We look at whether gold’s strong recent performance can continue, given the macroeconomic backdrop the Covid-19 crisis has created.
While most risk assets buckle under the strain of the coronavirus, gold continues to shine brightly. At the time of writing, the yellow metal was up 11.3% this year, outperforming all other major asset classes globally.
A plunging stock market coupled with declining real yields has propelled the so-called “haven of last resort” to its highest level since 2012.
This has been partly fuelled by rising demand from investors in exchange-traded-funds (ETFs). According to the World Gold Council, gold-backed ETFs added 298 tonnes, or net inflows of $23 billion in the first quarter of 2020 – the highest quarterly amount ever in US dollar terms and the largest tonnage addition since 2016.
Past performance is not a guide to future performance and may not be repeated. Source: Refinitiv Datastream and Schroders. Data to 1st May 2020. Notes: Gold = Gold in USD, US treasuries = ICE BofA US Treasuries Index, Hard EM sovereign debt = ICE BofA USD Hedged Emerging Markets External Sovereign Index, Global corp = ICE BofA USD Hedged Global Corporate Index, Global HY = ICE BofA USD Hedged Global High Yield Index, Global equities = MSCI World $, EM equities = MSCI Emerging Markets Index $, Commodities = Bloomberg Commodity Index.
Two key reasons why investors are turning to gold
1. As a store of wealth. Gold is often regarded as a safe-haven asset in times of economic uncertainty because of its unique properties. It is a rare earth metal that is easily convertible into cash, has no counterparty risk and its supply growth is limited (the stock above and below ground is relatively fixed). These features make the precious metal an attractive store of wealth when other financial assets deteriorate in value.
For example, over the past four decades, gold has on average delivered positive returns during an equity market drawdown. At present, global equities have partially recovered their losses, but it is too early to say whether the worst is behind us. In the past, there have been around three “false dawns” during major equity sell-offs. The possibility of a double-digit recession or an anaemic recovery cannot be discounted. Against this backdrop, gold looks likely to remain a highly coveted asset in investor portfolios.
Past performance is not a guide to future performance and may not be repeated.
Source: Refinitiv Datastream and Schroders. Notes: S&P 500 drawdown calculated as change in index price level from peak to trough. *Exceptions in 1980-1982 can be attributed to real yields jumping from -5% to 8% while dollar debasement fears subsided, and in 1998, when the Asian Financial Crisis triggered a rapid reversal in Asian gold jewellery demand.
2. Negative real yields. A major deterrent for investing in gold is that it pays no income compared with other safe-haven assets such as bonds. In other words, there is an opportunity cost to investing in gold when your money could be earning a yield elsewhere. Hence, when real yields (i.e. adjusted for inflation) approach zero or go negative (either because inflation expectations go up, or nominal yields go down), the opportunity cost of owning a zero-yielding asset such as gold decreases. This is what has happened recently.
Over the past year, gold has rallied on the back of declining real yields, as shown below.
Past performance is not a guide to future performance and may not be repeated.
Source: Refinitiv Datastream and Schroders. Data to 23rd April 2020. Notes: real yield = 5-year US TIPS.
However, gold has not always correlated with real yields. Historically, the level of yield has determined the strength of this relationship. That is to say that, when bonds offer negative or low real returns, gold prices closely track changes in real yields. But when bonds offer high real returns, then the correlation between gold and real yields breaks down.
For example, the correlation turned sharply negative after the Global Financial Crisis (GFC) when real yields fell below zero. In contrast, for most of the 1980s and 1990s, the correlation was close to zero as real yields were higher.
Source: Refinitiv Datastream, Cleveland Fed and Schroders. Data to 31st December 2019. Notes: based on quarterly changes. Real yields = 5-year US TIPS as at end of 3-year period. Data before 1997 calculated as nominal 5-year Treasury yield minus 5-year inflation expectations.
What could further increase the price of gold?
As central banks pump an unlimited amount of monetary stimulus into the economy, real yields are likely to stay anchored around zero or negative long after the crisis has abated, as policymakers attempt to remedy the structural damage to the economy. This backdrop should support gold investment demand.
At the same time, there is the added risk of inflation overshooting once lockdowns are lifted and the economic recovery starts. Unprecedented increases in fiscal spending combined with monetary stimulus raise the possibility of inflation surpassing target levels.
Governments could be prepared to tolerate higher inflation in order to erode their skyrocketing debt burdens. Should this be the case, gold would be expected to strengthen further as investors seek refuge amid fears that their currency is being debased.
In the past, the price of gold increased significantly when the rate of inflation accelerated by at least 2% or more (i.e. annual inflation went from 1% to 3%, or 3% to 7%, etc.).
Past performance is not a guide to future performance and may not be repeated. Source: Refinitiv Datastream and Schroders. Data from January 1971 to 31 December 2019.
