Investment Strategy Bulletin
CAN GOLD REALLY ACT AS A HEDGE?
Low yields have prompted some investors to turn to alternative assets, among which stand real assets like real estate and commodities. The rally in gold prices (+27% year to date) was particularly impressive during the first quarter, as well as after the Brexit shock, largely as a result of falling US real interest rates. As such, when we revised down our expectations for the peak of the US Federal Reserve (Fed) tightening cycle in May, we upgraded our positioning on gold to neutral. Despite current investor appetite for the commodity, we would not recommend adding more exposure as the downside risks seem larger than the upside potential (expect prices to range between USD1200-1400/oz over the coming months with market fears and Fed repricing). We see more hedging potential on US bonds, especially on the long end of the curve.
From a fundamental standpoint, physical demand is likely to remain weak as gold prices are still close to all-time highs when denominated in emerging market currencies, especially Indian rupees. In addition, the marginal costs of the mining sector (around USD900/oz) suggest that supply is likely to accelerate at current market prices.
As such, gold moves have nothing to do with fundamentals (its physical market) but is today wholly dependent on financial demand. Indeed, with negative interest rate policies implemented by several major central banks diminishing the hedging capacity of traditional safe-havens, such as government bonds, the appeal of gold is reinforced during periods of market turmoil. As a result, in the first half of 2016, gold ETFs enjoyed their strongest inflows since 2013.
That being said, taking a position on gold today means taking a very bearish view on the Fed (US dollar and real rates are the most stable drivers of gold over the long run). With mounting wage pressures, the likelihood of a re-pricing of the US tightening cycle by the end of the year – even a gradual one – should not be underestimated. Given current complacent market positioning, this dynamic could lead to a marked sell-off in gold, similar to those experienced in November 2015 (-10%) and May 2016 (-7%). In addition, even if we think that the low-rates environment is here to stay, possible fiscal tailwinds in the US are likely to limit downward pressures on rates. In all, we see limited upside for gold prices from the point of view of our baseline scenario of a still-stable US growth / limited downside for US real rates / absence of systemic risks. Notably, a scenario of lower growth and deeply negative real rates in the US -as witnessed in 2013- is far from our baseline scenario.
This does not mean that gold cannot benefit from transitory market fears: for example, the uncertainties surrounding Brexit were a strong support for gold prices in June as it was seen as a systemic risk by some market participants. In our view, however, Brexit should not be considered a systemic risk given the size of the UK economy. Meanwhile, the main candidates for such risk (i.e. a hard landing in China, recession in the US, political turmoil in the Euro area), even if they might face structural issues, still have enough ammunition to overcome their respective challenges – at least in the short run.
We acknowledge that gold has recently exhibited good performance in case of equity drawdowns. But it is important to bear in mind that: 1/ a negative correlation between gold and equity should not be taken for granted; 2/ with an annualised volatility exceeding 17% (to be compared with 3.5% on a global government bond index and 15% on US equities), gold should be viewed as a substitute for equity risk. As such, introducing gold in a multi-asset portfolio means adding to the overall risk while increasing the rate sensitivity.
Gold moves are almost entirely fuelled by financial demand, itself fuelled by market fears. We, therefore, expect gold to remain particularly volatile, ranging from USD1200-1400/oz with market fears and Fed repricing. This is likely to penalise its return-to-risk profile and makes it less attractive from a multi-asset perspective. In addition, the net speculative position in gold futures spiked to a five-year high, leaving gold vulnerable to retrenchment from here. Finally, maintaining an exposure to long-dated US bonds seems more interesting to us from a risk-return point of view, not to mention the carry associated to this investment.
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