Investment Commentary

Summary

• India’s equity market has outperformed major equity markets in 2021, triggered by signs of economic recovery and an accommodative monetary policy from the Reserve Bank of India (RBI)
• On 26 November the BSE Sensex witnessed its biggest daily fall in the last seven months due to fears about the new COVID variant identified in South Africa and a sell-off by foreign institutional investors (FIIs) who are concerned about overvalue in the equity market
• Gold historically exhibits negative correlation during equity sell-offs and the domestic gold price increased by 1.3% on 26 November.¹ Gold may remain attractive to Indian investors who wish to preserve their capital

The Indian equity market has outperformed major equity markets in 2021

The Indian equity market witnessed positive returns this year, buoyed by strengthening signs of economic recovery after the second wave of the pandemic and an accommodative monetary policy stance by the RBI (Chart 1).²

Chart 1: The Indian equity market has outperfomed major equity markets in 2021

Return on equity markets in 2021

The lofty returns on Indian equities have raised concerns over valuations; in November the BSE Sensex witnessed its biggest daily fall in the last seven months

The lofty returns on Indian equities have raised concerns around overstretched valuations and as a result various global financial firms have turned cautious on Indian equity. Traditional valuation metrics, such as the price-to-earnings (P/E) ratio, have remained above the historical average values.³ Also, the current yield gap of 2.23% remains well above the 15-year average of 1.67% – indicative of an overvalued equity market in the country (Chart 2).⁴

Chart 2: The current yield gap has outstripped its long-term average

Spread between 10-year Indian government bond yield and BSE Sensex earnings yield

The BSE Sensex started November on a positive note, supported by a higher composite purchasing managers index (PMI) and higher GST collections in October, and as result gained 2.4% during the first half of the month.⁵ However, it faced challenges in the second half of the month due to various factors such as concerns over global issues, including the new COVID variant, fresh lockdowns in some European countries, and concerns over rising global inflation, as well as domestic concern over high equity valuations in India. On the back of these concerns foreign institutional investors unremittingly withdrew funds from the Indian equity market during the last seven days of the month. The BSE Sensex fell by a sharp 6.1% in the second half of the month with a notable fall of ~1688 points on 26 November 2021 – the biggest daily fall in the last seven months (Chart 3).

Chart 3: On 26 November the BSE Sensex witnessed its biggest daily fall in the last seven months

Gold’s role during a market sell-off The diversification benefits of gold are widely acknowledged, as its negative correlation to equities and other risk assets generally increases as these assets sell off (Chart 4). Historically, gold has worked to preserve capital during stock market downturns. For example, during the global financial crisis, equities and other risk assets tumbled in value; gold, by contrast, held its own and increased in price, rising 53% in rupees from December 2007 to February 2009.⁶ And in the most recent sharp equity market pullbacks of 2018 and 2020, gold’s performance remained positive.⁷ Also, during the recent sell-off on 26 November, domestic gold price increased by 1.3% to end at Rs48,153/10g. Considering gold’s role during equity sell-offs, it may remain an attractive investment for Indian investors who wish to preserve their capital.

Chart 4: Gold has been more negatively correlated with Sensex in extreme market sell-off conditions

Correlation between gold and Sensex in various environments of equity performance since

The heightened equity market valuation has attracted inflows into Indian gold ETFs Indian gold ETF holdings almost doubled in 2020 to 28.3t from 14.8t at the end of 2019, led by safe-haven demand during the pandemic and higher returns on gold. The inflows into gold ETFs continued in 2021 amid a correction in the gold price, with gold ETF holdings increasing to 35.4t by the end of October. The high equity market valuation in India has supported these inflows, both during last year and to date in 2021, as concerns around over-valuation have led investors to turn to gold to preserve their capital against a possible equity market downturn (Chart 5).

