Checkmate

Gold is on a Tear

Gold has been on a tear in 2019. The gold price recently breached $1,500, after smashing the $1,370 ceiling of its long-term range in June. This is impressive when considered in the context of a reasonable economy, a strong U.S. dollar and resilient equity markets throughout 2019. The seesaw between risk-on and -off, the ongoing debate over economic data and forecasts, permutations around the U.S.-China trade situation and, most recently, the beginning of an impeachment inquiry, all seem to have little effect on gold, which has posted positive daily performance on both sides of those short-term influences.

So, what gives?

Gold Has Dual Purpose: Portfolio Insurance for Inflation or Deflation

Like other forms of faith, those who believe in gold will not apostatize, and most who do not believe cannot be convinced. That is the generational fallout from some 50 years throughout which the majority of the global population believed that fiat currency was the only legitimate store of value. On that score, I would hope that gold will eventually be judged on the quality of its track record ―its massive liquidity, strong price performance versus fiat currencies, and eventual use as a digital savings asset and payments medium (see The Rebirth of Gold as Money).

My career has involved interacting with many of the most notable investors in the gold sector. Although these gold aficionados all share similar long-term belief in the advantages of gold, it has never ceased to amaze me how different their macro-economic outlooks are, especially as it relates to the potential for harmful inflation or deflation. Similarily, few strategists or economists go into depth about what extreme scenarios could play out for either of these possibilities. Let’s consider both in the context of the gold’s utility as an asset.

Gold has successfully been used by savers as a store of value during periods of high inflation and corresponding currency devaluation. Deflation, on the other hand, triggers debilitating solvency and liquidity issues which usually lead to severe market corrections, again leaving gold as a better asset to own outside of those correlated with credit and equity markets. The reason why gold supporters do not debate their differentiated macro forecasts is that gold is a chameleon that can benefit from both outcomes, and thereby provides insurance from negative market developments stemming from polarized monetary outcomes, as shown in Figure 1.

Figure 1. Gold Provides Proven Portfolio Protection1

This chart measures the performance of Spot Gold versus the S&P 500 Index versus during 11 crisis periods since 1985. Gold returned an average +6.4% compared to -21.7% for the S&P 500 for these 11 crisis periods.

Source: Tocqueville Asset Management. See explanation of crises in footnote 1. 

A Mandatory Portfolio Allocation

This observation about gold fits like a glove to the current set of circumstances in the financial world. Theoretical models predict that record low and negative interest rates should drive extraordinary investment in even marginally accretive economic and national projects, creating tightness in the economy, rising labor costs and ultimately inflation.

On the contrary, many current economic indicators, including the yield curve, suggest that investors should raise cash and prepare for the worst. That is also not happening, as equity markets are buoyant, at least in the U.S., and indicators of credit stress remain resilient. Nevertheless, the situation is like a coiled spring, ready to fire in either direction.

Furthermore, ten years of growth have left both equity and credit markets expensive and over-bought. Infrastructure projects and real estate values are more linked to cap rates than to rents. Correlation among all these markets is dangerously high, and low volatility levels signal that complacency has set it. Leading indicators of credit stress, while still relaxed, are just starting to show signs of over-exuberance.

In the context of markets, which we propose at this stage require tail-risk hedging, gold has an enviable track record as a non-correlated store of value and insurance provider. The World Gold Council outlines the increasing utility that gold has within a financial portfolio in Figure 3.

Another factor that underscores gold’s increasing importance as a crisis offset asset can also now be demonstrated ― that U.S. Treasuries are no longer asymmetrically correlated to market risk. As we illustrate below, Treasuries now carry more correlation to equity market risks than they have historically, while gold displays low correlation to traditional asset classes and provides protection against portfolio drawdowns.

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