The yen (JPY) has weakened significantly during the first half of 2022: it has registered an 18% depreciation against the US dollar (USD) and now the JPY/USD stands at its lowest point since 1998. Three main factors have weighed on the yen (Chart 1):
There has been a sharp widening of the interest rate spread between Japan and other key markets, such as the US, as the Bank of Japan (BoJ) continues its ultra-easing monetary policy to support the local economic recovery; in contrast, other major central banks are accelerating their tightening policies to cool inflationary pressure
Japan’s worsening trade deficit – driven by higher raw material costs and a growth slowdown in major export markets such as China – has contributed to local currency weakness
Chart 1: Widening US-Japan yield spread (left) and trade account deficit (right) weighed on the JPY
Source: Bloomberg, World Gold Council
Concerns about slower economic growth and higher costs have not only weighed on the local currency, but also negatively impacted local assets. For instance, the Nikkei 225 stock index has fallen by over 8% in H1 2022 and the local bond index has dropped by 5%.1
But gold’s performance in yen has benefited from this currency weakness. This year uncertainties across the globe, including rising inflation, heightened geopolitical risks and higher financial market volatility, have pushed up the price of gold despite higher interest rates in major regions. And while the international gold price gain was limited by a stronger dollar amid the US Fed’s aggressive rate hikes, its performance in yen staged a 19% return y-t-d (Chart 2).2
Chart 2: Gold – in JPY – has outperformed major Japanese assets
*Based on the Bloomberg Commodity Index, LBMA Gold Price PM, the TOPIX Real Estate Index, the Bloomberg Japan Aggregate Total Return Index, the Nomura BPI JGB Index, the TOPIX Index, the MSCI Japan Index and the Nikkei 225 Stock Index between 31 December 2021 and 30 June 2022. All calculations are in yen.
Source: Bloomberg, World Gold Council
As an asset universally owned and traded, gold is subject to the law of one price: gold’s value should remain the same to investors in every market across various currencies after factoring in additional costs3, otherwise there will be arbitrage opportunities. This has been the primary driver of gold’s strong performance in non-US currencies as gold’s price in a country’s own currency changes relative to the currency’s value:
Table 1: Gold’s performances in various currencies shows its strength*
Turkish lira
Japanese yen
Pound sterling
Euro
Indian rupee
Chinese renminbi
Australian dollar
Gold's performance in the currency
26.81%
18.52%
11.43%
8.6%
6.65%
4.77%
5.57%
Currency performance against USD
25.51%
17.94%
11.08%
8.48%
6.24%
5.4%
5.19%
*Based on daily data of LBMA Gold Price PM in these currencies and their value relative to the US dollar between 31 December 2021 and 30 June 2022.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
There is an important implication here: gold can help preserve purchasing power. And this may be particularly relevant for Japanese households and investors in the current environment. The yen’s sharp depreciation has compounded significant price increases in the global commodities upon which Japan relies, particularly energy (over 90% of Japan’s energy supply comes from abroad4).
But when we measure the value of commodities by gold, we find that price increases are more moderate than when measured in yen – currency weakness is offset by the strength of gold in yen, as previously mentioned (Chart 3).
Chart 3: Commodity price surges were milder when measured by gold
*Commodities’ value in gold is calculated by dividing the commodity price by gold’s price during the same period. Comparison made between 31 December 2021 and 30 June 2022. All calculations are in yen.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
What does this imply? It points to the fact that gold, compared to fiat currencies, could help local consumers hedge a reduction in their purchasing power. And when we look further back into history, gold’s ability to hedge against purchasing power deterioration becomes much more evident (Chart 4).
Chart 4: Fiat currencies and commodities have deteriorated in value relative to gold
* As of 30 June 2020. Relative value between ‘gold’: LBMA Gold Price PM, ‘commodities’: Bloomberg Commodity Index, and major currencies since 2000. Value of commodities and currencies measured in ounces of gold and indexed to 100 in January 2000.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
Gold’s store of value is underpinned by its stable demand and supply dynamics. Unlike currencies, whose supplies have expanded at a significant pace, especially after the 2008 Global Financial Crisis, mined gold production has averaged 1.6% y-o-y growth during the past 20 years. And diversity in the sources of gold demand – investment and consumption – has contributed to gold’s stable value over time.
As KURODA stated recently, the BoJ is likely to stick with its ultra-easing monetary policy to accommodate the nation’s economic recovery. So the divergence in interest rates between Japan and other key markets such as the US is likely to continue. Meanwhile, with the price of raw materials remaining elevated, Japan’s trade deficit could apply further pressure on the yen.5 A cloudy outlook for the currency will likely continue to negatively impact on the purchasing power of Japanese households, especially when local inflation is rising fast.6 Gold, with its ability to protect purchasing power and hedge against inflation, may become a more relevant asset in Japan going forward.
Footnotes
1 Calculations are based on the Nikkei 225 stock index and the Nomura BPI JGB index between 31 December 2021 and 30 June 2022.
2 Based on daily data of the Bloomberg US dollar index; on 13 May the DXY index reached its highest since early 2003. Return calculation is based on changes between 31 December 2021 and 30 June 2022.
3 These additional costs may include freight, premium/discounts related to local demand and supply changes, as well as local market policy restrictions.
Gold has fallen more than US$100/oz over the past month, with the bulk of the decline occurring over two days last week. After trading quietly around US$1,810/oz during the July 4th US Independence Day holiday, gold fell to around US$1,770/oz on Tuesday and then to around US$1,740/oz on Wednesday, where it has remained since.