Chart 5: Indian gold ETFs continued to attract inflows amid concerns over heightened stock market valuation

Conclusion

The Indian equity market has outperformed major equity markets, witnessing positive m-o-m returns from May to October triggered by strengthening signs of economic recovery after the second wave of the pandemic. But in November it has faced challenges due to global concerns, such as the new COVID variant and the continuous withdrawal of funds from FIIs on the back of an overstretched equity market valuation. Indian investors may benefit from turning to gold in such a scenario due to gold’s role as a diversifier and its downside risk protection. And concerns over higher equity valuations in India have attracted investors towards gold ETFs over the last two years. Going forward, the high equity market valuation may be one of the key factors persuading Indian investors to invest in gold.

Footnotes

¹MCX Gold Spot in INR ended 1.3% higher on 26 November at Rs48,153/10g

²The RBI initially cut its policy rate by 75bps in March 2020 and subsequently by 40bps in May 2020. It has kept its policy rate at 4% since May 2020 with an accommodative monetary stance.

³As of 26 November 2021 the P/E value of BSE Sensex at 26.7 is well above the 10-year and 5-year average P/E value of 22 and 25.9 respectively.

⁴The current yield gap is as of 26 November 2021.

⁵India’s composite PMI increased to 58.7 in October from 55.3 in September. GST collections increased to Rs1.3tn in October from Rs1.17tn in September to reach the second highest GST collections ever since the GST system came into force.

⁶Based on the MCX Gold Spot price in INR from 1 December 2007 to 27 February 2009.

⁷Based on the MCX Gold Spot price in INR from 1 October 2018 to 27 December 2018 and from 31 January 2020 to 31 March 2020.

The Chinese central bank has intensified its easing monetary policy efforts to accommodate the nation’s slowing economic growth. On December 15, the People’s Bank of China (PBoC) made a 0.5% cut in financial institutions’ required reserve ratio (RRR), injecting around RMB1.2tn to the market. This was the second RRR cut in 2021 as local policy makers prioritise the pursuit of economic stability. And following last week’s RRR adjustment, the PBoC lowered the one-year local Loan Prime Rate (LPR) by 5bps this Monday, the first LPR cut in 20 months.

Chart 1: China recently lowered its RRR and one-year LPR

Just as global investors are pricing in possibilities of major central banks’ monetary tightening in the near future, China made rate cuts. We believe China’s easing monetary policy measures might lead to at least two consequences.

First, the opportunity of holding gold for Chinese investors is likely to fall

On the one hand, demand for fixed-income assets generally increases as the central bank injects liquidity to the market, pushing down bond yields as a result. On the other hand, the PBoC’s accommodative stance has boosted investors’ expectation of further reduction in China’s benchmark policy rates such as the medium-term lending facility (MLF) rate and the open market operation (OMO) rate, weighing on local bonds’ expected future yields as a result.

Chart 2: The local bond yields tends to fall when the monetary policy is accommodative

The RRR and weekly average 10-year government bond yield in China

Coupled with the rising inflation of recent months and the expectation for consumer prices to further increase in 2022, the real yield of the 10-year local government bond, often viewed as the local opportunity cost of holding gold, has the potential to fall further.

Second, the Chinese Yuan (CNY) might face devaluation pressure

Generally speaking, a lower interest rate is beneficial for local demand and imports, increasing demand for foreign currencies and reducing demand for the domestic currency. Also, a lower interest rate tends to result in a higher supply of the local currency, coupled with its reduced demand, weighing on the domestic currency.

The divergence between China and other key regions’ monetary policy stances might accelerate the CNY’s depreciation. This is because capital tends to enter regions with rising yields from countries with falling interest rates, creating higher demand for the foreign currency and reduces demand for the lower-yielding country’s currency.

Chart 3: A lower local yield usually means a weaker RMB

The real effective RMB Index and the real 10-year Chinese government bond yield*

Implications for China’s physical gold demand in 2022

Our analysis of quarterly data in the past decade unveils four key factors impacting Chinese investors’ interest in physical gold investment:

• The 10-year government bond yield
  A lower opportunity cost of holding gold often bodes well for local gold bar and coin demand
• Inflation
  Local investors tend to purchase more physical gold products for wealth preservation when inflation rises.
• The local currency
  Local bar and coin demand increases when there is a depreciation in the local currency as investors seek purchasing power protection.
• Income
  Our analysis also reveals a positive correlation between local gold bar and coin demand and households’ income changes in the previous period. Usually, Chinese consumers buy more gold bars and coins for gifting or long-term saving purposes when their wealth expands.

