Investment Commentary

I recently joined David Marsh, Chairman of OMFIF, for a conversation on gold. We discussed the strategic outlook for gold and explored the recent trends that we have been seeing in the market. 

Topics that we cover include...

•  Gold's price performance 
• The impact of the pandemic on gold
• Gold’s value as a source of returns, liquidity and diversification
• The drivers of the strong investment demand for gold

Krishan Gopaul, of our global research team, and Claire Lincoln, Head of Sales EMEA recently presented at the SPS virtual conference on alternative investing for pension funds. Watch the video replay below, where they discuss why gold’s characteristics make it a worthy long term strategic investment.

Their presentation focused on looking at gold from two alternative perspectives;

• Is it time to swap out some bonds for gold?
• Why should investors look at gold as an asset class in its own right rather than just a subset of broader commodities?

Last week, I had a great conversation with Matthew McLennan, of First Eagle Investment Management, organized by Institutional Investor about the increasingly relevant role alts are playing in portfolios.

You can listen to the replay below.

We recently started a gold position for a number of our portfolios, replacing some of our treasury inflation protected bonds (TIPS). Here we’d like to provide further explanation on how we understand gold in the current environment.

 

The first two drivers on our list of gold price factors are US Treasury Bonds and Inflation. It is particularly interesting to review and analyse these in detail, specifically the US Treasury Inflation Protected Securities – bonds commonly referred to as ‘TIPS’. TIPS can tell us a lot about the evolution of the gold price.

TIPS are a special type of treasury bond issued by the US government where the coupon and the principal are protected against inflation. Therefore, the price of those bonds has two different components: a bond component and an inflation component. TIPS go higher when bonds go up or when inflation goes up. Where it becomes slightly tricky is the fact that these two prices tend to be negatively correlated over time making it more difficult to anticipate.

Coming back to gold and TIPS, the chart below highlights how those two assets have performed very similarly over the last 15 years (we adjusted the TIPS to reflect the large divergence in terms of volatility between gold and TIPS by a factor of 2.5x). In short, gold could be seen somehow as ‘TIPS on steroids’. This echoes the argument that gold is a bond and a hedge against inflation. 

Source: Nutmeg, MacroBond

 

Using only the last five years, the performance of the two asset classes is even more similar and there is strong evidence that gold is close to an equivalent version of US treasury inflation protected bonds.

Source: Nutmeg, MacroBond

 

Gold & Nutmeg portfolios 

The inflationary risks described above informed our recent call to add gold to some of our portfolios. However, this call should also be seen in the context of the other assets we hold. Nutmeg has moved back to a neutral equity position because economies look to be on a recovery path, government policy is firmly pro-growth and covid problems now seem to have a better ‘risk-reward’ outlook.

That better ‘risk-reward’ comes from the likelihood any future lockdown will be local and partial rather than general. In addition, news about several effective covid vaccines is likely to break in the next couple of months; a necessary step before normalisation can really set in.

But, as ever, risks are not absent. Apart from the ongoing risk to the post-shutdown recovery, there is US election risk as well as geopolitical and oil price risks to consider – not to mention Brexit risk.

In order to structure portfolios that mitigate these risks, asset allocators usually turn to the US dollar, government bonds (such as TIPS) or gold. Yet, as we have detailed, government bonds are at extreme level vs. history, to the point where many are negative yielding – this means that if held to maturity an investor will not receive their capital back. The dollar has also become expensive and even gold has risen over 25% in 2020.

Normalisation in a post-covid-vaccine environment would further increase risk of “reflationary” factors in economies and markets. Neither the $ nor government bonds would perform well in this setting but gold can still play a role here. This is because gold is a multifaceted financial asset. It can continue to play its role as an inflation-protected-bond proxy but can also play its ‘commodity price’ role if real yields and inflationary expectations do begin to normalise. Finally, it can play its role as systemic hedge if there are structural interruption to markets via geopolitical crisis.

So, even though gold has appreciated significantly already, its enhanced diversification characteristics, compared to government bonds and the US-dollar, make it a sound addition to multi-asset investment portfolios. Nutmeg has moved to replace its (positively performing) position in US inflation-protected-bonds (TIPS) to add small gold positions across relevant portfolios in order to benefit from gold’s enhanced diversification potential.

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.

After the record gold price highs in August and then a substantial, although not unexpected, correction, we've been very busy at the World Gold Council fielding a wide range of questions, many of them seeking an explanation for those price movements. And, talking to reporters across the world, I've again been struck by how so many questions are extremely short-term in nature.

While the COVID-19 crisis is very different from the Great Financial Crisis of 2008, and the European Sovereign Debt Crisis that followed, I remember pondering then whether long-termism and strategic thinking (among investment professionals and market commentators) are victims of such major systemic crises. Does the severity and scale of the immediate challenges, and the understandable desire to return to Business-As-Usual as soon as possible, blinker investors (and journalists) from looking further forward? And do these crises prevent market participants from looking beyond the immediate market debris and gloom to identify enduring solutions and consider, in practical terms, how to build future resilience?