Two major financial indicators appear involved in the move. Firstly, the US dollar has strengthened sharply this week, especially when looking at the trade-weighted DXY index from Bloomberg as a proxy for US dollar strength. Economic weakness in Europe, yen weakness on a failure by Japan to address inflation and political turmoil in the UK are amongst the reasons for the strength of the greenback. Secondly, industrial commodity weakness has been closely associated with the move in gold. There has been a tight correlation between moves in crude oil and gold over the past few days (Chart 1), but other metals have fallen hard too, with copper at lows not seen since late 2020.
Chart 1: Brent crude and gold have been trading closely over the past few days
Notes: 10-minute intraday price bars of spot gold and ICE Brent futures. Gaps in the Brent crude price represent non-trading hours.
Source: Bloomberg, World Gold Council
Recent investment flows in gold have been weak. COMEX gold futures net longs have fallen over the past few weeks and as of last Tuesday – the latest available data – net longs were at their lowest for three years. Most of this move was due to new shorts entering the market. And following two consecutive months of net outflows, gold ETFs have seen a further 25t of outflows month-to-date in July.
We feel there are three major underlying reasons for what has been happening:
US economic expectations have shifted from extreme worries about inflation towards growing fears of recession and this has led to a reshuffling of portfolio positioning. Broad-based commodity index selling has occurred, with investors cutting exposure across all commodities (Chart 2), and this has contributed to weakness in gold.
Secondly, the Fed is talking and acting more aggressively than other major central banks, which is supporting the dollar on expected and realised interest rate differentials. Europe and the UK are stuck with high inflation caused by energy prices rather than domestic demand, so the central banks are being understandably slow to hike here.
Finally, momentum in gold has played a role. It is likely speculative traders who play gold in the short term were watching US$1800/oz as a key level and, when this gave way, were quick to cut longs or add to shorts. Seasonally, although a poor rationale to trade anything, gold is often weak in the summer, and this adds to their negativity on gold and news of the India duty hike will only have helped that view.
Chart 2: Speculative traders have exited commodity positions en masse in recent weeks
Notes: Average futures net long as a share of open interest across 24 commodities. Net long = non-commercial long + non-reportable long – non-commercial short – non-reportable short. Combined futures and options contracts.
James Grant, noted economic expert and Founder and Editor of Grant’s Interest Rate Observer, joined us to share timely insights on key topics including:
Potential inflation scenarios and economic growth outcomes including stagflation, recession and a “soft landing”
I recently presented virtually at Pension Bridge Alternatives APAC - Mid Year Review, and discussed gold's strategic role in a portfolio. I shared key factors that make gold a strategic asset, and then explored gold's recent performance, drawing on some of our latest research pieces, like Gold Demand Trends.
Rising rates and a strong dollar have had a significant negative effect on gold’s performance despite support from geopolitics and inflation
We believe gold’s headwinds may start to subside while supportive factors will likely remain, thus encouraging demand for gold as a long-term investment hedge
Many of the investors we talk to feel that gold’s performance should be much stronger considering multi-decade high inflation across the world. Yet, what may not be evident to everyone is that gold has outperformed most major assets so far in 2022 (Chart 1). In fact, gold has done much better than inflation-linked bonds both in the US and elsewhere. And we believe that gold’s performance so far this year reflects the behaviour of its underlying drivers.
Chart 1: Gold has been a top-performing asset so far in 2022*
*As of 21 September 2022. Based on Bloomberg Commodity Index, US Dollar Spot Index, BofA US 3-month Treasury Bill Index, LBMA Gold Price PM, Bloomberg US TIPs Index, Bloomberg US Agg Bond Index, Bloomberg Global Agg Bond Index, S&P 500 Index, MSCI World Index, Bloomberg Global Inflation-linked Agg Index, MSCI EM Index and NASDAQ Composite Index between All calculations are in USD. Source: Bloomberg, ICE Benchmark Administration, World Gold Council
Let us expand. Gold is generally driven by four key drivers: economic expansion; risk and uncertainty; opportunity cost; and momentum.
In 2022, gold has been supported by greater risk and uncertainty, the most obvious coming from geopolitical tensions. High inflation has also been a contributing factor – but not all investors have perceived the inflation risk in the same way. This is most clearly seen by the stark difference between US CPI and long-term inflation expectations implied by the bond market (Chart 2). In short, while inflation has been high, US bond investors believe that the Fed will do whatever is necessary to bring inflation down and will do so effectively. Not all investors may agree.
Chart 2: Bond investors expect the Fed to effectively bring inflation down*
*Data as of 31 August 2022. Based on US CPI y-o-y and US 5yr-5y forward breakeven rate (as implied by the difference in real and nominal forward yields). Source: Bloomberg, World Gold Council
Gold has also had to contend with much higher opportunity costs: both from continuously increasing interest rates and the strongest US dollar for 20 years.1 A commonly used simple (but reductive) model for gold – based solely on real rates and the dollar – suggests that gold should have fallen by more than 30% thus far (Chart 3). Further, our Gold Return Attribution Model (GRAM) indicates that negative investor sentiment, with heavy gold ETF outflows and weak positioning in the futures market, has put additional pressure on gold. Weak Chinese demand earlier in the year did not help either.