As 2021 comes to an end and 2022 approaches, we are actively searching for clues of possible changes in next year’s global and regional gold markets. Unlike other key markets, China is entering into a different economic cycle and stepping up its easing monetary policy. We believe this could be supportive for local retail and institutional investors’ interest in gold.

For more quantitative forecasts, in-depth economic and gold market outlook, please stay tuned for our Global Gold Market Outlook 2022 and Chinese Gold Market Outlook 2022 releasing early 2022.

India has made great strides since its economic liberalisation in 1991. Looking back over the past 30 years underlines how far the country has come. Between 1991 and 2021, India’s economy grew from US$275bn to US$ 2,946bn and its foreign exchange reserves soared from US$1bn to more than US$630bn. The middle class expanded and household incomes rose, with per capita net annual income rising from Rs7,000 in the early 90s to Rs126,968 in FY2020-21.¹

India’s middle class is expanding fast. Analysis from consultancy Bain & Company, for instance, suggests that the number of middle-class households will grow by 140mn between 2018 and 2030, while the number of high-income earners could increase by 21mn.² This is likely to presage an almost four-fold increase in consumer spending, from US$1.5tn in 2018 to US$5.7tn by 2030. India has also seen a change in saving patterns among its households in recent years: the savings rate, which was above 34% in 2010, had dipped to 30% in 2018 and continues to inch lower to this day.³ Rather than just putting money into saving, consumers in India have begun to invest.

With rising incomes and an increase in spending, investors have shown a growing interest in Indian equities. This is exemplified by the increase in ‘demat’ accounts, used to hold shares and securities in an electronic (or ‘dematerialised’) format. The number of these accounts more than quadrupled from 16.7mn in 2009 to 73.8mn by the end of October 2021.⁴ Similarly, the amount of money flowing into equities through Systematic Investment Plans (SIPs) has also surged in recent years, reflecting growing awareness of mutual fund investment. Average inflows to SIPs more than doubled between 2016 and 2020, from Rs.35bn to Rs.95bn a month in 2021.⁵

As Indian investors allocate a higher share of their capital to equities, they have exposed themselves to greater risk. Gold plays an important role in helping investors manage the risk-return profile of their overall portfolio allocation. Gold played its role as a safe-haven asset during the pandemic year of 2020 and has continued to provide a hedge against market volatility in 2021. These attributes have been recognised not only by Indian investors but also by the Reserve Bank of India (RBI).

Indian gold ETFs continued to attract inflows in 2021

As the gold price rose more consistently in 2019, sentiment in the Indian gold ETF market improved - albeit marginally. It was in 2020 that momentum picked up significantly. The rising gold price, increased volatility in equity markets and economic uncertainty due to COVID-19 fuelled safe-haven demand into Indian gold ETFs. As a result, net inflows almost doubled in 2020 taking total gold ETF holdings in India to 28.3t by the end of that year.

This positive momentum carried into 2021. Indian investors continued to pile into Indian gold ETFs, driven by a lower price point, concerns over higher equity valuations and safe haven demand. Net inflows increased by 9.3t, taking gold holdings to 37.6t by the end of 2021 (Chart 1).

Chart 1: Total holdings of Indian gold ETFs increased further in 2021

Holdings of Indian gold ETFs on Indian exchanges

The Reserve Bank of India (RBI) ramped up its gold purchases in 2021

After adding 41.6t in 2020, the RBI ramped up its gold purchases in 2021, buying an additional 77.5t and taking its total gold reserves to 754.1 by the end of the year (Chart 2).⁶ The RBI added gold in order to diversify its foreign reserves and it is highly likely that it will continue to purchase gold in 2022. Many of the factors for gold ownership highlighted in our 2021 Central Bank Gold Reserves Survey are likely to remain relevant, giving continued uncertainty over the outlook for the economy.⁷

