Gold has been a popular investment for centuries, and for good reason. Despite gold also being a core part of the All Seasons Portfolio and other macro oriented diversified portfolios, I have barely covered this asset in isolation at all on the blog. Let us therefore explore in this article, the benefits of gold as an investment and its place in a diversified portfolio, like the All Seasons Portfolio.
To start with, gold is perhaps most known for its ability to hedge against inflation, its low correlation with the stock market, and its relationship with real interest rates. In this article, we will discuss these key factors and how they relate to investing in gold. We will also be looking at its relationship with the M2 money supply and currency exchange rates (a falling gold price in USD does not necessarily mean a price decline when measures in EUR).
Gold as an inflation hedge
First, let’s explore the role of gold as an inflation hedge. Inflation is the increase in the prices of goods and services over time, and it erodes the purchasing power of money. When inflation rises, the value of traditional investments, such as stocks and bonds, may decline in real terms. In contrast, the price of gold tends to rise during periods of inflation, making it an attractive investment for those seeking to protect their wealth.
Gold is often viewed as a store of value that can maintain its purchasing power over time. Unlike fiat currency, which can be printed by central banks at will, the supply of gold is limited, and it cannot be easily manipulated. As a result, many investors turn to gold as a hedge against the devaluation of paper currency.
But the gold price is vulnerable against significant increases in real yields. While we will be discussing this relationship in more detail further below, it is worth mentioning that even during the inflationary environment in 2022 in the US, the gold price in USD did not perform that well, as interest rates were aggressively hiked by the Fed.
In a relative sense though, gold performed much better than fixed income assets, such as long-term bonds (both nominal and real), which has much deeper drawdowns in 2022.
However, as inflationary pressures persist (inflation rate still being elevated and the M2 money supply not having declined after the Covid-19 surge), gold could perform better in 2023 in an environment of still elevated inflation and more cautious interest rate policy from central banks.
Gold in a portfolio (Modern Portfolio Theory)
Next, let’s examine the low correlation between gold and the stock market and thus how gold plays a role in a diversified portfolio. The stock market is known for its volatility, and it can be difficult for investors to find investments that are not highly correlated with the market. Gold, however, has a low correlation with the stock market, making it a useful diversification tool.
During periods of market turbulence, investors may flee to safe-haven assets like gold, driving up its price. This flight to safety effect can help to cushion the impact of a downturn in the stock market, making gold an attractive investment for risk-averse investors.
In the context of portfolio management, the efficient frontier and modern portfolio theory (MPT) can be useful tools for constructing an investment portfolio that includes a gold allocation.
MPT is a framework for portfolio construction that takes into account the expected returns and risks of different assets, as well as the correlation between those assets. The goal of MPT is to create a portfolio that maximizes expected returns for a given level of risk or minimizes risk for a given level of expected returns.
The efficient frontier is a graphical representation of the set of portfolios that achieve the highest expected returns for a given level of risk or the lowest risk for a given level of expected returns. The efficient frontier is often used in MPT to help investors find the optimal asset allocation for their investment portfolios.
When considering an investment in gold, MPT suggests that adding a gold allocation to a portfolio can improve its risk-return characteristics, particularly during periods of market stress. Since gold has historically exhibited low correlation with other asset classes, adding gold to a portfolio can help to reduce its overall risk.
However, the optimal level of gold allocation will depend on an investor’s specific investment objectives, risk tolerance, and financial situation. Too much gold in a portfolio may lead to underperformance in periods when the asset class is out of favor, while too little gold may result in missed diversification benefits during times of market stress.
By using MPT and the efficient frontier, investors can find the optimal allocation to gold in their portfolios that balances expected returns and risk. The efficient frontier can help investors to identify the optimal allocation that maximizes expected returns for a given level of risk or minimizes risk for a given level of expected returns. In the last 50 years, the Sharpe ratio optimal stock/gold portfolio has been an allocation has been a 72.3% / 27.7% allocation, albeit this ratio varies a lot depending on the lookback period used for the backtest.
