Gold – Losing its Lustre?

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December 2021 Monthly CiN-sights

Equity market volatility returned in the final trading days of November amid fears the new Omicron Covid-19 strain could derail the global recovery, after major US indices and the EU Stoxx600 had recorded multiple new all-time highs. The new market peaks were despite simmering inflation fears, with both US headline and core inflation rates hitting the highest levels since the early 1990’s and the EU reporting its highest YoY level on record. Markets had been supported by robust Q3 earnings in both regions and dovish central banks. The ASX200 slipped 1.33% over the month.

In Carnbrea’s Asset Allocation process, we hold and label gold as an alternative asset. By definition, this means gold should have a low, zero or inverse correlation to traditional risk classes, such as equities.

We also regard gold it as a “Defensive Alternative” where its key attribute is capital preservation in economic conditions where we expect a devaluation of “fiat”1 currencies and rampant inflation. Despite this key attribute, over the last 12 months where we have seen extraordinary levels of money supply expansion and a sharp rise in inflation, gold has been at best, lacklustre.

However, gold has many faces and often behaves counter-intuitively to what investors believe should happen. Let’s analyse the current bull factors for gold:

  • Hedge against a weak US Dollar.
  • Inflation hedge.
  • Geopolitical hedge.
  • Fiat currency debasement hedge.
  • Alternative investment to negative Interest rates (real and nominal).
  • First choice for monies seeking Safe Assets.

Gold is often viewed and traded as a proxy currency. Like the Australian dollar, gold is priced in US Dollars. So, if the world has a negative view on the USD, then gold should rise in value – as does the AUD.

As gold does not pay an interest rate and has holding costs, it can be seen as akin to a perpetual zero-coupon bond, thus is ultra-sensitive to rising interest rates (as all long-duration bonds and assets are).

Gold is often viewed as a safe haven in periods of geopolitical uncertainty.

Gold has for a long time played the role of being the safe asset of the first choice. We would argue that cash ranks in front, given flexibility and familiarity – but, only for the short term. Until Bretton Woods in 1971, when Gold was delinked from the USD and replaced with naked fiat money, gold was “money”. Gold still makes up 16.4% of Central Bank assets2, which increased their holdings by 333 tonnes in the first half of 2021 and are some 40% above long-term average holdings3.

Chart 1: The purchasing power of major currencies and commodities has significantly eroded relative to gold

Why is Gold Struggling Now?

  • A strong USD as the US economy continues to outperform the rest of the world. This is courtesy of strength in US GDP and asset markets, thus consequently gold and the AUD have been pressured.
  • Gold Prices react negatively to rising interest rates in the short term. This year we have had rising rates and expectations of further rises.
  • Geopolitical tensions. Despite fears of Chinese aggression, Iran nuclear standoffs, etc., global tensions post the recent Xi Jinping and Biden talk’s looks to be diminishing.
  • Despite claims of inflation now being unleashed, the US Treasury Inflation Protected Securities (TIPs) market, where investors go to buy inflation-linked bonds, is telling a different story.
  • Gold may be losing its role as safe haven of first choice, with competition for this role being in the form of Crypto currencies.

Chart 2: Market value of gold and crypto assets: Cryptos are eating gold’s lunch, and there’s plenty more to eat

For Gold to rise from here in the Short-Term:

  • Inflation perceived as rampant, with Central banks unwilling or unable to keep the markets inflation expectations in check.
  • With bond rates managed by Central banks at unnaturally low levels, any sharp decline in real rates (whether less positive or negative) would boost gold prices
  • Markets come to the realisation that the global economy is unable to withstand even a small rise in policy rates. Japanification of bond markets.
  • Moderate moves in the steepening of the global bond yield curve. Rates do move but the Fed is able to allow tapering and then modest incremental rate moves.
  • Geopolitical shocks.
  • More expansion of money supply by Fiat currency printing central banks whether by Covid-19 relapse or other causes.

Chart 3: Major asset classes investment growth

Role of Gold in Carnbrea Model Portfolios

In our Balanced Portfolio as part of our Alternative allocation, we target a neutral holding of gold of 3.0-4.0%, held in an unhedged currency vehicle GOLD:ASX. Unhedged, as we see gold providing benefit in a “risk-off” scenario also coinciding with a weaker “risk off” currency such as the AUD. If we were sitting in Frankfurt where German Bunds are both negative in nominal terms and even more so in real terms this percentage would be higher.

As a real asset, gold should also begin to shine when real yields (after adjusting for inflation) remain negative i.e. when the bond rate remains under the inflation rate as they are now.

We expect gold to act as an insurance policy in an environment where inflation is running at an elevated level and as a consequence of excessive money printing which acts to debase all non-real assets. As gold, once an esoteric marginal asset, has now been democratised via ETF’s, it allows retail investors the same diversification access as institutional investors.

1 Fiat currencies are all kinds of money that are made legal tender by a government decree or fiat and not pegged to a physical commodity such as gold or silver (Britannica and Wikipedia)

2 International Monetary Fund, International Financial Statistics and data files.

3 World Gold Council, Gold Demand Trends Q3 2021.

4 BCA Strategy report, 25 November 2021. [1] VanEck

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Disclaimer

This information is provided by Carnbrea & Co Limited ABN 33 004 739 655, Australian Financial Services Licence No. 233763. Any advice included in this document is general in nature and does not take into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it is appropriate to you. If a product we recommend has a Product Disclosure Statement (PDS) or a Prospectus, you should read it before making a decision. Past performance is not a reliable indicator of future performance. Derivatives are leveraged products which means gains and losses are magnified and you may lose substantially more than your initial investment. We do not endorse any information from research providers that we provide to you, unless we specifically say so.