Chart 2: RBI ramped up its gold purchases in 2021

RBI 's gold reserves at end of the year

Indian investors face new challenges in 2022

Indian investors faced challenges in 2021: concerns of economic slowdown amid the emergence of the Delta variant and elevated equity markets. There may be similar concerns in 2022, but in addition there are likely to be new challenges:

• the possibility of higher and persistent consumer price inflation (CPI)
• an expectation of depreciation in the Indian rupee (INR), driven by the Fed’s higher interest rate and the widening trade deficit of 2021
• unexpected sharp and frequent policy rate hikes by the RBI.

In an environment of greater uncertainty and increased market volatility, gold’s attributes may help Indian investors improve the performance of their portfolios. Gold can enhance an investor portfolio through the following characteristics:

Gold is an effective portfolio diversifier

Gold benefits from flight-to-quality inflows during periods of heightened risk. The greater a downturn in stocks and other risk assets the more negative gold’s correlation to these assets becomes. But gold’s correlation not only works for investors in times of turmoil. Due to its dual nature as both jewellery and investment, gold’s long-term price trend is supported by income growth. When stocks rally their correlation to gold can increase, driven by the wealth effect and, sometimes, by higher inflation expectations (Chart 3).

Chart 3: Correlation of Indian stocks versus gold*

Correlation between gold and SENSEX in various environment of stocks' performance

Gold has provided healthy returns in the long run

Returns are a crucial factor for any asset class. Looking at the last fifteen years, gold in rupees has delivered an annualised rate of return of 11.7%, marginally higher than equities (11.6%) and higher than returns on other asset classes such as bonds (government and corporate) and cash.⁸ Over the last five years, gold has underperformed equities but outperformed other asset classes such as bonds and cash (Chart 4).

Chart 4: Gold's long-term performance compared to other assets*

Gold can enhance portfolio performance

This combination of returns and diversifier properties means that adding gold can enhance the risk-adjusted returns of a pension fund portfolio. Indian investors with an asset allocation equivalent to that of an average institutional investor portfolio would have benefitted from including gold (Chart 5). Our analysis also shows that adding between 7% and 18% in gold to an average Indian institutional portfolio over the last decade would have resulted in higher risk-adjusted returns (Chart 6).⁹

Chart 5: Risk-adjusted return of a hypothetical institutional investor portfolio with various allocations to gold

Chart 6: Range of gold allocation for each hypothetical portfolio mix

Conclusion

Gold can clearly be considered a good investment for Indian investors. Well recognised for its diversification properties, it can deliver strong returns too. Adding 7-18% of gold to an Indian institutional average portfolio over the last decade would have resulted in higher risk-adjusted returns – an appealing scenario in these uncertain times.

Since the Global Financial Crisis, it has been a turbulent ride for investors the world over. Europe has certainly been no exception: investors in the region have had to adapt to a high-risk environment. And as COVID-19 has introduced a new set of challenges to portfolio construction and return generation, robust risk management strategies are a top priority; wealth protection is as important as growth.

The ultra-low rate environment presents challenges to portfolio construction

The lack of yield on offer in the prolonged ultra-low rate environment has prompted many investors to extend maturities, move further along the credit curve, or increase allocations to alternative assets. These strategies may generate greater returns, but they also bring with them greater risk. And while bonds have traditionally been considered a hedge against downside risks and market corrections, the low yields currently on offer mean they may no longer bring the same diversification and protection benefits from decades past.

Inflation risks have undoubtedly increased

Rising inflation has become the number one topic for investors in Europe and initial hopes that it would quickly subside have begun to fade. Like many other central banks across the world, the Bank of England (BoE) and the European Central Bank (ECB) now face the difficult challenge of reining in rapid price rises while nurturing the nascent economic recovery (Chart 1). Despite recent record CPI readings, the ECB currently remains committed to its accommodative monetary stance. And in the face of multi-decade high inflation, the BoE has suggested that interest rates will only rise modestly going forward. But concerns around the persistence of inflation have intensified speculation as to the speed at which fiscal and monetary support is adjusted. These changes could threaten markets: tightening too soon could run the risk of tipping the economy back into recession, while tightening too late could result in inflation getting out of control. Investors may therefore need to review their strategic asset allocations to ensure they have the appropriate portfolio protection in place.

