Why Gold Is More Than Just Glitter
Gold is an important part of my portfolio. Not because I am a gold bug or because I wear gold as jewelry. I include gold because of the only free lunch in investing and that is diversification. Gold is unique as an asset class because it has very different risk and returns drivers from other asset classes. Therefore, gold has a very low correlation with other asset classes in terms of returns. Below are the respective rolling 60 days correlation between the daily returns of gold and that of some of the other common traditional asset classes.
The correlation between gold and S&P 500 fluctuates around zero over time. Gold tends to be negatively correlated with S&P 500 during a stock market crisis which makes gold a good safe haven asset.
The correlation between gold and US REITs also fluctuates around zero over time. This is similar to the correlation between gold and S&P 500 which is to be expected since US REITs and S&P 500 have a strong positive correlation.
The correlation between gold and US treasuries fluctuates around zero although they tend to be more positively correlated in recent years. The fact that gold and US treasuries are not positively correlated all the time is interesting because they are both regarded as safe-haven assets. This is useful for times when US treasuries go down together with stocks as we have seen in recent times due to inflation.
Gold is more positively correlated with treasury inflation-protected securities. This is to be expected as both are regarded as inflation hedges. But even so, the positive correlation is not strong all the time with even negative correlation at times. This again makes gold a unique inflation hedge.
Gold is a commodity and hence we expect it to be positively correlated with a broad commodity ETF such as DBC. But again, gold proves its uniqueness by having only a loosely correlated relationship with DBC. Therefore, it is important to include gold even if you already have commodities in your portfolio.
What Makes Gold Unique?
The Most Precious Of Metals
Humans just had this natural attraction to gold since ancient times because of its natural beauty. Without any interactions between civilizations, each just evolved to the state of using gold as a medium of exchange and store of value. Gold also formed the common language of trade between civilizations despite having a different spoken language. It stayed that way until the gold standard was abandoned by Richard Nixon in the 70s. But even so, central banks still hold gold as an important part of their reserves.
The Most Useful Metal?
Besides its usefulness as a medium of exchange and store of value, it may also be the most useful metal in the world. It is a good conductor of electricity, it does not tarnish or oxidize, and it is extremely malleable allowing it to be worked with, pounded, and shaped without breaking. It is so malleable that it can be rolled thin enough to let light pass through it. Because of these useful qualities, gold has many uses today even if it is no longer used to back fiat currencies.
Gold can be crafted into beautiful ornamental objects and fine jewelry. It is used in the manufacture of electronics given that it is a highly efficient conductor which can carry tiny currents and remain corrosion-free. It is even used in aerospace where extremely dependable materials are paramount.
What Drives Gold Prices?
Supply and demand is the basic factor that drives all prices. Most of the natural gold has already been mined in the past. However, if a new gold mine is discovered or new technologies allow previously inaccessible sites to be mined, this might depress the gold price from the supply side. The demand side is where things start to get more complicated so let's look at some of the factors that drive demand.
China & India
China and India have traditionally been a great source of demand for gold because of traditions. Gold jewelry has been a traditional part of the dowry for a wedding. Perhaps related to this, owning gold jewelry is considered a status symbol as well. In the past, China and India’s economic growth has fuelled demand for gold and thus increased prices. This demand has softened in recent years, in line with their stabilizing economic growth. The upshot is that any crisis that happens in China or India might hurt gold prices.
Due to the historical relationship between gold and money, gold is still perceived as a store of value. Ever since the gold standard was abolished, the fear is that governments are debasing the value of fiat money through monetary policy. And with the US dollar as the world's reserve currency, the monetary policy of the Federal Reserve is closely watched. The strength of the US dollar is seen as a gauge of fiat money debasement. When the USD is weakening, markets interpret it to mean fiat money is being debased and demand for gold goes up as it is seen as a better store of value than paper money. The opposite is true. When USD is strong, demand for gold drops which might cause the gold price to fall. This is the reason why gold and USD tend to have an inverse relationship.
Safe Haven Demand
Gold is perceived as a safe haven asset. It can store its value in real terms and provides a hedge against rising costs of living, unlike cash. Hence, during uncertain economic times and when inflation expectations go up, demand for gold goes up. Central banks have their gold reserves as a safeguard against financial turmoil and inflation. According to the 2020 Central Bank Gold Reserves Survey, central banks have cited one of the top reasons they are holding on to their gold is because of the precious metal’s performance during times of crisis.
It seems like gold has failed to protect a portfolio during the current crisis so far. SPY is down about 13% this year but GLD is also down about 3.5%. While the drop is negligible compared to other asset classes, a proper safe haven asset should be generating profits rather than losses for a portfolio. However, now that we know the major drivers for gold prices, we can understand the lackluster performance of gold better.
China is in the midst of a COVID-19 crackdown. This is on top of the earlier "common prosperity" drive which led to regulatory crackdowns on some of the big China companies. It doesn't help that the real estate sector might be on the cusp of a major crisis. This impact on one of the major demand drivers for gold is significant.
The US dollar has been on a tear since the beginning of the year due to the relative hawkishness of the Fed compared to other central banks in fighting inflation.
This is perhaps the most significant headwind for gold this year. The dollar strength seems to be abating as other central banks are catching up in their rate hikes. We are already seeing gold prices moving up recently.
Markets are dynamic and things are always changing. There is no crystal ball to tell us where prices are moving next. But from the perspective of building a resilient portfolio, as long as gold continues to be non-correlated to other asset classes and it is still behaving as expected, then it still belongs in my portfolio.