As we often hear, ‘beauty is in the eye of the beholder’, and this maxim is also true when it comes to investments, especially for gold.
Gold can play a variety of roles in a portfolio, including providing portfolio diversification, downside protection or a defence against volatile stock markets. Its role may change at various points in the market cycle, and there will be times when its performance is unexciting. Nevertheless, a structural allocation to gold has a good track record in enhancing the risk/reward characteristics of a diversified portfolio.
Gold has performed well over the last 20 years, with the price per ounce in US dollars rising around 440%.¹
Its strongest periods of performance have, unsurprisingly, tended to come during periods of uncertainty – in particular, the Global Financial Crisis and the Covid pandemic. It has also been a long-term beneficiary of the tendency for governments to increase their structural debt, thereby debasing their currencies.
In contrast, the gold price has tended to struggle during benign economic conditions. As it pays no income, there is always an opportunity cost to holding gold, which is magnified when the risk-free rate is higher. Ostensibly, the current environment would therefore appear to be a difficult one for gold, with interest rates at decade long highs. That said, there are various factors that may drive the gold price higher from here in both the short and long term.
Short-term: central bank buying and a weaker US dollar
One of the unintended consequences of sanctions against Russia has been that the central banks of ‘unfriendly’ powers – Russia, China and Iraq² – have stepped up their purchases of gold in an attempt to diversify away from the US dollar. The scale of gold buying may be far higher than is reported by central banks, and China in particular may be holding more gold than is currently being disclosed.
This is pushing up against limited supply. While there has been steady increase in production since the 1970s, it has been flatlining in recent years. It is difficult to measure the output of unlisted companies, so exact supply data is difficult to obtain, but supply and demand appear to be tipping in favour of a strengthening gold price.
In the short term, 10-year government bond yields and the performance of the US dollar, alongside speculative positioning, are the key determinants of the gold price. Last year, higher inflation was a positive driver of the gold price, but it was offset by a stronger dollar and higher interest rates. However, the drag from the dollar and higher yields are starting to ease. Equally, it would appear that speculators are not currently positioned for a gold rally. As such, there is room for them to increase their positioning.
Longer term: defence against currency debasement
The Bretton Woods agreement, which held from 1944 to 1971 saw global currencies fixed to the US dollar and the US dollar fixed to gold. That changed when Nixon abandoned the gold standard. This allowed governments to increase debt, breaking the link between fiat currencies and gold. Since then, gold has acted as an important defence against the currency debasement associated with rising government debt levels.
Government debt in the US (and in many other countries) has ballooned in recent years, due to events such as the global financial crisis of 2008 and the Covid pandemic and is now at record highs. These deficits persist despite full employment, and there appears to be little political will to turn the tide on spending. In the near term, this is likely to continue to put upward pressure on the gold price, while the dollar falls and treasury yields remain high.
Its role as a portfolio diversifier holds firm. At times, it may underperform the stock market, but its correlation to the MSCI All Countries World index is low, and it has shown its mettle during difficult periods for stock markets. This was particularly notable during the sell-off of equities and gold in 2022, during which gold played its historically traditional role in protecting portfolio values. It was uncorrelated to both bonds and equities last year, holding steady whilst both other asset classes fell.
There are risks of course. The biggest risk now is the impact of higher interest rates. For the time being, the historic link is broken. Rising real yields, the interest rate on a government bond after expected inflation, have not had a downward effect on the gold price – but this could return. Nevertheless, central banks appear to be nearing the end of their interest rate rising cycle. The Federal Reserve and European Central Bank may already have reached their peak. The US central bank may even cut rates next year.
It is also worth remembering that gold is not just there as a return-seeking asset in a portfolio, but for downside protection and diversification. It provides a vital offset against riskier assets, such as equities and an important ballast to market volatility.
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