Gold as an asset class has always provoked sharp divergences of opinion, from those who view it as the ultimate hedge against inflation, to those who will not consider it in portfolios.
What cannot be argued with is the recent performance of gold, hitting multiple highs, and, as the chart below shows, sharply outperforming the US equity market, returning more than twice the gains of the IA Global sector over the past three years.
But even among specialist gold investors there are different views as to what is behind the upward momentum in the gold price and whether it can continue.
One theory is that emerging market central banks, spooked by the exclusion of the Russian rouble from the global financial system reacted by buying gold, lest such a fate hit their economy, and because the current political environment in the US makes owning Treasuries, which traditionally compete with gold as a safe-haven asset, relatively less attractive.
Such buying activity would be extremely positive for gold, as it would be long-term buying by entities unconcerned with day-to-day price movements, and would, in the words of Jim Luke, commodities fund manager at Schroders, “put a floor on the gold price”.
His view is that the extra demand has come almost entirely from Asia and China, although more recently the inflows have come from buyers in the western world, which prompts him to say that “there won’t be a big fall in the gold price from here, despite it hitting all time highs. For an investor to think gold is going to fall sharply from here, they would have to think that the US fiscal deficit won’t be a problem, that the dollar won’t be weak”.
Ned Naylor-Leyland runs the gold and silver fund at Jupiter. He says the role of central bank buyers in driving up the gold price has been overstated, as although buying activity from those institutions has been material, he says the size of the gold market means even such a significant buyer could not drive the price to the extent it has.
Instead, he says, the gold price rise has tracked the rises seen in futures markets — that is, investors betting on the future direction of the gold price, indicating that the market movements reflect a broadly held view about the attractiveness of the asset class.
Rates and measures
Gold’s role as a safe-haven asset class means it competes with US government bonds as a safe haven.
If US real bond yields — that is the yield after the rate of inflation is considered — and to a lesser extent, nominal bond yields — that is the yield without considering inflation — are rising, then the attractiveness of gold may be diminished.
This is because gold itself does not pay an income yield. So if the yield on a US government bond rises to say, 5 per cent, as happened with the 30-year bond last week, then an investor is receiving a guaranteed 5 per cent return if they just hold on to the bond, so the gold price must rise by at least that, in order to match the return.
That should mean rising US yields makes gold less attractive, while falling yields make it more attractive.
But as the chart below shows, in recent years, as US government bond prices have fallen, and so yields risen, the gold price has also risen.
Naylor-Leyland’s view is that the correlation is with real yields, the chart above reflects nominal yields, and real yields have risen in recent years as the rate of US inflation has fallen.
But the Jupiter man’s view is that something more structural may have changed this time as investors are spooked by the size and persistence of the US deficit, “and the change of language from the White House” about cutting the deficit.
Investors seeking a safe haven may not wish to have exposure to the potential fall in US government bond prices as a result of the extra issuance needed to fund the deficit, or the extra volatility that has been a feature of the asset class in recent years.
Luke says the continued rise in yields, rather than making government bonds more attractive, is having the opposite effect, as the losses make the assets less attractive.
Digging deep
While the gold price has risen, Luke says his fund has captured those gains via investments in gold bullion, but he notes that the valuations at which the gold-mining companies trade have not kept up with the rise in the gold price, prompting him to also allocate some of the capital in his fund to mining stocks.
His fund is mandated to own gold directly, or the equities, in proportion to where he sees the value at any given time. Right now he says he is “overweight” to both the equities and to gold directly, due to valuations.
Luke says one of the reasons mining stocks, particularly smaller company stocks, have remained at subdued valuations is that many of the traditional buyers of such assets have been retail clients in the US, a cohort he says has now turned to buying cryptocurrency.
Of the larger mining companies, he says: “We have the strange situation where the gold price is being driven by eastern investors buying bullion, but the gold miners are trading at valuations that reflect where western investors’ attitudes to equities are now. While that dislocation remains, the risk-to-reward ratio is very attractive for owning the equities.”
Naylor-Leyland says the discount is particularly acute among companies that are exploring for gold right now, rather than those already producing, with his focus being on miners in stable political jurisdictions.
Wealth perspective
Simon King, chief investment officer at Vermeer Partners, has long used gold in his portfolios.
He says: “Gold has formed part of strategies since we started Vermeer. We regard it as a true diversifier and importantly an attractive asset in its own right. It has to be held on a constant basis rather than traded.
“We believe that over longer time periods it is an inflation hedge and a reliable safe haven in periods of stress.
“In our view naysayers tend to over-focus on short-term performance and correlations. We like the fact that you can touch it and we know how much of it is in existence, and [that] explains our continuing preference for it over cryptocurrencies.”
King accesses gold via the use of exchange traded funds.
James Sullivan, head of partnerships at Tyndall, says: “As an asset class, it is hard to view gold as a proxy for equities, similarly, it is hard to view it as an alternative to bonds. They each have very different characteristics.
“Therefore, its closest relative is arguably currency, or the smorgasbord that is alternatives. It is within this pot that one should consider an allocation, if at all.
“Gold is a currency that thrives on schadenfreude such as negative real yields, or broader macro uncertainty, and it is a potential go-to during (or preferably in the lead up to) less pleasant conditions that lead to volatility and periods of risk off.
“However, the typically binary nature of the performance of bullion does come with its own risks, notably the risk of missing out.”
David Thorpe is senior investment editor of FTAdviser
