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July 2018

Expanding horizons with gold

Christopher Dhanraj
Director
Head of iShares Investment Strategy

Key points:

  • Episodes of higher volatility in 2018 have led many investors to search for alternative drivers of returns and downside protection.
  • We find that the low correlation of gold versus other traditional asset classes provides investors with a diversifying tool in constructing a multi-asset portfolio.
  • The investment function of gold as a defensive asset and store of value also helps it serve as a potential hedge against stock, bond, and currency volatility.

Factors influencing gold’s diversification benefits

Historically, gold has been a diversifying compliment to a traditional stock and bond portfolio throughout market cycles. Figure 1 illustrates that the correlation between monthly returns of gold and other asset classes over the past 20 years ranges from 0.3 to -0.3, suggesting the asset has low or negative correlations to most other major asset classes.

This diversification reflects a variety of factors unique to commodities generally, as well as those idiosyncratic to gold itself. As with most other commodities, gold has benefited historically from a weaker dollar environment, as its price is normally benchmarked in U.S. dollars. Additionally, late-cycle supply shortages and high levels of economic activity have also been supportive for commodities broadly.

However, gold’s historical reputation as a store of value, its role as a luxury good, and individual economic dynamics all expose the commodity to unique drivers of returns.

Figure 1: Gold is uncorrelated to other
major asset classes

Gold is uncorrelated to other major asset classes

Source: Thomson Reuters, BlackRock, as of 6/4/2018. Notes: “Comdty” represents the Bloomberg Commodity Index. For indexes used please see the footnote at the end of the piece.1

Hedging attributes of gold

In the present environment, with higher equity volatility and geopolitical uncertainty, gold can play a role as a potential hedge. Additionally, during major market corrections over the past two decades, gold has successfully off-set losses sustained from equities and higher-beta fixed income exposures (Figure 2).

Furthermore, given gold is priced in dollars, and typically appreciates in a falling dollar environment, it has for the greater part of several years performed in-line with an increase in inflation expectations that has occurred in tandem with a decline in the value of the dollar (Figure 3).

However, since gold offers no cash flows, it is susceptible to an erosion of its value from rising interest rates as well as inflation. In an environment of runaway inflation and a weaker dollar, this argument would likely change, but as the dollar has recently been firmer as investors have repositioned for a slightly more aggressive Federal Reserve and after the 2017 dollar sell-off, this outcome seems unlikely. Therefore, as rates move higher in the U.S., the driver of that move – namely faster economic growth – suggests an environment where real rates are increasing and driving the move higher. As higher real rates offer better cash flows after inflation, they become more attractive relative to assets with no cash flows – like gold – leading to an environment where gold underperforms.

Figure 2: Losses sustained during financial crises were offset by gold appreciation

Losses sustained during financial crises were offset by gold appreciation

Source: Thomson Reuters, BlackRock, as of 6/27/2018. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Figure 3: Gold has risen with inflation expectations as the dollar has depreciated

Gold has risen with inflation expectations as the dollar has depreciated

Source: Thomson Reuters, BlackRock, as of 6/27/2018. The breakeven inflation rate represents a measure of expected inflation derived from the difference between the yields of a 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities. Gold is represented by the LBMA Gold Price, a troy ounce index. Past performance does not guarantee future results.

Futures and ETP positioning sending mixed messages

After a strong year of inflows in 2017, when the largest gold exchange traded products (ETPs) pulled in just shy of $3 billion in assets, 2018 has already matched those inflows2 (Figure 5).

Uncertainty in markets and geopolitics have been the key drivers of this acceleration in flows. But looking forward, headwinds to the asset class could portend a shift in the second half of the year.

Gold wiped out its 2018 gains in the month of May, and is now trading at year-to-date lows, as of June 26th.3 It is not unusual to see a spring slowdown; May and June have posted back-to-back months of price declines on average over the last 30 years as demand from consumers in emerging markets for luxury goods containing gold picks up during the holiday season and during the Indian post-harvest wedding season.

In addition, investors in the futures market have been rapidly trimming their exposure to the metal (Figure 4). Hedge funds and other large speculators pared bullish bets on bullion to the lowest level in more than two years as the spot price fell below $1,300 an ounce.4

Figure 4: Futures position has moved sharply lower in the raw commodity since February

Futures position has moved sharply lower in the raw commodity since February

Source: Thomson Reuters, BlackRock, as of 6/27/2018. Gold price is measured by LBMA spot gold price for a troy ounce. Past performance does not guarantee future results.

Figure 5: Inflows into gold ETPs have kept a relatively strong pace despite futures slowdown

Inflows into gold ETPs have kept a relatively strong pace despite futures slowdown

Source: Thomson Reuters, BlackRock, as of 6/27/2018.

Conclusion

In the shorter-term, risks to consider include a potential rally in the dollar. Although the twin fiscal and current account deficits of the U.S. point to a weaker dollar in the longer-term, short-term growth prospects and current interest rate differentials are supportive for the dollar.

However, all things considered, gold is a unique commodity that has historically had low correlation to other assets, providing diversification benefits to investors. Given this, a modest exposure to gold could be suitable for some investors.