The fact that gold has performed as well as it has, all things considered, is a testament to its global appeal and more nuanced reaction to a wider set of variables.
Chart 3: The gold price would’ve been much weaker if it were solely determined by interest rates and the dollar
*As of 31 August 2022. Model estimated using OLS, in levels, using data from Jan 2007 to August 2022.
Sources: Bloomberg, ICE Benchmark Administration, World Gold Council
Looking forward…
We believe that both interest rates and the dollar still pose risks for gold.
With central banks playing catch up, the frequency and magnitude of these decisions has resulted in markets being more sensitive than usual to monetary policy – and gold has been no exception.
However, we are cautiously optimistic. For one, given how much tightening has occurred so far, we would expect rate hikes to slow down, allowing some of gold’s other supporting factors to play a more important role. Also, the fact the other central banks are being more resolute in their policy decisions – partly to curb inflation, partly to defend their currencies – should weigh on the US dollar.
Further, positioning in gold futures has turned net short again and this, historically, has not lasted long – often mean reverting in subsequent weeks. At the same time, central bank demand for gold remains quite strong. Finally, as recessionary and geopolitical risks increase, 2 investors may shift to more defensive strategies, looking for high quality liquid assets such as gold to reduce portfolio losses.
footnotes
1. For example, in the 1970’s, in addition to rising inflation, gold was also supported by a weakening dollar
UK financial markets have gone into full-blown crisis in the last few weeks. The government’s ‘mini-budget’ announcement on the 23rd September was poorly received by global investors, leading to a sharp spike in UK government bond volatility. One consequence of this was severe dysfunction in the liability-driven investment (LDI) market, forcing the BoE to step in. As this turmoil may prompt pension schemes to reconsider their strategic asset allocations, we look at how gold could have and can play a role in defined benefit (DB) pension schemes.
Where does an LDI strategy fit in a pension scheme structure?
The key objective of a pension scheme is to pay its members the benefits they’re owed as and when they fall due. And for so long as a scheme has a funding deficit, it will need to invest in both growth assets to earn a suitable level of return and assets that move in line with the value of its liabilities. In other words, assets that, like the value of its liabilities, are sensitive to fluctuations in interest rate and inflation i.e. UK gilts and UK inflation-linked bonds (Chart 1).
Chart 1: The value of liabilities are responsive to UK gilt yields
S179 Liabilities using data from the Pension Protection Fund (PPF) and 25yr UK gilt yields
Sources: Bloomberg, Pension Protection Fund, World Gold Council
*Data as of 31 August 2022.
It is however difficult for a scheme to achieve this twin objective of closing a funding deficit and hedging interest rate and inflation risks without introducing leverage. And whilst leverage could be introduced in the growth portfolio, options to do so are typically limited. As a result, leverage has historically been introduced in the matching portfolio through an LDI strategy, enabling the pension scheme to then invest in a wide range of growth assets (equities, high yield, emerging market debt, private assets etc.).
How is LDI collateral managed and what happened between September 23 and 28?
Since the start of 2022, yields on long-dated gilts have increased 2% reaching 3.2% on 31st August. For UK DB schemes not fully hedged, this has provided a welcome tailwind to funding positions by decreasing the present value of liabilities relative to the value of assets. In fact, the Pension Protection Fund (PPF) has recently estimated that aggregate pension funding position has improved by £185bn over that period (Chart 2).
Chart 2: Rising yields provided a welcome tailwind to aggregate pension funding positions
Historical aggregate funding position of schemes in the PPF universe and 25yr UK gilt yield*
Sources: Bloomberg, Pension Protection Fund, World Gold Council
*Data as of 31 August 2022. Funding position calculated as assets less ‘s179’ liabilities
Whilst rising interest rates (and falling liabilities) have tended to improve funding positions, they have also resulted in increased collateral calls due to the falling values in LDI assets. To be clear, this is to be expected as the aim of LDI is to mirror the movements in pension scheme liabilities. Against this backdrop, for schemes engaged in leveraged LDI, collateral calls have been frequent in the first 8 months of the year.
And up until September 23, the adjustments to collateral pools fluctuated gradually over time, enabling pension funds to follow their trusted process to source cash - initially from predetermined liquidity positions and then from other assets within the wider portfolio, as deemed appropriate. Realising the latter assets was however not immediate. It sometimes took a few days before the proceeds of any sale could be moved into the LDI portfolio to replenish the collateral pool.
The ‘mini-budget’ heaped more pressure on LDI strategies
With easily realisable assets already running low, the scale and speed of the rise in interest rates triggered by the government’s tax cut announcement on the 23rd September placed enormous strain on the system. 30-year real yields moved up circa 2% in three trading sessions and there was simply not enough time to get the required assets in to the LDI funds to meet the unprecedented margin calls.
It is these margin calls on levered fixed income positions that resulted in disorderly selling. The shortage of immediately available liquidity combined with a feedback loop in the process by which some derivatives position were being cup (to reduce leverage) led to a set of circumstances in which the market was very close to a vicious circle. The events forced the Bank of England to step in by announcing it would buy long-dated UK government bonds to stabilise the market. And although we’ve seen some short term relief in the gilt market, the movements since early October show that these troublesome circumstances remain (Chart 3).
Chart 3: 30-year Real Gilt Yields – recent movements
Sources: Bloomberg, World Gold Council
An opportunity for gold?