As gold, like other commodities, is an asset which is more volatile than stocks and bonds, gold’s weight in a portfolio should be relatively light. This is especially true when adding a risk parity approach, where allocation is based on each asset’s risk contribution, by allocating equal amounts of risk rather than allocating an equal amount of capital. This is the basis for the All Seasons Portfolio strategy which I employ, where gold holds a weight of 7.5% (in a commodity basket of 15%), while stocks make up 30% of the portfolio. These are close to the optimal allocations (see below), albeit the sample period is much shorter due to availability of asset class data.
In summary, modern portfolio theory and the efficient frontier can be useful tools for investors looking to construct a portfolio that includes a gold allocation. By taking into account the expected returns, risks, and correlations of different asset classes, investors can find the optimal allocation to gold that balances risk and return.
Gold and real Interest Rates and Money Supply
Now, let’s discuss the relationship between gold prices and real interest rates, as we alluded to earlier in this article. Real interest rates are the nominal interest rates adjusted for inflation. When real interest rates are low or negative, gold tends to perform well. This is because gold is a non-yielding asset, meaning it does not pay interest or dividends. In contrast, when interest rates are high, investors may prefer to hold interest-bearing assets like bonds instead of gold.
The relationship between gold prices and real interest rates can be explained by the opportunity cost of holding gold. When real interest rates are low, the opportunity cost of holding gold is also low, making it more attractive to investors. Conversely, when real interest rates are high, the opportunity cost of holding gold is higher, leading some investors to sell their gold holdings and invest in interest-bearing assets instead.
Furthermore, gold can act as a hedge against the government issuing the bonds defaulting, meaning that a part of a portfolio should still be allocated to gold even though interest rates are rising. Especially these days when the US debt ceiling discussion again flaring up, with the Treasury expecting to be able to fund its obligations until May/June 2023, gold can be a decent hedge in case the situation is not resolved prior to summer. What actually happens if the debt ceiling is breached is unprecedented and uncertain, but it is unlikely that the debacle will not be resolved at least shortly after the issues arise.
Moving on to money supply. The development of money supply in M2 can also affect the gold price. M2 is a measure of the money supply that includes cash, checking deposits, savings deposits, and other liquid assets. When the money supply in M2 increases, there is more money available in the economy, which can lead to inflationary pressures. As we discussed earlier, gold is often seen as an inflation hedge, which means that its price may rise when there is an increase in the money supply.
When the money supply in M2 increases, it can also lead to a decline in the value of the currency, which can further increase the demand for gold as a store of value. In addition, a higher money supply can lead to lower real interest rates, which we also discussed earlier. When real interest rates are low, gold becomes more attractive since it has no yield, as the opportunity cost of holding gold is lower.
Applying theory to practice, let’s have a look at what is going on with M2 today. While the Federal Reserve has been tightening its monetary policy, the M2 money supply has barely declines since its peak in April 2022. Notably, M2 is still 50% higher than it was just before the launch of fiscal stimulus in the Covid-19 crisis. That is a crazy amount of money in circulation (historically speaking), and if this does not decline soon, there may be a case for further increases in the gold price.
Another way that the development of the money supply in M2 can affect the gold price is through changes in the demand for gold by central banks. Central banks hold gold as part of their foreign exchange reserves, and their purchases or sales of gold can have a significant impact on the gold price. If central banks are increasing their purchases of gold, it can signal a lack of confidence in the value of their own currency, which can further increase demand for gold.
In summary, the development of the monetary supply in M2 can affect the gold price in several ways. An increase in the money supply can lead to inflationary pressures, lower real interest rates, and a decline in the value of the currency, which can all increase demand for gold. In addition, changes in the demand for gold by central banks can also affect the gold price.
The gold price in other currencies than the dollar
The dollar index (DXY) is a measure of the value of the US dollar against a basket of other currencies, including the euro, yen, and British pound. As a result, the development of the dollar index can have an impact on the price of gold, which is typically denominated in US dollars.
When the dollar index is high, as it has is now at historically high 103, it can put downward pressure on the gold price, when priced in dollars. This is because a stronger dollar can make gold more expensive for buyers using other currencies, reducing their demand for the metal, especially as gold futures and other derivatives are commonly priced in dollars. Conversely, a weaker dollar can make gold more attractive to buyers outside the US, potentially increasing demand and pushing up the gold price.
