The Investors have embraced gold in 2020 as a key portfolio hedging strategy. Looking ahead, expectations for a faster recovery (V-shaped) from COVID-19 are shifting towards slower recovery (U-shaped), or potential setbacks from additional waves of infections (W-shaped). Regardless of the recovery type, the pandemic will likely have a lasting effect on asset allocation. It will also continue to reinforce the role of gold as a strategic asset. And we believe that the combination of high risk, low opportunity cost and positive price momentum looks set to support gold investment and offset weakness in consumption from an economic contraction.
GOLD OUTPERFORMED IN H1 AS EQUITIES RECOVERED
Gold had a remarkable performance in the first half of 2020, increasing by 16.8% in US-dollar terms and significantly outperforming all other major asset classes (Chart 1). By the end of June, the LBMA Gold Price PM was trading close to US$1,770/oz, a level not seen since 2012, and reaching record or near-record highs in all other major currencies (Table 1). Though equity markets around the world rebounded sharply from their Q1 lows, the high level of uncertainty surrounding the COVID-19 pandemic and the ultra-low interest rate environment supported strong flight-to-quality flows. Like money market and high-quality bond funds, gold benefited from investors’ need to reduce risk, with the recognition of gold as a hedge further underscored by the record inflows seen in gold-backed ETFs.
ECONOMIC RECOVERY MAY COME IN VARIOUS SHAPES
The COVID-19 pandemic is having a devastating effect on the global economy. The IMF is currently projecting a 4.9% contraction in global growth in 2020, with high levels of unemployment and wealth destruction.
There is a growing consensus that a swift V-shaped recovery is morphing into a slower U-shape recovery or, more likely, the possibility that a recovery in H2 is short lived as recurring waves of infections set the global economy back, resulting in W-shaped recovery.
For investors, this is not only keeping uncertainty levels high, but may also have a long-lasting impact on their portfolio performance. Against this backdrop, we believe that gold can be a valuable asset: it can help investors diversify risks and may positively contribute to improving risk-adjusted returns.
COVID-19 IS UPENDING ASSET ALLOCATION
In response to the pandemic, central banks around the world have aggressively cut rates and/or expanded asset purchasing programmes to stabilise and stimulate their economies. However, these actions are leading to several unintended consequences on asset performance:
• soaring equity market valuations are not always backed by fundamentals, increasing the chance of pullbacks
• corporate bond prices are also increasing, pushing investors further down the credit-quality curve.
• short-term and high-quality bonds have limited – if any – upside, reducing their effectiveness as hedges.
In addition, widespread fiscal stimuli and ballooning government debt levels are raising concerns about a long-term run up of inflation, or significant erosion of the value of fiat currencies. Deflation, however, is seen by some as the more likely risk in the near term.
As these dynamics heighten risk and lead to the possibility of ever lower returns than expected, we believe that gold can play an increasingly relevant role in investor portfolios.
EQUITIES ARE GETTING (VERY) EXPENSIVE AND COULD SEE SHARP PULLBACKS
Global equities were on a virtually uninterrupted one-way trend for more than a decade. The COVID-19 pandemic changed that, resulting in a significant pullback, with all major equity indices dropping by more than 30% during the first quarter. However, equities have recovered sharply since – especially tech stocks. But stock prices do not appear fully supported by company fundamentals or the overall state of the economy.
This has often been referred to as the Wall Street vs. Main Street divide. In the US, for example, price-to-earnings ratios have jumped to levels not seen since the dot-com bubble in the span of a few months (Chart 2).
And while many investors are looking to take advantage of the positive price trend, there is growing concern that such frothy valuations may result in a significant pullback, especially if the economy experiences a setback from a second wave of infections. Gold’s effectiveness as a hedge may help mitigate risks associated with equity volatility.
BONDS MAY OFFER ONLY LIMITED PROTECTION
The low rate environment has also pushed investors to increase the level of risk in their portfolios via buying longer-term bonds, lower-quality bonds, or simply replacing bonds with even riskier assets, such as stocks or alternative investments.
Going forward, we do not believe investors will achieve the same bond returns they have seen over the past few decades. Our analysis suggests that investors may see an average compounded annual return of less than 2% (±1%) in US bonds over the next decade (Chart 3). This could prove particularly challenging for pension funds, as many are still required to deliver annual returns between 7% and 9%. Lower rates increase pressure on the ability to match their liabilities and limit the effectiveness of bonds in reducing risk. In this context, investors may consider gold as a viable substitute for part of their bond exposure.
STAGFLATION, DISINFLATION, DEFLATION?
While it is fairly evident that lower interest rates and asset purchasing programs are impacting asset price valuations, it is less clear what effect expansionary monetary and fiscal policies will have on inflation. Some believe that quantitative easing and increasing debt levels are inherently inflationary and that, sooner or later, consumer prices will spiral out of control even if economic growth remains subdued (ie, stagflation). Others, however, point out that previous– albeit not as aggressive – quantitative easing measures have not resulted in rampant inflation (at least not yet). An additional camp points to the Japanese experience and predicts that deflation may happen first. In fact, there are some indications that this is starting to happen already. For example, while the price of necessities spiked during the lockdown in China, consumer price inflation has fallen from 5.2% in February to 2.5% in June. And some economists predict outright deflation by the end of the year. Gold has historically protected investors against extreme inflation. In years when inflation was higher than 3% gold’s price increased 15% on average. Notably too, research by Oxford Economics shows that gold should do well in periods of deflation. Such periods are characterised by low interest rates and high financial stress, all of which tend to foster demand for gold.
GOLD INVESTMENT WILL LIKELY OFFSET WEAK CONSUMPTION
Gold’s behaviour can be explained by four broad sets of drivers:
• Economic expansion: periods of growth are very supportive of jewellery, technology and long-term savings
• Risk and uncertainty: market downturns often boost investment demand for gold as a safe haven
• Opportunity cost: interest rates and relative currency strength influence investor attitudes towards gold
• Momentum: capital flows, positioning and price trends can ignite or dampen gold's performance.
In the current global economic environment, three of the four drivers are supportive of investment demand for gold, namely:
• high risk and uncertainty
• low opportunity cost
• positive price momentum.
Conversely, an economic contraction will likely result in lower demand for gold in the form of jewellery, technology or long-term savings. This is particularly evident in key gold markets such as China or India.
Historically, investment demand during periods of financial stress has offset weakness in consumer demand and we believe that 2020 will be no exception. However, gold’s performance may depend on the speed and shape of the recovery, which investors can analyse using QaurumSM.