Pension funds will always want to manage their investments in a liability-aware manner. But recent UK market moves may prompt them to reconsider how their strategic asset allocations need to evolve. We feel this could present an opportunity for gold.
Indeed, gold’s traditional role as a safe-haven asset means it comes into its own during times of high market uncertainty as witnessed over the last few weeks. Whilst the BoE’s intervention helped to temporarily bring down yields in longer-dated bonds, the gilt market remains under pressure along with other assets typically held by pension funds. Sterling corporate bonds were down over 8% in the 2 weeks following the ‘mini-budget’ while the UK’s domestically focussed FTSE 250 index fell more than 7%. Gold, on the other hand, posted positive returns (Chart 4).
In times of market stress, with a broad range of pension assets falling in value, holding effective diversifiers such as the precious metal can help alleviate pressures. In other words, utilising a gold allocation as a source of liquidity could have reduced the amount of forced-selling in other assets already subject to price pressures, given them more time to recover.
Chart 4: Post mini-budget returns (£) for gold versus UK bonds and UK equities
Sources: Bloomberg, World Gold Council
*Data from 23 September to 11 October 2022
Moreover, the long-term implication of last week’s events might be that pension schemes reconsider the level of illiquidity in their portfolios. Private debt, private equity or real estate all have some compelling investment characteristics but schemes need to be confident they have sufficient liquid assets in their portfolio and can rebalance quickly across their funds.
In effect, there is now a risk that haircuts will need to be taken to realise illiquid assets. The gold market on the other hand is large, global, and highly liquid. It is also more liquid than several major financial markets, including euro/yen and UK gilts, while trading volumes are like those of US 1-3 year treasuries (Chart 5).
Chart 5: Gold trades more than many other major financial assets
One-year average trading volumes of a number of major assets in £*
Sources: Bloomberg, Bank for International Settlements, UK Debt Management Office (DMO), Germany Finance Agency, Japan Securities Dealers Association, World Gold Council
*Average daily volumes from 1 January 2021 to 31 December 2021.
**Gold liquidity includes estimates of OTC transactions and published statistics on futures exchanges, and gold-backed exchange-traded products.
The scale and depth of the market mean that it can also comfortably accommodate large, buy-and-hold institutional investors. And in stark contrast to many financial markets, gold’s liquidity does not dry up, even at times of financial stress, making it a compelling addition to a DB portfolio.
Food for thought as pension schemes digest the recent collateral squeeze and reassess their strategic asset allocations...
Cathy Hackl, Chief Metaverse Officer and Co-Founder at Journey, joins us for the latest episode of our Strategic Edge video interview series. In conversation with our North America Chief Market Strategist, Joe Cavatoni, this two-part video explores the Metaverse – what it is, what it means for the world – and the future of the gold market.
As inflation continues to bite, the risk of stagflation has not disappeared. As a reaction, gold has been attracting attention from Australian investors due to its historical superior returns during such periods.
The potential bumpy road ahead
Markets may be vulnerable to negative shocks this year, notably stagflation. In Q4 2022, the CPI rose 7.8% y-o-y, the fastest pace in 32 years.1 (Chart 1). As the RBA noted in its February meeting, while inflation rose higher than expected, wage growth continued to pick up – this could in turn put further pressure on inflation. Additionally, the central bank dialled down its growth projection further, to 1.5% over 2023.2 Slower global growth and tighter financial conditions were cited as main concerns.
Chart 1: Australia’s inflation kept soaring while GDP growth is set to weaken*
*Note: 2022 Q4 GDP growth based on Bloomberg’s economists’ median forecast.
Inflation implications
Elevated inflation can, broadly speaking, create issues for investors. The correlation between bonds and equities tends to rise during high-inflationary periods (as evidenced in our investment update). Gold, on the other hand, has long been considered a hedge against inflation, and historical data confirms this (Chart 2). Also, gold’s annualised return of 7.6% in AUD over the past 20 years has outpaced the Australian and world CPIs.3
Chart 2: Gold has historically performed well in periods of high inflation
Major asset returns in AUD as a function of quarterly inflation*
*Based on Australian quarterly CPI, AusBond 0+ Composite Index, Bloomberg Barclay Global Agg, ASX300 Index and MSCI World Index between Q4 1992 and Q4 2022 due to data availability. All calculations in AUD.
Source: Bloomberg, World Gold Council
And should stagflation arise?
It poses significant challenges to super portfolios as it can severely disrupt financial markets and hamper the performance of major assets. Historical data shows that gold has benefited investors with attractive returns during such periods (Chart 3).
Chart 3: Gold, in AUD, has delivered superior performances during stagflation periods in Australia*
*Data between Q1 1973 and Q4 2022. Part of the indices only date back to 1990s. All calculations in AUD. Based on quarterly data of Australian GDP, CPI, LBMA Gold Price PM, AusBond 0+ Composite Index, Bloomberg Barclay Global Agg, ASX300 Index, MSCI World Index and Bloomberg Commodity Index.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
The 2023 headwinds for supers are not set to ease up. Against this backdrop, gold may have a significant role to play over the coming year and beyond to help protect portfolio performance and deliver upon member expectations.