Chart 1: UK and European inflation moved sharply higher in 2021

ESG considerations are also shaping portfolios

Environmental, social and governance (ESG) issues are beginning to influence the shaping of asset selection and strategies. Not only is this in line with wider societal expectations but it is also driven by a host of legal and regulatory changes. In Europe, for example, the Sustainable Finance Disclosure Regulation has imposed mandatory disclosures on ESG for asset managers and financial market participants. This is part of a wider set of measures which form the European Commission’s Action Plan on Sustainable Finance. As a result, investors of all stripes are searching for ways to align their portfolios with the global transition to more responsible and sustainable investments.

Investors in Europe recognise the strategic benefits of owning gold

Europe has long been a significant source of demand for retail gold investment. Per capita gold consumption in Germany and Switzerland is among the highest in the world.¹ However, we believe institutional investors also recognise the benefit from allocating a proportion of their portfolio to gold. Despite potential rate hikes, both nominal and real interest rates remain historically low, keeping the opportunity cost of holding gold supressed. Low rates also highlight gold’s attributes as a source of genuine, long-term returns – particularly when compared to historically high levels of global negative real-yielding debt. Our back-testing analysis has found that adding gold to a hypothetical average UK or European pension portfolio over the past 20 years would have resulted in higher risk-adjusted returns (Chart 2).

Chart 2: Adding gold would have increased risk-adjusted returns of a hypothetical UK (left-hand side) and European (right-hand side) pension fund over the last 20 years

Through robust optimisation analysis, we also find that the higher the portfolio risk, the larger the required gold allocation to offset that risk. More detail on this analysis, as well as gold’s unique attributes as an investment asset, is available in our recently updated Relevance of Gold as a Strategic Asset report. As a result, we continue to believe that gold has an increasingly relevant role to play in helping UK and European investors navigate the evolving landscape of risk and uncertainty.

Spot #gold is trading around $1827/oz with a $0.30/oz bid-ask spread on Friday morning in London.

Although it bounced after stronger US inflation data, it couldn't hold those gains as yields firmed late in the day.

But lets look at a slightly longer term perspective...

Since the start of the year, #gold is essentially flat...

...yet 10-year treasury yields are about 65bp higher (less negative)

There have been a lot of questions about why gold is not weaker this year - the Fed is obviously going to hike A LOT and starting in March. The move in real yields would normally have pointed to lower #gold prices yet hasn't.

True, inflows into ETF have been supportive this year, but have been relative small at 'only' 55t or $3.26bn.

Managed Money held via Comex #gold futures hasn't helped, however, with net longs 112t lower between 28/12 and 1/2/21.

Some have suggested that large central bank buying has been taking place, but there is no evidence of that and I haven't heard any talk of unusual flows.

Rather it may be because of less exciting supply and demand fundamentals.

From the executive summary of our recently-published Gold Demand Trends...

There's also another factor that doesn't get as much attention as it should - (small investment) Bar and Coin demand, which was again very strong in Q4-21 and for 2021 as a whole.

And finally #gold supply fell in 2021, with technical issues leading to Mine Production disappointment, especially in the second half of the year.

Recycling fell 11% y/y in 2021 too.

For more information on underlying supply and demand in the gold market, which goes some way to explain this year's resiliance in #gold, see our recent #GoldDemandTrends publication.

Download it here: Full Year and Q4 Gold Demand Trends 

Follow me on Twitter for more regular insights on gold.

The local stock market remained volatile after the Chinese New Year (CNY) holiday (Chart 1). External uncertainties such as global equity market volatility amid central banks’ tightening expectations in main regions and adjustment in key sectors, among other factors, might be main contributors. Looking ahead, weaknesses in local economic growth and stagflation-like pressure could keep Chinese stock market volatility elevated throughout the year. And as we will show below, gold, a non-RMB asset, could play a strategic role in Chinese investors’ portfolios. 

