%), while the 10-year real yield has bounced between 1.55% and 2.25%, with no clear pattern.  Why?

In order to understand this, we need to examine other drivers of gold relative to the US dollar.

US fiscal deficit. One possible explanation is that investors are starting to care more about US fiscal and monetary profligacy. Both presidential candidates ran on platforms of higher spending. This is one reason we believe inflation is likely to stay higher for longer. More concern about the value of the US dollar might be reflected in the dollar devaluing against gold, even as it stays strong against other currencies.

Supply / demand. The timing of the divergence between real Treasury yields and gold started in February of 2022. This is when Russia invaded Ukraine, and when the US responded in part by targeting Russian central bank reserves as part of its secondary sanctions package. Previously, the US had targeted Russian companies, but not central bank reserves. As a primary impact, Russia started to increase gold reserves while necessarily letting its Treasurys run off. Thus, there was relatively more demand for gold and relatively less demand for Treasurys.

Central banks have been large buyers of gold over the past two years. The timing may have been driven by the aforementioned US sanctions. Central bank buying of gold has increased from 450 metric tons (tonnes) in 2021 to 1,081 tonnes in 2022 and 1,049 tonnes in 2023. The largest central bank gold increase in 2023 was China, which increased its gold holdings by 225 tonnes, or 11%.

Questioning of reserve currency status. Some might say that the weaponization of the dollar has intensified the desire to work toward an alternative world reserve currency and that this accounts for gold’s recent strength. Many countries (e.g., China, Brazil, Iran, Russia) would like to settle trade using a currency other than the US dollar, because as long as global trade is settled in US dollars, they may perceive their central bank reserves as at risk of being used as a geopolitical tool. In recent years, we’ve seen several attempts to decouple from the US dollar, including China-Brazil bilateral trading in their own currencies, China-Russia doing the same, and countries like the UAE and Kenya buying oil in their own currencies.

Evidence for this perspective is inconclusive, though. If global investors were more concerned about their Treasury holdings, we’d expect to see the US dollar weaken versus other currencies in addition to weakening versus gold. This has not happened – the US dollar has been roughly flat for the past two years.

Coordinated monetary policy easing. Another possible explanation for gold outpacing real US Treasury yields is devaluation of all currencies against gold, not just the US dollar. We are beginning another coordinated central bank easing cycle (despite buoyant markets and – at least in the US – strong economic growth). Most countries are reporting fiscal deficits for the same reason as the United States – ageing demographics. In the past year, nearly all developed market central banks have lowered rates. (The one exception is Japan, which has raised rates from -0.10% to +0.25%). This means that all else equal, currencies would weaken versus hard assets; this may also be driving the strong gold price.

What does this mean for investing, and can gold’s strength continue? Given impending elder care spending from demographic realities in the US and elsewhere, fiscal spending is likely to stay high, which may drive higher rates and higher inflation. So the fiscal deficit argument may continue. The incremental central bank demand may have run its course as gold’s high price may have crimped central bank demand. According to gold.org, central bank demand in Q3 2024 was 49% below the prior year’s demand. As far as the US dollar retaining dominance, we expect that the US dollar is safe as the world’s reserve currency. The vast majority of global trade still settles in dollars and the US is regarded as stable with respect to property rights and the rule of law. Global monetary easing looks likely to continue at present. Thus, some of the possible explanations for gold’s recent appreciation may continue, while others are unlikely to. In such a world, precious metals and real assets may warrant a larger position in portfolios.

Disclosures