Foundations of gold

Despite some large price swings, gold has solid underpinnings

Gold had enjoyed a strong run even before COVID-19, and was given an extra boost when the virus spread across the world and investors headed for safe havens. Prices were volatile following a surge in the dollar and speculation that investors were selling their safest investments (figure 3). But we believe gold still has strong underpinnings, not least of which is its traditional status as a safe haven in times of turmoil.

Another trend that should work in gold’s favour is negative real interest rates (meaning actual rates are below inflation). If inflation surges due to unprecedented government and central bank stimulus, that should support gold. So too should any increase in geopolitical risks, such as the oil price war deteriorating into armed conflict in the Middle East.

Gold remains resilient

Gold’s brief selloff may have also been driven by a temporary rise in real rates as inflation expectations fell in the early reaction to the coronavirus outbreak. They were already very low, and fears of a deflationary bust in the global economy pushed them lower still. However, they have since stabilised, and we don’t think real rates are likely to increase meaningfully in the near term. Indeed, the flood of central bank and government stimulus is also leading to some speculation that inflation could take off once recovery comes, though we also see this as unlikely given a number of structurally disinflationary trends.

If coronavirus is to be a deflationary bust, the natural hedge is usually long-dated bonds, or bonds that are more sensitive to, and therefore benefit from, falling interest rates. But in the current unusual environment of negative real yields, the cost of carry (income foregone) for holding gold is far lower than it would be normally, making it more attractive even in this scenario.

If the coronavirus crisis turns out to be a temporary demand shock, and the barrage of demand-focused monetary and fiscal stimulus then fuels rising inflation expectations, potentially pushing real yields even lower, then gold should also respond well.

One of many diversifiers

Gold is just one of many assets we classify as diversifiers — investments that tend not to move in step with equities, and which in some cases can move in the opposite direction. For diversifiers to work as part of a long-term asset allocation strategy, we believe it’s important to hold a wide range of diversifying strategies and asset classes to vary exposure to different risks.

For instance, corporate bond prices fell along with shares during the 2008 financial crisis, highlighting the pitfalls of a traditional approach to diversification, which was to hold a mixture of traditional equity and fixed income securities. History has taught us that correlation across asset classes increases during periods of stress. Including a range of strategies and asset classes with a low correlation to equity markets in portfolios can help ensure better diversification.

However, it still makes tactical sense to consider which diversifying strategies are most suited to the evolving investment environment. During the recent turmoil, we’ve seen positive returns from macroeconomic strategies, which look for relative value across different asset classes and securities.

These opportunities tend to be greater when markets are unsettled and volatility is high. Given uncertainty arising from trade wars, protectionism, US elections and now a global pandemic, we expect there will be plenty of opportunities for these strategies in the coming months.

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