Stagflation-like pressure may intensify in 2022

Driven by the low base of 2020, China’s GDP growth surged in the first half of 2021. However, sporadic COVID-19 outbreaks, surging costs for many industries amid supply-side shocks, the hampered real estate sector, and complicated external conditions led to a slowdown in the second half. Y-o-y growth in Chinese GDP amounted to 4.9% in Q3 and 4% in Q4, the lowest quarters in decades (Chart 1).

China’s economic growth slowed in H2 2021 and this could continue into 2022:

• GDP growth is likely to decelerate further in 2022 primarily driven by the country’s long-term economic growth path transition, continued stress in the real estate sector, threats of further pandemic-related lockdowns and geopolitical tensions. 
• Inflationary pressure in China might rise. With downstream sectors’ margins being squeezed amid surging costs as the Producers’ Price Index rocketed last year, more and more consumer goods companies have begun to announce price rises.¹  And if the pork cycle initiates, pork prices could rise in 2022 contributing further to higher inflationary pressure.² 

This echoes the OCED’s most recent outlook (Chart 3).

An economic slowdown and rising inflation are the two key ingredients for a stagflationary environment, or stagflation-like pressure. This could have serious implications for Chinese investors. Table 1 shows our analysis of performance of the main RMB asset classes during historical stagflation-like periods in China between 2004 and 2019. We found that:

• Risk assets experience higher volatility

During the seven stagflation-like periods we studied, stocks and commodities exhibited heightened volatilities and losses 

• Bonds yield negative returns

On average, the ChinaBond New Composite Index yielded a -0.5% average return during the periods under analysis

• RMB gold outperforms other major asset classes 

Gold, however, averaged a 9% return during China’s stagflation-like periods. 

Table 1: Chinese investors tend to be risk-off during stagflation-like periods

Major RMB asset performance during stagflation-like periods in China*

As a non-RMB based asset with a global market, gold can help Chinese investors navigate local equity market turbulence. Our analysis shows that when Chinese equities plunge, RMB gold exhibits a negative relationship with the local stock market. And this correlation turns positive when Chinese stocks rally. This is the diversifier every investor desires: protection during bad times and prosperity in good times. 

But a question we frequently get asked is:

Can gold still function as a strategic part of my portfolio when the US enters a tightening cycle that could weigh on gold’s performance? 

To answer this question, we examined RMB gold and Chinese equities between December 2008 and December 2018 – a time when the US Federal Reserve was hiking rates. And RMB gold maintained its effectiveness as a Chinese equity market risk diversifier. 

In fact, in our 2022 Gold Outlook we mention that while rate hikes are likely approaching, real rates might remain low and lead to lower-than-expected gold price performance headwinds. Lingering inflationary concerns in many key markets could continue to be a key driver of gold. And with the possibility of tail events rising, global financial market volatility could increase, highlighting gold’s strategic role as an effective hedge against stock market turbulence. 

Summary

In the Year of the Tiger China’s economy could face threats, such as a slowdown in growth and higher inflation. And to help cushion these shocks the PBoC has stepped up its efforts to ensure ample liquidity in the economy by cutting policy rates.³ China’s monetary policy stance in 2022 should remain supportive, potentially further reducing the opportunity cost of holding gold for local investors. 

Going forward, RMB gold could be a valuable addition to Chinese investors’ portfolios if stagflationary pressure in China intensifies. And should the CNY weaken due to a mismatch between monetary policy in China and key Western markets, we believe that gold, a non-RMB asset, will be especially relevant for Chinese investors who wish to protect their wealth and purchasing power. 

Footnotes

¹For more information, please visit: 【深度】消费品上市公司涨价潮涌！这一次涨价逻辑有何不同？影响多大？_价格 (sohu.com)

²Please visit: 新一轮猪周期有望在今年第二季度开启？猪肉板块新年以来逆市上涨4.58%，这些潜力品种获北向资金加仓！-证券日报网 (zqrb.cn) and Pork prices in China are about to rise again, the risk of exploding consumer inflation - Tridge for more information

³For more information, please visit: Three takeaways from China's key conference for 2022 economic plan - CGTN and China’s cut of interest rates to spur economic growth - Global Times.

