GOLD IN PORTFOLIO RISK MANAGEMENT – A BRIEF OVERVIEW

When the asset market was down across the board in Q4 of 2018, institutional investors started eyeing gold as a hedge. But the equity market recovered in Q1 of 2019 and gold dipped below the $1,400 per ounce price from which it broke in Q1.

Presently we are observing institutional investors going into gold again, especially into ETFs, physical gold and mining stocks. Hedge funds are turning to gold with so many sovereign bonds in negative yield territory. A country selling a century bond with a 1,2% yield on the open market is just one sign that investors do not believe interest rates are going up any time soon.

Another thing to note is that the demand for gold by central banks in 2018 was the highest since the closure of the gold window by the US in 1971. It rose by 74% compared to 2017, with Russia leading by a large margin.

 

SHIFTING MARKET FUNDAMENTALS?

Could the combined market movements mentioned above be a sign of shifting market fundamentals as major players acknowledge a longer spell of depressed interest rates or even an oncoming recession? Some commentators have compared the current situation on the markets with the 1970s, when expansionary monetary policy was followed by an upsurge in commodity prices.

But today it is not quite clear if one can really expect a bullish commodity market considering the geopolitics of trade and currency wars that the major players are engaged in. It is more difficult to see gold simply as a commodity leader that will be eventually be followed by a larger commodity complex. It is no surprise that silver follows gold in this case, but the upsurge of other commodities not traditionally used as a hedge is dependent on the expanding global trade.

 

GOLD AS HEDGE IN PORTFOLIO RISK MANAGEMENT

While the total return on gold in 2018 was negative, -1,9%, High Yield Bonds and Investment Grade Bonds performed even worse. But gold performed rather well in Q4 of 2018, when all asset prices were depressed. Gold mining stocks gained 17% and gold itself appreciated 7%.

As we have already discussed, there are reasons to challenge gold as a store of value. Gold is very volatile and can undergo brief swings in either direction, which can be exploited by short-term arbitrage.

But the prevailing trends concerning gold are about the long term. And these trends can be long enough to get beyond an investor’s immediate horizon. The downward trend that began in 1980 lasted for 20 years. The next upward cycle lasted for 12 years. And now we could be 7 years into a downward trend.

Source: Macrotrends historical gold price in USD

The reason for the long cycles could be the fact that gold prices have little to no impact on the economics of everyday life. While commodities like grain and copper may have a huge impact on economies affecting prices and employment level, gold is mostly used for hoarding, and the small part of it used for industrial production is often recycled.

These long cycles make it more difficult for long-term investors to buy low and sell high. Failing to sell at the peak followed by a rapid slide could mean decades of waiting before an investment recovers in nominal terms, while at the same time there is no yield to compensate for the loss of purchasing power of the US dollar.

Having said all of this, it is very difficult to find reasons not to hold gold in your portfolio as a hedge against sudden shocks, and it is this valuable characteristic of gold that should be incorporated in the emerging field of value preservation technologies.

 

CONCLUSION

Gold is a good diversifier to have in what some economists have come to call “The Everything Bubble Economy”. When the next downturn comes, gold will likely be a good choice for an equities hedge, given that so many sovereign bonds are in the negative yield territory.

Recently there has been a lot of fintech innovation with some promising integration of gold’s hedge value into new architectures. But the advantage that gold still holds is the trust it has developed over centuries, while new fintech still has to prove itself. With some luck, proper regulation combined with timely innovation will enable investors to avail themselves of the best of both worlds in one package when the next crisis strikes.

Image source: Adobe stock
David Prezelj
David Prezelj

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