Gold, an effective store of value amid yen weakness
Ray Jia
Head of Research (Asia Pacific, ex-India) and Deputy Head of Trade Engagement (China) World Gold CouncilThe yen (JPY) has weakened significantly during the first half of 2022: it has registered an 18% depreciation against the US dollar (USD) and now the JPY/USD stands at its lowest point since 1998. Three main factors have weighed on the yen (Chart 1):
Chart 1: Widening US-Japan yield spread (left) and trade account deficit (right) weighed on the JPY
Source: Bloomberg, World Gold Council
Concerns about slower economic growth and higher costs have not only weighed on the local currency, but also negatively impacted local assets. For instance, the Nikkei 225 stock index has fallen by over 8% in H1 2022 and the local bond index has dropped by 5%.1
But gold’s performance in yen has benefited from this currency weakness. This year uncertainties across the globe, including rising inflation, heightened geopolitical risks and higher financial market volatility, have pushed up the price of gold despite higher interest rates in major regions. And while the international gold price gain was limited by a stronger dollar amid the US Fed’s aggressive rate hikes, its performance in yen staged a 19% return y-t-d (Chart 2).2
Chart 2: Gold – in JPY – has outperformed major Japanese assets
*Based on the Bloomberg Commodity Index, LBMA Gold Price PM, the TOPIX Real Estate Index, the Bloomberg Japan Aggregate Total Return Index, the Nomura BPI JGB Index, the TOPIX Index, the MSCI Japan Index and the Nikkei 225 Stock Index between 31 December 2021 and 30 June 2022. All calculations are in yen.
Source: Bloomberg, World Gold Council
As an asset universally owned and traded, gold is subject to the law of one price: gold’s value should remain the same to investors in every market across various currencies after factoring in additional costs3, otherwise there will be arbitrage opportunities. This has been the primary driver of gold’s strong performance in non-US currencies as gold’s price in a country’s own currency changes relative to the currency’s value:
Table 1: Gold’s performances in various currencies shows its strength*
*Based on daily data of LBMA Gold Price PM in these currencies and their value relative to the US dollar between 31 December 2021 and 30 June 2022.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
There is an important implication here: gold can help preserve purchasing power. And this may be particularly relevant for Japanese households and investors in the current environment. The yen’s sharp depreciation has compounded significant price increases in the global commodities upon which Japan relies, particularly energy (over 90% of Japan’s energy supply comes from abroad4).
But when we measure the value of commodities by gold, we find that price increases are more moderate than when measured in yen – currency weakness is offset by the strength of gold in yen, as previously mentioned (Chart 3).
Chart 3: Commodity price surges were milder when measured by gold
*Commodities’ value in gold is calculated by dividing the commodity price by gold’s price during the same period. Comparison made between 31 December 2021 and 30 June 2022. All calculations are in yen.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
What does this imply? It points to the fact that gold, compared to fiat currencies, could help local consumers hedge a reduction in their purchasing power. And when we look further back into history, gold’s ability to hedge against purchasing power deterioration becomes much more evident (Chart 4).
Chart 4: Fiat currencies and commodities have deteriorated in value relative to gold
* As of 30 June 2020. Relative value between ‘gold’: LBMA Gold Price PM, ‘commodities’: Bloomberg Commodity Index, and major currencies since 2000. Value of commodities and currencies measured in ounces of gold and indexed to 100 in January 2000.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
Gold’s store of value is underpinned by its stable demand and supply dynamics. Unlike currencies, whose supplies have expanded at a significant pace, especially after the 2008 Global Financial Crisis, mined gold production has averaged 1.6% y-o-y growth during the past 20 years. And diversity in the sources of gold demand – investment and consumption – has contributed to gold’s stable value over time.
As KURODA stated recently, the BoJ is likely to stick with its ultra-easing monetary policy to accommodate the nation’s economic recovery. So the divergence in interest rates between Japan and other key markets such as the US is likely to continue. Meanwhile, with the price of raw materials remaining elevated, Japan’s trade deficit could apply further pressure on the yen.5 A cloudy outlook for the currency will likely continue to negatively impact on the purchasing power of Japanese households, especially when local inflation is rising fast.6 Gold, with its ability to protect purchasing power and hedge against inflation, may become a more relevant asset in Japan going forward.
Footnotes
1 Calculations are based on the Nikkei 225 stock index and the Nomura BPI JGB index between 31 December 2021 and 30 June 2022.
2 Based on daily data of the Bloomberg US dollar index; on 13 May the DXY index reached its highest since early 2003. Return calculation is based on changes between 31 December 2021 and 30 June 2022.
3 These additional costs may include freight, premium/discounts related to local demand and supply changes, as well as local market policy restrictions.
4 For more information, see: Japan's Vulnerable Energy Supply Situation - The Federation of Electric Power Companies of Japan(FEPC)
5 For more information, see: Global Economic Prospects June 2022 (worldbank.org)
6 For more information, see Japan Inflation Rate (CPI) - Japan Economy Forecast & Outlook (focus-economics.com)
Recent moves in gold
John Reade
Senior Market Strategist World Gold CouncilGold has fallen more than US$100/oz over the past month, with the bulk of the decline occurring over two days last week. After trading quietly around US$1,810/oz during the July 4th US Independence Day holiday, gold fell to around US$1,770/oz on Tuesday and then to around US$1,740/oz on Wednesday, where it has remained since.
Two major financial indicators appear involved in the move. Firstly, the US dollar has strengthened sharply this week, especially when looking at the trade-weighted DXY index from Bloomberg as a proxy for US dollar strength. Economic weakness in Europe, yen weakness on a failure by Japan to address inflation and political turmoil in the UK are amongst the reasons for the strength of the greenback. Secondly, industrial commodity weakness has been closely associated with the move in gold. There has been a tight correlation between moves in crude oil and gold over the past few days (Chart 1), but other metals have fallen hard too, with copper at lows not seen since late 2020.