Commodities are on a tear in 2022, driven by consumer spending, supply chain issues and most recently, tensions with Russia. Brent and WTI oil are well above $100/bbl., up more than 50%.¹ Nickel was up over 200% at one point during the month- a move so large that the metallic value of a US $0.05 nickel was worth twice its monetary value. Finally, broad-based commodities indices like the S&P GSCI and Bloomberg Commodity (BCOM) indices are up anywhere between 30% and 40%. Broad-based commodities have provided solid returns for investment portfolios, but the exponential price increase for many commodities may require investors to re-evaluate the magnitude of their commodity holdings, and potentially rotate some of that exposure into gold.

We’ve discussed extensively that gold is the most effective commodity investment separating itself from individual and broad-based commodity indices. While an inflationary environment is generally supportive for commodities, gold has historically outperformed broad-based commodities. Historical analysis shows that gold returns averaged 25% in years when inflation was above 5%. Commodities have returned just over 20% (Chart 1) – but that includes the strong commodity performance over the past 15 months. To put things into perspective, February’s US CPI showed a 7.9% y-o-y increase. 

Chart 1: Gold and broader commodities perform well in high inflation environments, but commodities break down in low inflation markets

Gold and commodity returns as a function of inflation*

Gold has historically lagged broader commodities in the preliminary stages of commodity reflationary periods, like the current one. Ultimately, it has tended to outperform, which could be replicated in the current case as it plays ‘catch-up’ in 2022 (Table 1). 

Table 1: Gold historically lagged in commodity-led reflation periods but outperformed over the long run

Inflation-related asset returns during the most recent reflationary periods in the US, on an annualised basis*

Gold really separates itself from other commodities is in systemic risk-off environments. Risk-on assets have fallen this year, but it has been more of a steady pullback of 10-12% versus a systemic event. Should equity markets fall very rapidly, historical data suggests gold to be a better hedge than commodities.

Commodities and gold have both been great components of diversified portfolios in 2022. But a sizeable portion of commodity index gains has been driven by the large weights of oil and energy in the indices. This weight is over 50% in the S&P GSCI and 30% in the BCOM Index. While many investors like to look at the relationship of oil and gold, we know that over the past 50 years there has been little correlation between oil and gold.

If global supply chains open, and/or geopolitical tensions in Russia ease, it would not be surprising to see a sharp pullback in oil and other currently-strained non-gold commodities. It is also possible that gold could lose some of its recent momentum as well. However, gold is much less volatile than individual commodities, particularly oil, and many times less volatile than broad-based commodity indices; both of which is the case over the past year (Chart 2). This is also the case over the long run, with the long term volatility of gold similar to that of US equities, and well below individual commodities.

Chart 2: Gold is less volatility than most individual and broad-based commodity indices

Annualised daily volatility of various commodities over the past year*

But the inflation story is unlikely to go away anytime soon, and market risks remain. Should gold fall, it would not be surprising to see more strategic gold investors opportunistically step in to buy at lower price levels. Therefore, it may be an ideal time to consider a rotation from broad-based commodities to gold. Gold possesses the positive qualities a commodities investor wants at a time like today: it offers downside protection, lower volatility and varied sources of demand. All of which leave gold in a better position to diversify a portfolio should oil or broad-based commodities retreat.

Footnotes

¹As of 9 March 2022

Gold surged past US$2,000/oz earlier this week,¹ nearly reaching the previous 2020 record.² This time, though, it was driven by continued concerns about the war in Ukraine, swelling commodity prices, and, more generally, the potential implications for the global economy. And while the gold price has come down from the week’s high, it’s still approximately 4% higher month-to-date.³

Against this backdrop, we are addressing the three questions investors have asked us most frequently in recent days.

