All That Glitters Is Gold
It is not a question about whether you should buy equity or gold. It is more about whether it should be an essential part of your portfolio. In this article we have highlighted the reasons why we recommend gold to be an integral investment along with other asset classes
Warren Buffett, the legendary American investor, has recently done some significant churning in his portfolio. He has sold more than a quarter of his stake in the best known US financial companies such as Wells Fargo & Co. and completely exited from Goldman Sachs. At the same time, he has also acquired stake in Barrick Gold Corp., a Canadian mining company. According to the filling by Warren Buffett’s Berkshire Hathaway Inc. with Security Exchange Commission, the company has bought 21 million shares of Barrick Gold worth USD 563 million, representing 0.3 per cent of Berkshire’s holding.
Such a move has come after the gold price has already rallied by more than 50 per cent in the last year. Even year till date, it has jumped by 35 per cent and has comfortably beaten the best performing equity indices. The gold rally that started somewhere in 2018 has only gathered momentum of late due to the corona virus pandemic and geo-political tension. This move has also been driven by a combination of high uncertainty about global economy, very low-interest rates and the positive price momentum. These are the conditions on account of which the gold price has historically witnessed a great jump.
Gold for the first time has breached the level of Rs 56,000 per gram recently. Though after that it has cooled off and has remained volatile. So for an investor, the moot question is whether the rise in price of gold is sustainable, especially after the recent volatility.
Golden Returns
There are reasons why gold may continue its golden run; however, not with the same pace as we have seen in the last one year. The yellow metal, since 1979, has given an annualised return of 10.75 per cent, which means every Rs 1 lakh invested at the start of 1979 in gold would have become Rs 80.25 lakhs by now. This return has easily beaten inflation during the period but has failed to beat the equity return. The return generated by equity as represented by Sensex has given better return in the same period, nonetheless with greater volatility. The Sensex in the last 41 years has had an annualised volatility of 25.6 per cent, whereas gold in the same period has volatility of 20.54 per cent.
The price appreciation of gold is not steady as with other asset classes. It has a long period when it does not perform or generate adequate returns; however, for a few years it gives stellar returns, which is more than enough to cover the past lower returns. For example, gold failed to generate any return for three consecutive years between 2013 and 2015. Nonetheless, in 2016 it became the best performing asset class.
Hence, it is not a question about whether you should buy equity or gold. It is more about whether it should be an essential part of your portfolio. In the following paragraphs, we will highlight the reasons why we recommend gold to be an integral investment along with other asset classes.
Protection against Volatility
The beauty of returns by gold as an asset class is that it performs better during volatile and uncertain times. It is considered a safe haven, an asset to buy when other assets are losing value. Therefore, investors prefer to buy gold to protect them from such uncertainty. Part of the current rise in gold is attributed due to the same reason. The pandemic has created a lot of uncertainty around the global economy. Even historically we see that whenever there is an unstable situation, gold performs. The graph below clearly shows that whenever investors are uncomfortable, gold shines. For example, during the great financial crisis after Lehman Brothers’ bankruptcy, gold generated a return of almost 8 per cent. Similarly, during 2011 after the downgrade of US and Europe financial crisis, gold generated exceptional returns. The following figure shows the returns by gold during different phases of instability.
No Interest Rate but Commodity Cycle
The most common viewpoint is that there is a negative relationship between gold and interest rates. When we refer to interest rate, it means interest rate in the US in general as gold is valued in USD. The logic behind such a relationship is that gold is not an interest-bearing asset. Why would an investor hold gold if interest rates are rising and gold doesn’t pay you anything? Also, when rates rise, investors flock to fixed-income investments that yield fixed return unlike gold which does not carry any such return. Thus, demand takes a back seat with prices remaining flat. There is another school of thought that says interest rate rises because of strong economy, which may lead to higher inflation and again gold demand increases as a hedge to inflation.
The data of last 40 years shows that predicting the gold price based on the outcome of interest rates on a shorter basis can be a difficult task. Data shows that gold can lead interest rates, or interest rates can lead gold. They can even go in the opposite direction for extended periods. Therefore, a more appropriate approach would be to follow the commodity as a whole. Commodity cycles, which consider all commodities together, are more predictable over long-term time periods to gold than interest rates.
Right now, except for energy, all the commodities are at a multi-year high and likely to continue if analysts are to be believed. It seems that we might be entering into a new commodity cycle, which will keep gold prices high. This is also reflected in higher activities at CME. On August 11, CME saw the second-highest metals’ volume day on record, with over 1,661,000 contracts traded.
Correlation with Equity
Gold does not show any statistically significant correlation with equity in the longer period. However, there is evidence that when equities are under stress, negative correlation can develop between gold and equities. Hence, gold can be a highly effective portfolio diversifier due to its low to negative correlation with equity and even debt. While correlation for most major asset classes, including gold, increased meaningfully during the most recent stock market selloff, gold’s correlation to the stock market remained flat to slightly negative over a longer period.
