Gold has had a place in human culture for millennia. Its natural beauty, durability and malleability have meant that it’s long been used to decorate our homes, bodies and streets. Today, however, many people buy gold purely as a form of investment, including us in LGIM's Asset Allocation team.
Gold has a history like no other asset class – so I won't try to do it justice in this blog, other than to show returns (after inflation) dating back to the 1700s.
Gold was considered the first physical form of currency as it replaced barter in ancient Greece. It later led to the rise of the gold standard – a monetary system where the value of several major countries’ standard unit of currency was directly linked to gold. This was the case until the 1970s, when the fiat money system was introduced. Even today, the commodity still behaves much like other major currencies.
With phrases such as 'as good as gold' still widely used, it’s little wonder the precious metal has earned the status of the 'ultimate safe-haven asset'. However, it has fallen out of favour in financial markets of late, recently hitting a 19-month low after experiencing five consecutive negative monthly returns.
This may come as bit of a surprise given populism, trade wars and what feels like a weekly emerging market currency crisis. So, what’s going on? It may not be so surprising when you consider that the S&P 500 recently reached all-time highs, higher short-term interest rates are increasing the opportunity cost of holding gold, there is little inflation pressure and the US dollar is strengthening. All of these factors are often synonymous with a weaker gold price.
However, gold is a real asset and thus regarded as a good hedge against rising inflation. According to Deutsche Bank’s report, since the gold standard was dropped in 1971, no country has seen average inflation below 2% (out of a sample of 87) and only 28 have seen it average below 5%. Investors particularly tend to turn to gold when there are concerns around inflation rising too rapidly. Although this is not our base case, we still think that the commodity holds a valuable place in a diversified portfolio as a long-term hedge against one of our tail risk scenarios: an inflation-induced ‘melt-up’ situation.
For instance, what if the Fed’s balance sheet unwind comes to an early end or the flattening of the yield curve persuades the Fed to pause in hiking rates? This could cause the economy to overheat and ultimately result in a flight to quality. The New York Fed’s underlying inflation gauge could understandably be a cause for some concern given that it has been increasing at a fast pace and is back at pre-crisis levels.
Gold could be particularly attractive in this kind of scenario as a potential safe haven against equity market crashes (as concluded by a piece of research from Trinity College Dublin.) This is not always a feature that can be expected from other real assets such as inflation-linked bonds, which typically carry a liquidity premium that can prevent them being resilient during stressed markets.
Importantly, the research also concludes that since stock prices often start to recover after a severe negative shock, gold loses its safe haven appeal in the long run. Historically, therefore, the first few days after a stock market crash have often provided most of the upside for gold, highlighting how critical timing can be. Trying to time the next equity market crash is difficult, so as market volatility picks up in the latter stages of the economic cycle, the need for portfolio hedges becomes ever more important.
Although gold's recent performance has been weak, it's important to consider this in context of the asset's long history. Arguably, real gold prices still appear elevated, so there could be further downside if risks don't materialise, inflation remains contained and interest rates normalise.
We currently like to own some gold, or shares in gold miners, in some of our more dynamic portfolios, and especially in unconstrained portfolios where opportunity costs are less of an issue. This is deep tail hedge for populism, trade wars, terrorism and erosion of trust in official institutions.
Indeed, we think that more unconventional monetary policy, including helicopter money or more deeply negative interest rates, could be on the table during the next downturn and investors could look at gold as one of the stores of value. In this light, we're looking for a golden buying opportunity!