Chart 1: Brent crude and gold have been trading closely over the past few days
Notes: 10-minute intraday price bars of spot gold and ICE Brent futures. Gaps in the Brent crude price represent non-trading hours.
Source: Bloomberg, World Gold Council
Recent investment flows in gold have been weak. COMEX gold futures net longs have fallen over the past few weeks and as of last Tuesday – the latest available data – net longs were at their lowest for three years. Most of this move was due to new shorts entering the market. And following two consecutive months of net outflows, gold ETFs have seen a further 25t of outflows month-to-date in July.
We feel there are three major underlying reasons for what has been happening:
Chart 2: Speculative traders have exited commodity positions en masse in recent weeks
Notes: Average futures net long as a share of open interest across 24 commodities. Net long = non-commercial long + non-reportable long – non-commercial short – non-reportable short. Combined futures and options contracts.
Source: Bloomberg, World Gold Council
Webcast: James Grant on inflation, rates, and geopolitical uncertainty
World Gold Council
The experts on goldJames Grant, noted economic expert and Founder and Editor of Grant’s Interest Rate Observer, joined us to share timely insights on key topics including:
Potential inflation scenarios and economic growth outcomes including stagflation, recession and a “soft landing”
Long-term implications of global monetary policy
Rethinking asset allocation amid increasing bond-equity correlations
Gold outlook: drivers and performance
Watch the conversation below.
Tipping the scales: gold's weight as a strategic asset
John Reade
Senior Market Strategist World Gold CouncilI recently presented virtually at Pension Bridge Alternatives APAC - Mid Year Review, and discussed gold's strategic role in a portfolio. I shared key factors that make gold a strategic asset, and then explored gold's recent performance, drawing on some of our latest research pieces, like Gold Demand Trends.
Enjoy the recording below!
You asked, we answered: Why has gold not performed better in 2022 despite high inflation?
Juan Carlos Artigas
Regional CEO (Americas) and Global Head of Research World Gold CouncilMany of the investors we talk to feel that gold’s performance should be much stronger considering multi-decade high inflation across the world. Yet, what may not be evident to everyone is that gold has outperformed most major assets so far in 2022 (Chart 1). In fact, gold has done much better than inflation-linked bonds both in the US and elsewhere. And we believe that gold’s performance so far this year reflects the behaviour of its underlying drivers.
Chart 1: Gold has been a top-performing asset so far in 2022*
*As of 21 September 2022. Based on Bloomberg Commodity Index, US Dollar Spot Index, BofA US 3-month Treasury Bill Index, LBMA Gold Price PM, Bloomberg US TIPs Index, Bloomberg US Agg Bond Index, Bloomberg Global Agg Bond Index, S&P 500 Index, MSCI World Index, Bloomberg Global Inflation-linked Agg Index, MSCI EM Index and NASDAQ Composite Index between All calculations are in USD.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
Let us expand. Gold is generally driven by four key drivers: economic expansion; risk and uncertainty; opportunity cost; and momentum.
In 2022, gold has been supported by greater risk and uncertainty, the most obvious coming from geopolitical tensions. High inflation has also been a contributing factor – but not all investors have perceived the inflation risk in the same way. This is most clearly seen by the stark difference between US CPI and long-term inflation expectations implied by the bond market (Chart 2). In short, while inflation has been high, US bond investors believe that the Fed will do whatever is necessary to bring inflation down and will do so effectively. Not all investors may agree.
Chart 2: Bond investors expect the Fed to effectively bring inflation down*
*Data as of 31 August 2022. Based on US CPI y-o-y and US 5yr-5y forward breakeven rate (as implied by the difference in real and nominal forward yields).
Source: Bloomberg, World Gold Council
Gold has also had to contend with much higher opportunity costs: both from continuously increasing interest rates and the strongest US dollar for 20 years.1 A commonly used simple (but reductive) model for gold – based solely on real rates and the dollar – suggests that gold should have fallen by more than 30% thus far (Chart 3). Further, our Gold Return Attribution Model (GRAM) indicates that negative investor sentiment, with heavy gold ETF outflows and weak positioning in the futures market, has put additional pressure on gold. Weak Chinese demand earlier in the year did not help either.
The fact that gold has performed as well as it has, all things considered, is a testament to its global appeal and more nuanced reaction to a wider set of variables.
Chart 3: The gold price would’ve been much weaker if it were solely determined by interest rates and the dollar
*As of 31 August 2022. Model estimated using OLS, in levels, using data from Jan 2007 to August 2022.
Sources: Bloomberg, ICE Benchmark Administration, World Gold Council
Looking forward…
We believe that both interest rates and the dollar still pose risks for gold.
Despite a sluggish start, central banks have acted aggressively to curb rising inflation. The US Fed delivered another 75bps hike this week, bringing its Fed funds target rate to 3.25%. And dot-plot projections suggest they may deliver an additional 75-125bps by year end. Similarly, the Bank of England increased its target rate by an additional 50bps and the Swiss National Bank by 75bps. Other central banks will likely follow suit.
With central banks playing catch up, the frequency and magnitude of these decisions has resulted in markets being more sensitive than usual to monetary policy – and gold has been no exception.