During the great financial crisis, the correlation between equity and gold return was negative 0.19. Even in the current selloff till March 23, 2020 the correlation stood at negative 0.025. In last four months we are again witnessing the correlation going below zero. This is the reason why gold has consistently benefited from ‘flight-to-quality’ inflows during periods of heightened risk. It is particularly effective during times of systemic risk, delivering positive returns and reducing overall portfolio losses.
The above graph shows the rolling correlation of the gold and Sensex daily returns for the trailing 12 months. It clearly shows that in normal times there is no significant correlation between both; however, during stressed times such as the year 2000 dotcom bust, great financial crisis or the last 24 months, gold is negatively correlated to Sensex. Therefore, we feel that gold protects one’s portfolio from volatility because the factors, both at the macro-economic and micro-economic fronts that affect the returns from most asset classes do not significantly influence the price of gold.
Geo-Political Factors
Geo-political factors impact gold prices negatively. It has been seen that gold prices increase well during geo-political turmoil. Trade war between the world’s two biggest economies in the last few months has boosted the prospects of the yellow metal. Crises such as wars, which have a negative impact on prices of most asset classes, have a positive impact on gold prices since the demand for gold goes up as a safe haven for parking funds.
Weakening Dollar
The USD since the start of April has fallen by almost 9 per cent against a basket of other currencies around the globe. Some of this sell-off may have to do with the fact that the dollar shot up by 6 per cent from the start of the year till March ending, much at the outset of the crisis, as people saw the dollar as a safe haven. It is still not clear how far the USD will decline, but a weak dollar would definitely benefit gold along with the emerging stock market. Both are witnessing a good run.
Under normal circumstances, gold and dollar share an inverse relationship. The graph above clearly shows the relationship. Since international gold is dollar-denominated, any weakness in the dollar pushes up gold prices and vice versa. The inverse relationship is because a falling dollar increases the value of currencies of other countries. This increases the demand for commodities including gold. It also increases the prices. And secondly, when the US dollar starts to lose its value, investors look for alternative investment sources to store value and gold is an alternative for those investors.
Gold Prices: Way Forward
The virus pandemic is far from over and, more importantly, its impact on the global economy is yet to be determined. There are indications that some countries like South Korea, Germany and other European nations that started to turn a corner earlier are now experiencing a new wave of the corona virus. Therefore, the expectation of fast recovery is not sure. Instead, market participants are bracing for a bumpy ride and a long road to recovery.
To ward off any negative consequence of this pandemic, central banks world over have aggressively cut interest rates, often in combination with quantitative easing. Even in India we have seen a sharp cut in interest rate along with various fiscal measures. This is a globally witnessed phenomenon. These initiatives are fuelling the stock market rally and that all the extra money being pumped into the system may result in very high inflation or, at the very least, currency debasements as already reflected in the weakening of USD.
According to a report by World Gold Council, ‘to put things into perspective, the gold price more than doubled from approximately USD 900 per ounce in early 2008 to its high more than three years later in the aftermath of the global financial crisis. In contrast, it has increased by just 30 per cent since the beginning of the pandemic’. Moreover, adjusting for inflation gold is yet to reach its previous high. Therefore, though gold has reached its all-time high in absolute terms, it is still down by almost 10 per cent after adjusting for inflation. The latest minutes released by US Fed in the month of August show that policymakers are considering tweaks to monetary policy that could result in the US central bank sticking with aggressive stimulus measures far longer than under its previous rubric. Therefore, we see that in a low-interest rate environment and easy money, gold continues to attract buyers hunting for a safe-haven asset. Some investors not very fond of gold might say that this may not be the best of investment moves by legendary investor Warren Buffet as with his investment in airline companies he might have to sell gold at a loss. However, we believe that there might be merit in making this move. It has been observed historically that gold mining companies are late to react and have the elasticity of greater than one. Therefore, we believe that this investment made by Oracle of Omaha might turn out to be other Midas touch.
What Should You Do Now?
Coming back to Warren Buffet, we believe a 5-10 per cent of gold allocation is ideal for most investors. The recent rally and volatility at a higher level in gold have worried us. Hence, investment in gold should be made in a staggered manner now. One of the best ways to invest for long term is to invest in sovereign gold bonds. These bonds are issued by the RBI and have sovereign (government) guarantee attached. The value of these bonds is linked to the price of gold. Capital gains on SGBs are exempted if held till maturity, i.e. eight years. Also, in between, if you require liquidity you can sell it on stock exchanges. The best thing about SGBs is the interest payment attached to it as investors stand to get 2.5 per cent interest on the initial investment. Therefore, as an investor you can buy gold as part of your portfolio, not exceeding 10 per cent, and the mode you can choose to invest in SGB.