• What is the relationship between the price of oil and the price of gold, and what can the oil market tell us about gold’s future performance?
• How likely is it that the global economy falls into stagflation and how may gold perform in this environment?
• Could recent geopolitical developments, including the war in Ukraine, change the role of the US dollar in foreign reserves and global trade?

What is the relationship between the price of oil and the price of gold, and what can the oil market tell us about gold’s future performance?

Generally, there’s no consistent relationship between gold and oil (Chart 1). The long-term correlation between the two assets is close to zero – ranging from -0.2 to +0.5 at any given time.

However, both gold and oil tend to perform well in periods of high inflation, albeit for different reasons. High oil prices can push consumer price baskets higher, which can result in high inflation. When high inflation persists, driven by commodities or other factors, investors look for hedges, often lifting gold investment demand – and its price – higher. In this case, the gold price tends to lag the movement in commodities, but gold has historically outperformed longer term.

So, while oil prices do not “cause” the gold price to rise – or fall – the economic environment that leads to a surge in oil can also result in higher gold prices.

The war in Ukraine is one such environment, as it stems from a geopolitical event with likely significant economic consequences, as well as an impact on energy prices, other commodities, and additional supply-chain disruptions more generally.

Indeed, commodity prices have risen exponentially in recent weeks. And while this could extend if the war continues, any potential resolution may bring prices crashing down. However, we don’t believe gold would see the same level of volatility even if it experiences a price correction. Gold supply has not experienced the same magnitude of disruption as other commodities and, in any case, vast above-ground stocks and much higher trading volumes of physical gold reduce the impact of newly mined supply. Some of the recent more tactical positions on gold could be liquidated, but we suspect that the surge in demand has also been driven by more strategic investors, looking for longer-term diversification and risk hedging which, together with opportunistic buying should the gold price fall, could cushion the potential pullback.

Chart 1: There is no consistent long-term relationship between gold and oil

Two-year rolling correlation between gold and oil returns*

How likely is it that the global economy falls into stagflation and how may gold perform in this environment?

The risk of stagflation around the world is certainly rising. Europe may feel it most acutely, fuelled by a combination of soaring commodity prices, energy dependency, and a weaker economic and financial environment – all of this now exacerbated by the war in Ukraine.

And while stagflation is also a risk for the US, it may not reel to the same extent. Both hard and soft economic data still signal that the US economy is resilient. However, if the spread between long and short maturity US Treasury bonds – a historically reliable bellwether for the economy – continues to flatten or inverts, it may signal that market participants anticipate a contraction down the line. Should energy and food prices stay high, stagflation risks might just be realised.

In October last year we wrote about gold’s historical performance during stagflationary conditions. With these risks now rising again we want to highlight the findings of that analysis. Needless to say, stagflationary environments are not good at all for financial markets, nor the economy. Slowing incomes and rising prices are an uneasy combination to say the least. Equities are historically hit hardest, while commodities and gold have done well (Chart 2). We are already seeing these dynamics play out in the beginning of 2022 and gold appears to be doing exactly what investors would expect it to. Performing well as a hedge when other assets are not.

Chart 2: Gold has historically performed well in periods of stagflation

Annualised average adjusted return (AAAR) for major asset classes since Q1 1973*

Could recent geopolitical developments, including the war in Ukraine, change the role of the US dollar in foreign reserves and global trade?

The role of the US dollar in international trade is well established, but the world has been slowly moving towards a more “multicurrency” system, especially with the increasing relevance of China in international trade. While gold is not an official currency, it’s an important part of the monetary system, especially in its role as a high-quality and liquid component to foreign reserves. In addition, contrary to fiat currencies, gold bullion is no one’s liability. And while it’s not often used as a direct means of exchange, it’s often an invaluable source of collateral and a hedge against systemic risk events. This partly explains the increase in demand for gold by central banks over the past decade (Chart 3), especially those from emerging markets that historically had a large percentage of US dollar assets in their foreign reserves.

Chart 3: Gold has been increasing as a strategic component to foreign reserves

Gold as a percentage of world foreign reserves*