Commodities
Paul Nicholson
Head of Investment Strategy
Gold - How much longer can it run?
Gold has experienced a strong rally, producing a return of +12% YTD (year to date), which compares favourably to broader commodity indexes which have produced +7% YTD (both in USD terms). In this article, we reengage with our long-term rationale for holding gold within our portfolios, analyse short-term market drivers, and ask how much longer the rally can last.
Figure 1: Gold vs Bloomberg Commodity Index
Source: Bloomberg. Data as of 11th June 2024
In the long-run gold is seen as a ‘safe haven’ asset. This has been underpinned by a robust track-record over many decades and market cycles, where it has exhibited strong diversification attributes for investors, and been a reliable store of value, and a robust hedge against inflation.
Diversification
Over time, holding gold can make multi-asset portfolios more robust through different macroeconomic regimes. Acting as a diversifier, gold can reduce overall portfolio drawdowns in periods of market stress. Over the last fifty years, gold has produced excess returns through recession-led equity market selloffs. Empirically, the gold price has peaked (median) ~12% higher after the start of a recession. In periods of market stress, gold can exhibit attributes of a ‘safe haven’ asset.
A store of value
For thousands of years, gold has been a store of value and medium of exchange. Tangibility is important here, given the untested nature of many alternatives, including digital assets and certain idiosyncratic paper currencies. With a finite supply, demand for gold provides scarcity attributes which derives its value.
The universal recognition of gold, and its highly liquid nature, tends to see demand intensify in periods of geopolitical tension. Families, institutions, and even countries have used gold to preserve wealth over long periods of time.
An inflation hedge
Another attraction for owning gold has been its historical role as an inflation hedge. The supply of gold is limited and can't be easily expanded; therefore, it is seen as a hedge against inflation. When fiat currencies lose purchasing power due to inflation, gold often retains or increases in value.
In reaction to COVID-19, government authorities raised trillions of dollars of debt to inject cash into the system. The potential for this to cause prices to inflate out of control and currencies to lose their spending power remains. Not only is higher inflation a possible risk, but it may even be the preferred outcome of governments with rapidly increasing debts.
There are many examples of countries utilising inflation as a means of reducing their national debt burdens. The UK effectively did this post the second world war, which saw the national ratio of debt as a % of GDP (Gross Domestic Product) fall from 250% to 40% by the 1980’s. This debt reduction was facilitated through an extended period of relatively high inflation (on average ~7% from 1945 to 1980). At first glance, this seems a logical solution, but the social and economic consequences are devastating. Gold is not subject to such devaluation, providing the attraction for investors looking to hedge against such an outcome.
The ECB (European Central Bank), the UK MPC (Monetary Policy Committee) and the US FOMC (Federal Open Market Committee) each espouse an inflation target policy of 2%. The COVID-19 pandemic produced a perfect storm of demand and supply factors, that saw inflation spike above 10%. Disinflation has followed since late 2022, but the last leg from 4% to 2% targets will prove most challenging. However, the inflationary impulses have taken hold globally, which were absent pre-pandemic era. Price pressures remain within the services side of our economies, with significant inflationary impulse remaining across wages and housing.
Figure 2: Will inflation reaccelerate, and follow the 1970’s experience
Source: Bloomberg. Data as of 11th June 2024. Data for 1970’s Inflation Path derived as 31/01/1971 to 30/04/1983.
This has led many investors to question central bank credibility, surrounding their ability and willingness to maintain their 2% inflation targets. The reacceleration of inflation in the latter decade of the 1970s provides a stark warning to investors, not to be complacent, especially as central banks are currently looking to reduce their restrictive monetary policies. Recent rhetoric around average inflation targeting policies, and an increased tolerance of elevated inflation levels, continue to lead investors to demand more gold.
Analysis of five-year real returns (i.e., after bouts of inflation) from US equities and gold since 1950, shows that gold does out-perform stocks across periods of elevated inflation.
Figure 3: Gold outperforms equities during periods of elevated inflation
Source: Bloomberg. Data as of 11th June 2024
Market drivers of performance
The price of gold has historically moved closely in line (inversely) with real bond yields. Real yields are the returns an investor can roughly expect to earn after inflation. As gold is a non-income generating asset (i.e., it produces no cash flow), there is an opportunity cost for holding gold versus the inflation-adjusted returns of alternative interest-bearing assets, like cash or bonds. In periods where higher real rates are available to investors, gold has historically underperformed. As displayed in Figure. 5, as real yields are pushed higher (yields are inverted in the chart), we would expect the gold price to track lower also. However, from 2022 real yields in the US have soared, and gold prices have not only held firm, but made new highs. There has been a significant breakdown in this inverse relationship causing a historically large dislocation.
Figure 4: Dislocation of historical relationship between Gold & real yields
Source: Bloomberg. Data as of 11th June 2024
This has left investors querying - what has been driving the price of gold recently? Investor demand does not provide a picture of strong demand flows, with flows into gold ETFs trending lower for the past three years, as seen in the Figure 6.
Figure 5: Gold ETFs have experienced outflows in recent years
Source: Bloomberg. Data as of 11th June 2024. Total Known ETF Holdings of Gold, as aggregated on Bloomberg.
An explanation comes in the form of central bank purchases, which have more than doubled their presence in the market. This is continuing as central banks diversify their foreign exchange reserves by increasing their gold holdings. China has been at the epicentre of this marginal purchasing power. Domestic concerns over Chinese property and the stock market have resulted in robust flows, as gold represents a dependable investment. Furthermore, gold is seen as a diversifier and a method of boosting the quality of China’s central bank assets, which now hold 4% of its foreign reserves in gold, up from 1% in 2014.
Figure 6: Central banks have been the marginal buyer
Source: Bloomberg index showing ‘Global Gold Demand from Central Bank Net Purchases Quarterly’. Metal Focus. Data as of 11th June 2024; ; units of million tonnes
Our take
Gold has had its detractors, forecasting a muted performance in the face of headwinds. Gold has performed well despite a rise in real rates (to which it has historically exhibited a strongly inverse correlation), so a reversion of the dislocation could be possible. For short-run investors, positioning and sentiment remains bullish, with valuations potentially stretched at US$2,350 per troy ounce versus an average production cost of US$1300 per troy ounce.
However, the marginal buyer remains unabashed, and has a significant arsenal, with a geopolitically motivated incentive to continue to buy. Diversification and value judgements depend on time horizons, and although the central bank buying may have pushed the gold price close to a record high in inflation-adjusted terms, the value of its ownership will only be determined in time.
Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up. These products may be affected by changes in currency exchange rates.
Warning: Forecasts are not a reliable indicator of future performance.