However, we are cautiously optimistic. For one, given how much tightening has occurred so far, we would expect rate hikes to slow down, allowing some of gold’s other supporting factors to play a more important role. Also, the fact the other central banks are being more resolute in their policy decisions – partly to curb inflation, partly to defend their currencies – should weigh on the US dollar.
Further, positioning in gold futures has turned net short again and this, historically, has not lasted long – often mean reverting in subsequent weeks. At the same time, central bank demand for gold remains quite strong. Finally, as recessionary and geopolitical risks increase, 2 investors may shift to more defensive strategies, looking for high quality liquid assets such as gold to reduce portfolio losses.
footnotes
1. For example, in the 1970’s, in addition to rising inflation, gold was also supported by a weakening dollar
2. Volodymyr Zelenskyy says Russia ‘wants war’ in rebuke of troop mobilisation | Financial Times
Reflections on a remarkable few weeks for UK DB pension schemes
Jeremy De Pessemier
Asset Allocation Strategist World Gold CouncilUK financial markets have gone into full-blown crisis in the last few weeks. The government’s ‘mini-budget’ announcement on the 23rd September was poorly received by global investors, leading to a sharp spike in UK government bond volatility. One consequence of this was severe dysfunction in the liability-driven investment (LDI) market, forcing the BoE to step in. As this turmoil may prompt pension schemes to reconsider their strategic asset allocations, we look at how gold could have and can play a role in defined benefit (DB) pension schemes.
Where does an LDI strategy fit in a pension scheme structure?
The key objective of a pension scheme is to pay its members the benefits they’re owed as and when they fall due. And for so long as a scheme has a funding deficit, it will need to invest in both growth assets to earn a suitable level of return and assets that move in line with the value of its liabilities. In other words, assets that, like the value of its liabilities, are sensitive to fluctuations in interest rate and inflation i.e. UK gilts and UK inflation-linked bonds (Chart 1).
Chart 1: The value of liabilities are responsive to UK gilt yields
S179 Liabilities using data from the Pension Protection Fund (PPF) and 25yr UK gilt yields
Sources: Bloomberg, Pension Protection Fund, World Gold Council
*Data as of 31 August 2022.
It is however difficult for a scheme to achieve this twin objective of closing a funding deficit and hedging interest rate and inflation risks without introducing leverage. And whilst leverage could be introduced in the growth portfolio, options to do so are typically limited. As a result, leverage has historically been introduced in the matching portfolio through an LDI strategy, enabling the pension scheme to then invest in a wide range of growth assets (equities, high yield, emerging market debt, private assets etc.).
How is LDI collateral managed and what happened between September 23 and 28?
Since the start of 2022, yields on long-dated gilts have increased 2% reaching 3.2% on 31st August. For UK DB schemes not fully hedged, this has provided a welcome tailwind to funding positions by decreasing the present value of liabilities relative to the value of assets. In fact, the Pension Protection Fund (PPF) has recently estimated that aggregate pension funding position has improved by £185bn over that period (Chart 2).
Chart 2: Rising yields provided a welcome tailwind to aggregate pension funding positions
Historical aggregate funding position of schemes in the PPF universe and 25yr UK gilt yield*
Sources: Bloomberg, Pension Protection Fund, World Gold Council
*Data as of 31 August 2022. Funding position calculated as assets less ‘s179’ liabilities
Whilst rising interest rates (and falling liabilities) have tended to improve funding positions, they have also resulted in increased collateral calls due to the falling values in LDI assets. To be clear, this is to be expected as the aim of LDI is to mirror the movements in pension scheme liabilities. Against this backdrop, for schemes engaged in leveraged LDI, collateral calls have been frequent in the first 8 months of the year.
And up until September 23, the adjustments to collateral pools fluctuated gradually over time, enabling pension funds to follow their trusted process to source cash - initially from predetermined liquidity positions and then from other assets within the wider portfolio, as deemed appropriate. Realising the latter assets was however not immediate. It sometimes took a few days before the proceeds of any sale could be moved into the LDI portfolio to replenish the collateral pool.
The ‘mini-budget’ heaped more pressure on LDI strategies
With easily realisable assets already running low, the scale and speed of the rise in interest rates triggered by the government’s tax cut announcement on the 23rd September placed enormous strain on the system. 30-year real yields moved up circa 2% in three trading sessions and there was simply not enough time to get the required assets in to the LDI funds to meet the unprecedented margin calls.
It is these margin calls on levered fixed income positions that resulted in disorderly selling. The shortage of immediately available liquidity combined with a feedback loop in the process by which some derivatives position were being cup (to reduce leverage) led to a set of circumstances in which the market was very close to a vicious circle. The events forced the Bank of England to step in by announcing it would buy long-dated UK government bonds to stabilise the market. And although we’ve seen some short term relief in the gilt market, the movements since early October show that these troublesome circumstances remain (Chart 3).
Chart 3: 30-year Real Gilt Yields – recent movements
Sources: Bloomberg, World Gold Council
An opportunity for gold?
Pension funds will always want to manage their investments in a liability-aware manner. But recent UK market moves may prompt them to reconsider how their strategic asset allocations need to evolve. We feel this could present an opportunity for gold.
