Gold - A Multi-Asset Midas Touch?

Gold has been used as a store of value and medium of exchange for millennia. Today, it seems to constantly trend as a topic of interest for those in search of better returns, diversification, and tail risk protection. Is this true and why? Should gold hold a strategic place within multi-asset portfolios?

Gold, like other commodities, has many uses: from technology applications to jewelry demand. Where it differs is in its historical linkages to monetary systems, lending it as a perceived store of value for central banks and investors alike.

Gold ETFs have seen remarkable growth over the past two decades as they have given investors an efficient way of gaining exposure.

What characteristics have propelled the growth in gold’s investment allocations?

The Proponents of gold argue that it exhibits the following traits. We will explore the validity of each.

• An inflation hedge
• An equity hedge
• Tail risk protection
• An alternative store of value

Inflation Hedge

Looking at long term correlations, gold doesn’t prove to be a very effective inflation hedge. Rather, it holds a stronger inverse relationship to real bond yields (real bond yield = nominal bond yields – inflation expectations).

This suggests that the price of gold depends on the environment surrounding inflation, rather than inflation itself. For example, in a stagflation environment of low/flat growth and rising inflation, real yields usually are falling, boosting gold prices. Stronger inflation, stronger growth and rising interest rates normally have real yields rising, which may pose a headwind to gold.

The current environment may be unique. If inflation and economic growth improve, central banks have already indicated they will not raise interest rates, not until inflation overshoots their targets for some time. This should keep real yields lower than normal even in a recovery situation. In this scenario, the usual gold price headwind might not accompany this recovery.

Equity Hedge

Historically, gold hasn’t shown to be a strong hedge to equities, with correlations closer to zero longer term and positive interim periods. However, low to zero correlation may still be beneficial in terms of diversifying sources of return. More importantly, in periods of equity drawdowns, gold has shown to be a good complement, as will be explored in the next section.

Tail Risk Protection

In periods of geopolitical crises or other macro dislocations, gold has been shown to help shield portfolio values during significant drawdowns, as illustrated below.

With the assumption that this relationship will hold going forward, this is a valuable trait in the portfolio construction arsenal - especially considering the lower efficiency of traditional government bonds to hedge downside risk (a topic we have explored in other articles). However, it should be noted that gold isn’t entirely immune to short-term periods of panic selling where investors are liquidating anything they can for cash.

Alternative Store of Value

One of the more common arguments by gold bugs are fears of fiat currency debasement (the loss of faith and confidence in currencies issued by governments). Increasing government deficit spending and the seemingly endless growth of central bank balance sheets has helped position gold as a potential alternative store of value. While an all-out monetary collapse is an extremely unlikely scenario, a risk of continued erosion in the confidence of paper money is not

Portfolio Implications – Strategic vs Dynamic?

Looking in the rear-view mirror over long swaths of time, it’s easy to infer the benefits of a strategic allocation to gold in a 60/40 portfolio. As mentioned, it has shown to lower risk, boost return, and be a strong value protector during significant drawdowns.

From a relative perspective, sizing should be gauged against overall active risk budgets. The low to negative correlation of gold to traditional asset classes can begin to dominate active returns quickly at higher allocations. We believe that an allocation in the 0-5% range should provide some relative drawdown protection, while balancing its contribution to active risk. In this low return environment, it is a game of centimeters!

When we zoom in on a shorter investment horizon, there are reasons for caution on timing of when to get in, as gold price can be volatile. There are opportunities to also layer on a dynamic allocation approach to try and better time position and sizing decisions.

Conclusion

With bond yields at historic lows, the defensive characteristics of bonds as dampeners to portfolio volatility, while not completely broken, are probably reduced. Finding and adding strategic allocations to diversified sources of return such as gold may help to protect portfolio values going forward.

Near term, we have a cautiously optimistic view of gold. Supporting our view is the expectation for real yields to remain low, as nominal yields will be constrained by central banks, while inflation expectations could modestly rise. We expect the continued growth in investor demand for gold, given its current underutilization in portfolios.

For our retail programs, our preference is to hold physical gold via ETFs. Currently we are not directly allocated to gold as we believe there will be a better entry point. Over the coming months there is the potential to see a more reflationary environment on continued monetary and fiscal support, less political uncertainty and better vaccine news related to COVID. This could be a short-term headwind to gold prices providing a more attractive entry point to establish a strategic position in gold.

Comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.