 

It's a story I have told very often, but I shall repeat it one more time: Speaking to a very experienced head of a private wealth management firm in the midst of the financial crisis, I was told, “I completely agree with what you have said regarding gold as a safe haven but, in all my years, I have never been able to sell an asset as insurance to a single investor,” or words to that effect. While I’ve heard similar statements (although rarely put so simply) from asset managers of all shapes and sizes, this has always struck me as bizarre, particularly if you consider the broader risk landscape over the last decade or so. And I think it has something to do with the prevalence of short-term thinking among investment professionals and advisors, which then seems to be exacerbated with each major crisis.

And, after a crisis, we often see a quite sudden return to risk, but still shadowed by the question as to whether this risk appetite is a sign of real recovery and rational expectations or more a reflection of tunnel-vision and short-term optimism. It may, of course, be both; indicative of investors buoyed by a market rebound rooted in solid growth prospects. Or it may be spurred by a desperate search for yield and, with so few options open to investors, convergent behaviour which then creates stretched asset valuations and potential ‘bubbles’. Either way, it is hard to understand why market insurance isn’t seen as a priority!

This is not to say that there aren’t sensible voices calling for investors to address this tendency. As the world’s leading investment consulting firm, Mercer, asked in a recent webinar focused on reframing asset allocation strategies for resilience, ‘Is your portfolio positioned to deal with long term trends?’¹ 

This is relevant for gold for many reasons, including because focusing purely on the short-term and immediate price movements can obscure investors from seeing the Big Picture; gold’s structural drivers and what creates enduring market growth – in both volume and value terms. I have, for well over a decade, been involved in telling the tale of ‘gold as a compelling long-term investment’, but I realise that the rationale behind that tale still often fails to register, perhaps partially because investment professionals and market observers aren’t really attuned to long-term perspectives. If they were, I think gold would be less of a challenge or an enigma to many of them. The World Gold Council clearly still has a job to do here!

Simply put, gold works as a long-term investment because it is bought by far more people in far more countries for far more reasons than any other asset. And many of the countries that buy large amounts are the world’s most populous nations, with fast growing economies and populations rapidly pulling themselves out of poverty, rising in wealth and income levels, and with cultural affinities to gold that stretch back millennia. These are long-term drivers that are unlikely to be reflected in any immediate price movements, but they help explain why the global gold market is many times larger and more valuable than it was two or three decades ago.

 

And, as any gold miner will tell you, gold is, from their perspective – from producing the stuff! - undoubtedly a long-term business. A vibrant and sustainable gold value chain needs long term planning, commitments, and investment. It’s a long way from the mine to the market, and the evolution of supply and demand dynamics does not happen overnight.

Of course, gold can also be a rewarding tactical and speculative investment, and the depth and liquidity of the modern gold market facilitates this too. We also often see during a crisis, when markets are under severe duress, gold’s immediate value often acts as a barometer of current wider market risk sentiment. This has been a primary driver behind gold’s recent performance, although matched by institutional investor gold purchases of a scale rarely seen before - surpassing even the elevated levels of demand after the financial crises of a decade or so ago.

These factors, and the consequences of earlier crises, are also significant to gold market participants and potential investors because they may signpost further structural changes in gold demand from the widening of its investor base. We should remember that the earlier financial crisis prompted a reawakening of demand for gold from European private investors and the reversal of central bank positions on gold, as globally they flipped from being sellers to major buyers. Gold proved its worth as a safe haven when most needed during that crisis, and those buyers have since remained a source of substantial demand for gold.

So, let’s look forward to see whether another structural change – the greater appreciation of gold by institutional investors – lies on the horizon and what that might mean for gold in the long term.

And, returning to another theme never far from my thoughts, we need long-term investment solutions that are potentially responsive and/or resilient to the enduring challenges and risks that will likely reshape our future investment decisions. That is, we need to reconsider how we evaluate and select assets in the context of the climate crisis, and the need to support sustainable development as a prerequisite to fostering wider well-being, peace and prosperity. Big problems and major aspirations that require long-term vision.

 

---

Footnotes

¹ https://www.brighttalk.com/webcast/2163/438586

I recently had a conversation with Greg Crawford, Director of Content Solutions at Pensions & Investments, as part of the DC West Fall Virtual Series by Pensions & Investments. We discussed the role that an allocation to gold can play, the outlook for gold and more.

Watch below!

Following the recent release of our Gold Demand Trends report for Q3 2020, one of the questions we are being asked frequently is how much influence the US election will have on gold demand and performance.

The simplest answer is that while, understandably, investors are closely following the US election for many reasons, it is just one of the many factors that influence gold at a global level. And specifically with respect to this election cycle any of the possible outcomes – whether a clear win by either Republicans or Democrats, or a contested election – will likely support one or several of the key drivers of gold investment demand.

Let me elaborate.

