Published: 9th July 2019
Product in Focus: ETFS Physical Gold (ASX Code: Gold)
Gold has been on a run in 2019 reaching a new all time high in AUD terms of over A$2000/ounce.
Gold price is influenced by economic uncertainty and momentum
Demand is high, driven by central bank and ETF purchasing
Gold has been on a great run in 2019. US$ spot gold is up 9.1% since the start of the year and has recently been trading above US $1,400 for the first time since 2013 (as at 8th July 2019). In Australian dollar terms gold is hitting new all-time highs above A$2,000 an ounce.
Fuelled by equity market volatility in late 2018 and recent heightened expectations of easing monetary policy, gold has performed precisely as would have been predicated by anyone anticipating the broader macro forces at work over the past year. Equity market volatility in early 2018 triggered a rally, which subsided as markets regrouped and set sail for new highs in the third quarter. Volatility returned the fourth quarter of 2018, driving gold higher again. All of this occurred with the backdrop of an abrupt shift in monetary policy from major central banks.
To put gold’s price activity into context, it is worth looking at the historic drivers of the gold price. Research by the World Gold Council highlights the four broad categories of factors that influence the price of gold;
This article looks at these four key factors in the context of the current market from a global perspective.
Factor 1: Economic Expansion
Despite much talk about the uncorrelated and counter-cyclical aspects of gold, like most assets, demand for gold is at least somewhat driven by the overall level activity and wealth in the global economy. Where savings and investment levels are high, demand for gold is high.
Recent years have seen growing demand for gold from both India and China as levels of disposable wealth have grown. These two countries now account for more than 50% of global demand for gold.
Conversely, a slowdown in the technology sector in late 2018 saw industrial demand fall by 3% in Q1 2019.
While a broader economic slowdown seems to be in progress, the diversity of demand for gold and its traditional role as a strategic investment asset makes it unlikely that a reduction in economic activity will have a significant negative price impact on gold in the short-term.
Factor 2: Risk and Uncertainty
As an investment asset gold is commonly deployed as a portfolio diversifier, inflation hedge and quasi-insurance policy.
Gold has shown persistently low levels of correlation with stocks and bonds over the long term, which means that the addition of gold to a portfolio is often able to improve risk-adjusted returns by adding diversification. Figure 3, below, shows the impact of adding gold to a typical balanced portfolio invested across Australian and international equities and fixed income (as represented by Vanguard’s LifeStrategy Balanced Fund).
The conclusion here is that over the long-run a relatively small allocation to gold in a portfolio can have a consistent impact on the risk/return profile of the portfolio. In addition, gold can also have a substantial impact when other asset returns are stressed. This is evidenced in Figure 3(b) by the lower drawdowns, or losses experienced during the largest negative events.
This leads us to gold’s commonly cited role as an “event risk” hedge. When major, unexpected events occur gold has, time and again, had a better outcome than equity markets. Figure 4, below, shows how gold fared versus the S&P 500 and ASX 200 through a selection of major financial events over the past four decades.
When negative market events occur, gold’s correlation with mainstream asset classes tends to reduce and even become negative. This is in stark contrast to many other “alternative” assets, such as hedge fund strategies. During the global financial crisis, these were seen to be highly correlated to equity markets as investors simultaneously rushed to the exit of anything but the safest stores of value.
Not only is gold highly liquid, its other important feature is that it has no credit risk. Unlike other asset classes, during times of financial stress when risk premiums are raised correlations between other assets rise as investors simultaneously look to sell, while gold often moves the other way on safe-haven buying.
While such major events are unpredictable by nature, there is a growing case to be made that equity market valuations are currently stretched and that the volatility seen in early and late 2018 could well return in the near-term. Even if the monetary authorities are ahead of the curve and manage to engineer a soft landing, late-phase bull-markets are synonymous with bouts of volatility. As with any insurance policy, premiums are paid in the hope you never need to make a claim.
Factor 3: Opportunity Cost
The most common argument made against investing in gold is that gold has no intrinsic value because it produces no income and in fact produces negative income if you account for storage and security costs. This is certainly true in a literal sense. As has already been demonstrated, however, this should not detract from the role gold can play in a portfolio and the potential value it adds.
The opportunity cost associated with holdi