Indeed, gold’s traditional role as a safe-haven asset means it comes into its own during times of high market uncertainty as witnessed over the last few weeks. Whilst the BoE’s intervention helped to temporarily bring down yields in longer-dated bonds, the gilt market remains under pressure along with other assets typically held by pension funds. Sterling corporate bonds were down over 8% in the 2 weeks following the ‘mini-budget’ while the UK’s domestically focussed FTSE 250 index fell more than 7%. Gold, on the other hand, posted positive returns (Chart 4).
In times of market stress, with a broad range of pension assets falling in value, holding effective diversifiers such as the precious metal can help alleviate pressures. In other words, utilising a gold allocation as a source of liquidity could have reduced the amount of forced-selling in other assets already subject to price pressures, given them more time to recover.
Chart 4: Post mini-budget returns (£) for gold versus UK bonds and UK equities
Sources: Bloomberg, World Gold Council
*Data from 23 September to 11 October 2022
Moreover, the long-term implication of last week’s events might be that pension schemes reconsider the level of illiquidity in their portfolios. Private debt, private equity or real estate all have some compelling investment characteristics but schemes need to be confident they have sufficient liquid assets in their portfolio and can rebalance quickly across their funds.
In effect, there is now a risk that haircuts will need to be taken to realise illiquid assets. The gold market on the other hand is large, global, and highly liquid. It is also more liquid than several major financial markets, including euro/yen and UK gilts, while trading volumes are like those of US 1-3 year treasuries (Chart 5).
Chart 5: Gold trades more than many other major financial assets
One-year average trading volumes of a number of major assets in £*
Sources: Bloomberg, Bank for International Settlements, UK Debt Management Office (DMO), Germany Finance Agency, Japan Securities Dealers Association, World Gold Council
*Average daily volumes from 1 January 2021 to 31 December 2021.
**Gold liquidity includes estimates of OTC transactions and published statistics on futures exchanges, and gold-backed exchange-traded products.
The scale and depth of the market mean that it can also comfortably accommodate large, buy-and-hold institutional investors. And in stark contrast to many financial markets, gold’s liquidity does not dry up, even at times of financial stress, making it a compelling addition to a DB portfolio.
Food for thought as pension schemes digest the recent collateral squeeze and reassess their strategic asset allocations...
Strategic Edge Video Series: Cathy Hackl on the Metaverse
World Gold Council
The experts on goldCathy Hackl, Chief Metaverse Officer and Co-Founder at Journey, joins us for the latest episode of our Strategic Edge video interview series. In conversation with our North America Chief Market Strategist, Joe Cavatoni, this two-part video explores the Metaverse – what it is, what it means for the world – and the future of the gold market.
Part 1
Part 2
Superannuation focus: Can gold slice through the inflation and potential stagflation headwinds?
World Gold Council
The experts on goldAs inflation continues to bite, the risk of stagflation has not disappeared. As a reaction, gold has been attracting attention from Australian investors due to its historical superior returns during such periods.
The potential bumpy road ahead
Markets may be vulnerable to negative shocks this year, notably stagflation. In Q4 2022, the CPI rose 7.8% y-o-y, the fastest pace in 32 years.1 (Chart 1). As the RBA noted in its February meeting, while inflation rose higher than expected, wage growth continued to pick up – this could in turn put further pressure on inflation. Additionally, the central bank dialled down its growth projection further, to 1.5% over 2023.2 Slower global growth and tighter financial conditions were cited as main concerns.
Chart 1: Australia’s inflation kept soaring while GDP growth is set to weaken*
*Note: 2022 Q4 GDP growth based on Bloomberg’s economists’ median forecast.
Inflation implications
Elevated inflation can, broadly speaking, create issues for investors. The correlation between bonds and equities tends to rise during high-inflationary periods (as evidenced in our investment update). Gold, on the other hand, has long been considered a hedge against inflation, and historical data confirms this (Chart 2). Also, gold’s annualised return of 7.6% in AUD over the past 20 years has outpaced the Australian and world CPIs.3
Chart 2: Gold has historically performed well in periods of high inflation
Major asset returns in AUD as a function of quarterly inflation*
*Based on Australian quarterly CPI, AusBond 0+ Composite Index, Bloomberg Barclay Global Agg, ASX300 Index and MSCI World Index between Q4 1992 and Q4 2022 due to data availability. All calculations in AUD.
Source: Bloomberg, World Gold Council
And should stagflation arise?
It poses significant challenges to super portfolios as it can severely disrupt financial markets and hamper the performance of major assets. Historical data shows that gold has benefited investors with attractive returns during such periods (Chart 3).
Chart 3: Gold, in AUD, has delivered superior performances during stagflation periods in Australia*
*Data between Q1 1973 and Q4 2022. Part of the indices only date back to 1990s. All calculations in AUD. Based on quarterly data of Australian GDP, CPI, LBMA Gold Price PM, AusBond 0+ Composite Index, Bloomberg Barclay Global Agg, ASX300 Index, MSCI World Index and Bloomberg Commodity Index.
Source: Bloomberg, ICE Benchmark Administration, World Gold Council
The 2023 headwinds for supers are not set to ease up. Against this backdrop, gold may have a significant role to play over the coming year and beyond to help protect portfolio performance and deliver upon member expectations.
Read our detailed investment update
Footnotes
1 For more, see: Australia Inflation Rate - 2022 Data - 2023 Forecast - 1951-2021 Historical - Calendar (tradingeconomics.com)
2 For more, see: Statement by Philip Lowe, Governor: Monetary Policy Decision | Media Releases | RBA
3 For more, see: Gold Price Returns | Gold Prices | World Gold Council