September Real Asset Review

Includes: GLD, REZ
by: J.D. Steinhilber

Real asset investments (e.g. real estate, commodities, and gold) registered across the board gains in September. By far, the most profitable real asset investment over the past five years has been gold, which has appreciated 19.2% per annum.

Gold is viewed by many as an alternate currency - one that is not subject to government-sponsored devaluation. One of the most important influences on the price of gold is the level of real interest rates, which can be derived by subtracting the expected inflation rate from the official short term lending rate. In the U.S., the official short-term lending rate is 0% to 0.25%. Inflation expectations looking out over the next five years are approximately 1.5%, so the "real" short term interest rate is negative 1.25 to 1.5%.

Moreover, the Fed is going to keep rates artificially suppressed for the foreseeable future. In this context, it is easy to see why gold is doing well. Investors seem to be increasingly asking themselves whether they should redirect a larger share of their "cash" investment allocation out of dollar-denominated deposits and into gold. Gold above $1000/ounce is certainly not without risk, but even from current price levels it is hard to imagine gold not outperforming cash over the next one to two years. Another factor that is increasing gold's appeal is that it can be owned via gold ETFs backed by physical bullion without the negative factors associated with other commodity investments that use the futures markets to gain their exposure.

Futures markets expose investors to additional risk factors such as (1) negative roll yield (a negative return resulting from rolling a futures contract from one month to the next when commodity futures markets are in "contango", as has typically been the case), and (2) regulatory restrictions on commodity funds' position sizes in futures markets. Lack of confidence in the U.S. Dollar is clearly another positive factor that is driving the price of gold higher. The dollar recently sank to a one year low against the Euro. Apart from the U.S. government's aggressive reflationary policies, an additional explanation for the dollar's weakness is its use as a funding currency for the "carry trade," whereby leveraged investors take advantage of zero percent U.S. financing costs to borrow dollars and buy higher yielding assets.

Betting against the dollar has become an awfully crowded trade in the short term , and an oversold bounce could occur at any time. A short term rebound in the dollar would coincide with a sell-off in risk assets, and perhaps anti-dollar assets such as gold, for the simple reason that leveraged long positions in such assets have been funded through dollar denominated borrowing.

The yield on the NAREIT All-REIT index has dropped to 4.89%. This level of yield remains uninspiring, given the negative fundamentals of the asset class. Other areas of the equity markets are more attractively valued, which continues to argue for an underweight allocation to U.S. REITs.