It is important to highlight that these debasement fears can materialise even if inflation remains under control. For example, after the GFC, aggressive quantitative easing in the US led to huge concerns that inflation would get out of control. These inflationary concerns did not materialise but that did not stop gold from rallying in the interim. However, now that extraordinary fiscal stimulus has been added to the policy mix, this time could be different.
Investment demand likely to outweigh collapse in jewellery demand
As well as being a monetary asset, gold is also a commodity used in jewellery and to a lesser extent technology. According to the World Gold Council, these two sources together accounted for 53% of total annual gold demand in 2019. Both are correlated with the economic cycle. So one possibility that cannot be ruled out is that jewellery and technology demand for gold collapses as a result of a significant long-term drop in people’s wealth.
We are already seeing a drop in demand, at least in the short-term, as the two largest jewellery markets, China and India, weaken and defer jewellery purchases. However, we believe that increased investment demand for gold is likely to outweigh the “wealth” effect for a number of reasons.
First, gold is more heavily traded today than in the past. Since 2000, the share of gold demand coming from investments and central bank holdings has grown from 16% to 47% today. This means monetary demand has become a more important driver of the gold price. Second, in the aftermath of the GFC, gold prices increased on the back of rising investment demand despite weaker jewellery purchases. Third, similar to 2008, global central banks are likely to dial up their gold purchases to protect their balance sheets and diversify away from negative real yielding assets. These factors should shore up the price of gold.
Past performance is not a guide to future performance and may not be repeated.
Source: Refinitiv Datastream and Schroders. Data to 2019.
Mine production unlikely to dent rally
Another scenario that could constrain gold is that gold miners capitalise on higher prices by ramping up mining production. For example, the volume of mined gold increased between 2008 and 2010, at the same time that the price of gold was surging. However, in reality, this production increase was a function of gold price increases which occurred several years earlier, as there is a long lag between gold discoveries and miners entering production.
Overall gold mine supply is quite inelastic in its relationship to price. Gold prices rose from an average US$310/Oz in 2002 to US$1950/Oz in 2011 (+650%).
Gold mine supply increased from 2.6 kiloton to 2.86 kiloton over the same period (+9%). In the short run, changes in the supply of scrap gold (recycled jewellery or industrial by-products) can be far larger than changes in mine supply, and are much more price sensitive.
Could a strong dollar hurt gold?
As gold is priced in US dollars, there is generally an inverse relationship between gold returns and the strength of the US dollar. When the dollar strengthens, gold becomes more expensive for non-dollar investors, which decreases demand for gold. Despite this, the correlation has recently become quite muted. This should not be too surprising as both gold and the dollar are perceived as safe-haven assets and both have risen this year. Ultimately, a strong dollar alone is not sufficient to hold back gold.
Gold as an insurance policy
The prospect of an extended market drawdown, depressed real yields and higher inflation should drive gold prices higher over the coming years. While weaker jewellery purchases combined with a strong dollar may act as a drag on gold, they are unlikely to trump gold’s status as the safe haven of last resort.
Against this backdrop, investors might be wise to allocate at least some portion of their portfolio to gold to hedge against the possibility of further macroeconomic headwinds. And even if things turn out to be better than expected, at least investors can sleep at night knowing they were protected.
Gold bullion or gold equities? The view from our fund manager James Luke:
“On a relative basis the outlook for gold equities is stronger today than at any point in the last 20 years. Gold producers are generating margins roughly 200% higher than at the peak of the last bull market in 2011. Gold producer equities are reflecting gold prices that are significantly below current spot prices. The macro environment that is driving current gold price strength is particularly favourable to gold producer profitability. Revenue is going up, while costs are firmly anchored.
“Essentially, we believe that gold miners produce a monetary asset for which the long-term outlook is very strong. However, they are currently valued at very depressed commodity producer valuations. This is partly due to the inability of the sector to generate strong returns in the recent past – particularly between 2005 to 2015.
«The reality is that gold producers today are in a very different position to previous years both in terms of return generation and management discipline.
«As an example, even after the recent correction in gold prices, gold producers are earning all-in-cost margins which are close to double those seen at the top of the previous gold bull market in 2011. By contrast, valuations are far lower. As the macro environment shifts, we think that 2020, even if there is more short-term stress, will come to be viewed as a historic turning point for the sector.
“Overall, then, the case for having a gold allocation split between gold bullion and gold equities (primarily gold producers) is strong. Investors understandably worry about the additional volatility of gold equities, as well as the risk that in deep equity market corrections gold equities dislocate from the gold price. The reality is that this risk exists for both the gold bullion price and gold equity prices.
«March 2020 can now be added to September 2008 as periods when gold and gold equities in theory should have been rising, but instead fell. That said, as long as we take a longer term view, it can be said with confidence that the dramatic macro shifts being triggered by crisis events, are very positive for both gold and the gold producers. In 2008 the crisis led to QE policies. Covid-19 is leading to combined QE/fiscal policies of an unprecedented size, which are also likely to trigger (and potentially even produce) expectations of significantly higher inflation.”
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