 

A historical perspective

Looking back, gold’s performance has not significantly differed based on the party controlling the White House. Since 1971, gold returns were 11% on average per year during Democratic presidencies and 10% during Republican ones¹. Similarly, gold returns were only slightly higher in the year following a challenger party’s victory relative to an incumbent party’s victory (7.9% versus 6.5% respectively).²

US gold demand

Gold is a global market; it is purchased by consumers and investors around the world for a myriad of reasons, but primarily as a means to preserve capital and diversify risk. The US is the third largest gold consumer market, accounting for approximately 7% of global physical gold demand in the form of jewellery, technology, bar and coin, and ETFs. And while activity in derivatives markets, especially through COMEX, generally represent positioning by US investors, there is still a large portion of physical gold demand that is influenced by global dynamics well beyond the US election.

 

High risk and low interest rates are not going away any time soon

The stakes are clearly high in this election. The political landscape has been increasingly divisive over the past several years – in the US and abroad – and investors are bracing for a potential period of even greater volatility. Many economists have published views regarding how a Republican or Democrat win might impact various macroeconomic indicators.

In our view, any potential outcome will likely support gold investment demand, albeit for different reasons.

• A Trump win will likely be seen as business friendly and constructive in terms of fiscal policy, supportive of the positive momentum the stock market has enjoyed for most of the past four years. On the flip side, trade tensions may resurface again and monetary policy will likely remain very accommodative for a long time
• A Biden win may create concerns of higher taxes and larger budget deficits, and result in corrections in the stock market, but it could be seen as more conciliatory in terms of trade. In this case we don’t believe that monetary policy will become more restrictive any time soon.
• A contested election or unclear outcome for a period of time, viewed as a concern by many will likely result in a a particularly uncertain period for financial markets.

In sum, the combination of a high-risk, low-rate environment is expected to maintain gold investment demand for the foreseeable future. As such, investors should prepare for ongoing high volatility as market conditions adjust to emerging developments.

 

---

Footnotes

¹ SSGA, What Impact Do US Politics Have on Gold? October 2020.

² Ibid.

It’s been an eventful week to say the least. In my last post before the US election, I examined how the possible outcomes may influence gold’s performance.

The results thus far indicate that Joe Biden will become the next president of the US, but as many expected, the election result was close and legal challenges remain – and will continue – delaying the official outcome for at least a month if not more. On this note, the gold price rose on the days following the election.

But while the US election saga continued to play out, on Monday the world was greeted with some very exciting news. Pfizer/BioNTech announced promising initial phase-three results for what looks to be the first vaccine proven to be effective against COVID-19. As a result, stock markets rallied, bond yields rose and, not surprisingly, gold sold off.

 

Monday’s price move, while large (-5%), was not unprecedented. Gold has seen approximately 16 single-day price drops of more than 4% over the last 15 years, the most recent this past August.¹ In this particular case, gold’s pullback was primarily driven by positive market sentiment (risk reduction) following Pfizer’s announcement and aided by investor positioning (momentum).

What's next? 

The key question facing gold investors now is whether this the start of trend reversal, a temporary move, or perhaps an opportunity to buy.

To understand gold’s performance, it is important to consider its four key drivers:

• Economic expansion: periods of growth are very supportive of jewellery, technology and long-term savings
• Risk and uncertainty: market downturns often boost investment demand for gold as a safe haven
• Opportunity cost: interest rates and relative currency strength influence investor attitudes towards gold
• Momentum: capital flows, positioning and price trends can ignite or dampen gold's performance.

 

Gold regained some ground on Tuesday and while price volatility may persist in the short term, we believe this could be seen as a buying opportunity for many strategic investors. The reasons are three-fold:

• Consumer demand may start to see signs of recovery. The price correction and slightly more positive economic outlook may revitalise gold’s consumer demand, removing – at least in part – one of the significant headwinds it has faced this year. Historically, Indian and Chinese consumers have often used price dips to buy gold. And we have seen similar behaviour among more strategic Western investors.
• Investment demand is not likely going away. While news about the vaccine is definitely positive and rightfully fuelling optimism, there are still challenges ahead. These include further trial results, peer review, approvals and distribution logistics which may delay its rollout to the general public, thus maintaining a level of uncertainty over the coming months. And some significant risks that existed prior to the COVID-19 pandemic remain as contributors to heightened global uncertainty (for example, Brexit, political gridlock in the US, trade tensions, etc.) But perhaps more importantly, the pandemic has already had a significant negative impact on the global economy that will take time – and a lot of stimuli from governments – to overcome.
• Loose monetary policy will reshape asset allocation. In addition to the fiscal largesse, interest rates are set to remain very low for a long time. As we discussed in our mid-year outlook, this may not only result in high inflation but is likely to re-shape asset allocation strategies for years to come. Amid such an environment, gold could play an increasingly relevant role as a diversifier and source of returns.

Where do we go from here? 2020 has been dominated by both the COVID-19 pandemic and the US election. As we begin to slowly move past these two events, investors are understandably looking ahead. Could the elevated levels of interest we have seen in gold this year begin to fade? We don’t believe so. We have seen a marked change in how investors are perceiving and using gold over the past couple of years, and with questions swirling about the effectiveness of traditional asset allocation models going forward, there is likely to still be an important role for gold.

 

---

Footnotes

¹ The gold price fell by 5.7% on 11 August 2020 based on the LBMA Gold Price PM.