However, the relationship between the dollar index and the gold price is not always straightforward. There are many other factors that can affect the gold price, including inflation expectations, interest rates, geopolitical tensions, and changes in global demand for the metal.
Looking ahead, if the dollar index were to continue to decline from its high of 115 in October 2022, below today’s 103-level, it could potentially provide support for the gold price. This is because a weaker dollar would make gold less expensive for buyers using other currencies, relative to American buyers.
It is also worth noting that the current level of the dollar index is high from a historical perspective, which could suggest that the dollar is overvalued relative to other currencies, and perhaps also gold. If this is the case, it could be an indication that the dollar is due for a correction, which could provide support for the gold price.
Thus, the development of the dollar index can have an impact on the gold price, but the relationship between the two is complex and can be influenced by many other factors. A weaker dollar could potentially provide support for the gold price, but investors should carefully consider a wide range of economic, geopolitical, and financial factors when making investment decisions related to gold or any other asset.
It is important to note that the relationship between the dollar index and the gold price may not be consistent across all currencies. When the dollar strengthens relative to other currencies, the gold price in USD may decrease, but the gold price in other currencies could remain stable or even increase.
Let us take a look at an example to illustrate this. If the dollar index were to decrease, the price of gold in USD may increase due to a weaker dollar. However, if the value of other currencies were to increase relative to the dollar, the price of gold in those currencies could decrease, potentially offsetting any gains in USD.
Therefore, when analyzing the relationship between the dollar index and the gold price, it is important to consider the impact on the gold price in other currencies as well. Gold is a global asset, and changes in currency exchange rates can have a significant impact on its price in different countries, but only as each currency is just another measure for prices of objects.
Changes in the dollar index can therefore affect the gold price in USD, but the relationship between the two may not be consistent across all currencies. It is important to consider the impact on the gold price in other currencies when analyzing the relationship between the dollar index and the gold price.
Let’s take another hypothetical scenario where the gold price in USD remains unchanged, while the dollar index (DXY) declines and the EUR strengthens against the USD.
Assuming a gold price in USD of $1,800 per ounce and an exchange rate between the USD and the EUR of 1:1.07 (the rate in February 2023), the gold price in EUR is €1,682.24 per ounce (1,800 / 1.07).
If the gold price in USD remains unchanged at $1,800 per ounce, while the exchange rate between the USD and the EUR strengthens to 1:1.15 due to the strengthening of the EUR against the USD, the gold price in EUR would actually decrease to €1,565.22 per ounce (1,800 / 1.15).
At the same time, let’s assume that the DXY declines from 103 to 95. This means that the USD is weaker relative to a basket of other currencies, including the EUR (even though a decline in DXY does not guarantee that EUR rises, as other currencies in the basket may rise to offset declines in the EUR/USD exchange rate). Note, though, that the EUR makes up 57.6% of the Dollar index. As a result, the EUR strengthens relative to the USD, which would also support a decrease in the gold price in EUR terms, ceteris paribus.
So, even if the gold price in USD remains unchanged, a decline in the DXY could still result in an increase in the gold price in EUR terms. In this scenario, however, the gold price in EUR would decrease to €1,565.22 per ounce due to the strengthening of the EUR against the USD, but the decline in the DXY could also potentially lead to an increase in the gold price in EUR terms if it is the other currencies in the basket that strengthen against the US dollar.
In conclusion, gold can be an attractive investment for those seeking to hedge against inflation, diversify their portfolio, and take advantage of low or negative real interest rates. We have discussed gold as an investment, and its role in a diversified portfolio, such as the All Seasons Portfolio. We have explored the benefits of gold as an investment, including its ability to hedge against inflation, low correlation with the stock market, and its relationship with real interest rates, M2 money supply and currency exchange rates. We have also explored modern portfolio theory and the efficient frontier and how they can help investors find the optimal allocation of gold in their portfolios, balancing expected returns and risk.
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