Why gold has overtaken bonds as the multi asset investor’s key diversifier

What drives the gold price?

With gold you have to think first about what the drivers are; it doesn’t have a cash flow and it’s not something that you can value in the traditional sense - as you would with equities or bonds - so how do you need to look at it? There are a number of factors to explore, from macroeconomic ones like growth rates, to inflation, interest rates and monetary policy. But in essence, gold pricing is driven by opportunity cost; and in this case that cost is set by real interest rates.

When real rates fall the opportunity cost for gold falls, and it tends to do well as a result. We’ve seen that in recent weeks, and even over the last several years. Tracking the real interest rate is a fairly reliable way to analyse when gold will do well or badly.

So what have we seen recently? Nominal rates have been kept, and remain, low, while at the same time we had a period in March where there was suddenly a fear-driven liquidation phase, and inflation expectations went very negative. But since then inflation expectations have started to rise and come back towards more normal levels. They’re still below long-term central bank targets, but they’re rising. So as inflation expectations rise while nominal rates are kept the same, real rates have been falling, creating a positive environment for gold prices. Indeed, we’ve seen this trend play out over the last couple of years. Since September 2018 - when equities arguably peaked versus gold and bonds - gold has outperformed the Nasdaq.

Why has gold been rising?

On the surface a surge in the gold price can seem to indicate fear in markets, and there may well be an element of that at play at the moment with geopolitical risk on the rise, but it’s not a major driver. What is perhaps more pressing, is that gold is seen as the “anti-fiat” currency. With currency investing you stand the risk of losing your purchasing power over time through inflation, and we are likely to see a period of financial repression with central banks keeping rates low, and there is a risk that with this surge in money supply and liquidity, we are indeed going to see rising inflation. For countries that have a huge debt burden, inflating away the problem is more straightforward than expecting to grow your way out of debt, particularly in an environment where productivity is so consistently low. So there is a clear incentive for economies to let inflation tick up over the longer term.

The final driver to explore is opportunity cost. We are reaching a seminal moment, where both long and short interest rates around the world have gone to zero, and the base rate is near enough at the floor. That means we’re seeing a surge in negative and low rate bonds, which leads investors to look for other diversifiers, and that’s what’s driving the investment demand for gold.

How have we been positioned?

So what have we done about all of this? For one thing we have always used gold as a diversifier, we had a modest amount going back a number of years, at around 2% or so. Then between 2017 and 2019 for different clients we increased our allocation to between 2% and 5%, adding by around 5% earlier this year, by removing exposure from broader commodities, and by a further 5% in the last few weeks. Now while there is plenty of support for the asset class, as with any investment there are also risks. In this case, while the simultaneous rise in the gold price and boom in the speculative end of the tech sector might seem at odds, in fact many of the same investors are behind the two trends. In the last few weeks retail investors on platforms like Robinhood have been crowding into silver ETFs, so doubtless there is an element of momentum behind the trade, which is always reason for caution. But on balance, this is close to an optimal environment in which to hold gold as a diversifier.

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