Gold and 2018: Looks Like the Perfect Storm

Gold prices hit a five-week high of $1,351.20 per ounce last Monday amidst reports of escalating threat of a trade war between the US and China, forcing investors rush to the safe haven gold. The gold prices also rallied on the back of Goldman Sachs analysts turning bullish on the yellow metal for the first time in over five years. The price increase was also fuelled by the appointment of John Bolton as the new national security adviser by Donald Trump, as the new adviser is considered a foreign policy “hawk”, accentuating geopolitical tensions.

The recent upsurge in gold prices is also attributed to the United States’ expulsion of 60 Russian diplomats for a nerve agent attack on a former Russian spy in Britain. Though the precious metal is always considered as the “go-to asset class” during times of political upheaval, it will be interesting to see whether the recent precipitous slide in the stock market will further fuel the surge in gold prices.

Four fundamental attributes of gold in a portfolio

Before we dwell deep into the relationship between stock prices and the yellow metal, let us consider how gold is positioning itself as a must-have in anyone’s portfolio, including large institutional investors.

First gold can be considered as a true and effective diversifier, particularly during times when other asset classes witness heightened volatility. Though other asset classes such as broad commodities, real estate, hedge funds were claimed to be a true diversifier, they failed to pass the test during the 2008-2009 financial crisis, as prices in all these asset classes dropped in tandem with stocks and other risky assets. However, gold has been consistently proved to be a real diversifier both during times of economic expansion and contraction:

Secondly, gold has been providing consistent returns over an extended period of time. The yellow metal’s price increased by an average of 10 percent per year since 1971. 

Gold’s performance would be more pronounced during volatile times. For instance, during the recent stock market sell-off on February 5th, the yellow metal rallied strongly and posted higher returns than the short term treasuries:

Gold’s effectiveness in times of uncertainty was evident last month when the yellow metal turned out to be one of the best-performing asset classes year-to-date, outperforming even treasuries and corporate bonds:

Thirdly, gold offers immense liquidity as it is traded in large global markets. According to World Gold Council Report, the precious metal clocks anywhere between $150 billion and $220 billion worth of trades per day through spot and derivative contracts over-the-counter. As gold offers both size and liquidity, the yellow metal figures among the strategic holding for large buy-and-hold institutional investors:

Fourthly, gold buttresses portfolio performance through enhanced risk-adjusted returns. Data points for the 10-year period from 2006 reveal, by adding even 2% in gold, one could have achieved enhanced returns with reduced volatility, resulting in higher risk-adjusted returns. The following graph highlights how someone having higher risk in his portfolio can achieve enhanced risk-adjusted portfolio returns by allocating a higher portion to gold, as the yellow metal offset the risk from other asset classes.

Why Gold Now?

Gold posted record gain of 30 percent in 2010 and since then the price of gold just showed some technical rebounds, with its price hovering in the tight range of $1,050 to $1,350 over the past few years.

On February 5th, stock markets witnessed one of the most substantial drops in recent years, while gold rallied strongly on that day. This scenario revived strong view that gold can deliver strong returns and reduce portfolio risk when the prices of other asset classes drop precipitously. It is felt in the present backdrop of a strong correction in the stock market, rising inflation, geopolitical unrest and the likely end to the low-interest rate regime; gold would turn out to be the go-to-asset class to preserve wealth.

Amidst the recent geopolitical unrest emanating from US-China trade war and expulsion of Russian diplomats, there are lots of headwinds pointing towards gold. Historical data reveal gold’s correlation to stocks typically becomes more negative during market pullbacks. The “pet rock” turned out to be more effective as a hedge when a market correction has been broader as witnessed during Black Monday, the 2008-2009 financial crisis, and the European Sovereign Debt crisis:

Gold has also proved to be a hedge against inflation. It has been shown that over a long period, gold returns have outpaced the US Consumer Price Index. As is evident from the following chart, in years when inflation has been higher than 3%, on average gold prices have increased by over 14%.

Gold demand has grown considerably during the recent past thanks to economic development witnessed in emerging markets, especially China and India and advent of exchange-traded products offering lower cost of ownership of gold. Investors’ attitude towards gold changed after the 2008-2009 financial crisis, as they started showing increasing interest in gold as risk management tool. Various central banks, led by emerging markets too have expanded foreign reserves, resulting in increased net gold demand.

Echoing positive sentiment, World Gold Council in its 2017 Annual Review forecast four themes would drive gold demand in 2018. The four factors identified by WGC are: strong growth in global economy, rising interest rates, frothy asset prices and market transparency such as the launching of LME precious by London Metal Exchange facilitating the efficient transaction in London wholesale market.

During the post-crisis era, investors have been uttering “Tina” implying “There is no alternative” to investing in equities since bond yields have been offering limited yield or income. However, following gradual interest rate hike by the Fed, the three-month Treasury bill yield rose to 1.66 percent now, just trailing the current US equity dividend yield of 1.88 percent. Similarly, for the first time since late 2008, the 3-month Libor rate rose last month above the dividend yield. As the stock market turning more volatile and geopolitical tensions escalating each day, global investors would look at gold as an able ally to their preserve wealth. Hence 2018 could turn out to be the “perfect storm” for gold.