The current economic cycle is ageing. At some point, expansion will fade away. We do not expect a recession in 2019 – but as more investors focus on the inevitable transition away from growth, we expect to see more volatility in markets. And there is a need to protect against this.
One way of doing so is by allocating money to assets that can maintain their value or even gain in difficult market environments. Gold is a good example. We hold gold in many client portfolios, both directly and indirectly through multi-asset funds.
The price of gold has steadily been creeping higher over the last few months. At around $1,300 per ounce, its now close to the highest levels of the past 5 years – but still some 30% below its 2011 peak.
Gold has long been popular with investors. It is a physical asset that is comparatively easy to store and move. Furthermore, gold isn’t at risk of default. It has a number of other attributes that make it attractive to a wide range of investors, including private clients, institutional asset mangers and central banks.
Gold is often viewed as a hedge against inflation risk. When you hold cash, there’s a risk that the purchasing power of that dollar, pound or euro weakens. This may happen because of actions by a government or central bank or it may simply be a result of rising prices. Either way, investors have long believed that gold does a better job of holding onto its purchasing power. As a result, gold has traditionally protected value in periods of rising inflation.
Whilst in the near term inflation in developed markets has been relatively subdued, we are conscious that there remains the potential for an increase in inflationary pressures.
In the US, this may come about as a result of a tight labour market and a recovery in the oil price. In the UK, the big inflation risk is a “hard” or “no-deal Brexit.” This would likely see a devaluation of sterling against other major global currencies, which would raise the cost of imports. This in turn could result in higher prices throughout the economy.
We are happy to maintain an allocation to gold as a hedge against these potentially inflationary scenarios.
Protection in periods of volatility
Historically gold has also tended to perform well during periods of equity market volatility, as investor sentiment weakens and demand for perceived safe haven asset rises.
This was very apparent in the fourth quarter of 2018. Global equity markets fell sharply, with the MSCI World All Country Index down 11%, whilst gold rose +10%. Equity markets have started 2019 on a much stronger footing. Many would have expected gold to give back its gains as equity markets have recovered but interestingly this hasn’t been the case.
This may reflect the fact that the macroeconomic landscape is punctuated by significant risks that could cause more equity market volatility, including US political dynamics and trade policy, a slowdown in Chinese and global growth, and Brexit.
The chart below shows how gold tends to perform strongly during periods when equity markets are in distress.
The argument for having an allocation to gold as part of a multi-asset portfolio is further supported by the fact that the opportunity cost of owning gold is currently relatively low.
The price of gold is often viewed in the context of the real yield that is available on other safe assets, such as developed market government bonds. The real yield reflects the return you get after adjusting for inflation. For instance, 2-year US government bonds currently have a “nominal” yield of 2.5%. However, with inflation of around 2%, the real yield is just 0.5%. So investors are giving up a pretty paltry inflation-adjusted return to own something that can protect them against much higher inflation and in other difficult market conditions too.
Higher yields on other assets and the price of gold
In general, when investors can get an attractive real yield on other safe assets, there will be less demand for gold, putting pressure on its price. Conversely, when real yields are low, as is currently the case across the US, the UK and Europe, the "opportunity cost" of owning gold drops.
Central banks are a key driver of real yields and in particular the Federal Reserve in the US. Their interest rate increases over the past three years have driven up nominal yields on US government debt. As a result, real yields have moved higher, putting pressure on gold. However, in January, the Federal Reserve gave a very strong indication that any further interest rate increases were on hold. Other central banks, which are well behind the Fed in raising interest rates to more normal levels, don’t seem to be in any rush to catch up.
This suggests that nominal yields are unlikely to rise further, which should be supportive for the gold price. If inflation does start to pick up, which we think is a distinct possibility, real rates could even fall from current levels, which would be more supportive for the gold price.
We think there is still a relative opportunity in gold, especially in light of few true diversifiers, and see it as a highly attractive asset to own in client portfolios.
Who’s buying gold?*
Central banks added 652 tonnes to official gold reserves in 2018, the second highest yearly total on record
Net purchases jumped to their highest since 1971 as a greater pool of central banks turned to gold as a diversifier.
Annual jewellery demand was virtually unmoved: down just 1t from 2017
Increased demand in China, the US and Russia broadly offset sharp drops in the Middle East. Indian demand was stable at 598t (-4t).
Gold exchange traded funds and other similar investments saw annual inflows of 68.9t (down from 206.4t in 2017)
Stock market volatility and signs of faltering economic growth in key markets fuelled a growth in the final quarter of 2018, but Europe was the only region to see net growth over the year.
Individuals' investment in gold bars and coins posted annual growth of 4%
Coin demand surged to reach a five-year high of 236.4t, the second highest on record. Demand for gold bars held steady at 781.6t, the fifth year in succession of holding in a firm 780-800t range.
2018 saw marginal gains in the volume of gold used in technology, crimped by Q4 slowdown
After healthy gains during Q1-Q3, a combination of slowing smartphone sales, the trade war and mounting uncertainty over global economic growth contributed to a 5% decline in Q4.
*Source: The World Gold Council