Why gold outperformed other assets recently

(January 26, 2015 - by Russ Koesterich, CFA, Blackrock)

Gold is benefiting from today’s low interest rate monetary climate, and Russ says its diversifying effects mean the metal can be a valuable risk management tool for investors.

I’am advocating gold as a long-term investment and also as a risk management tool. Today, I remain bullish on the metal for two reasons – the monetary climate and gold’s diversifying qualities.

Gold is up nearly 8% this month, outperforming most equity indexes. Gold & dash; more than any other commodity – is a natural beneficiary of the current monetary regime, which is characterized by negative real interest rates.

 

Gold has had a better 2015 so far 2015-01-20

Gold outperformed other assets as investors fear another bout of global slowdown

The above graph compares the performance of spot gold (GLD)(IAU) with the S&P 500 (SPY)(IVV) for the month so far. The S&P 500 has lost close to 2% since the start of the year, whereas gold has returned about 8% to its investors in the same period.

Gold outperformed most global equities (QWLD) as fears of a global slowdown spooked investors. Most developed markets (EFA), with the exception of the United States, are seeing slow growth, especially Europe (EZU).

In addition, political instability in Greece has added to Europe’s woes. This has led to high volatility (VXX) in most markets. Remember, although the US economy is witnessing growth, the stock markets are affected by the goings-on elsewhere since a global slowdown is bad news for exports.

These fears have led to a scramble toward safe havens such as gold and Treasuries (TLT). The ten-year U.S. Treasury is trading well below the 2% mark, close to 1.8%. Recently, treasuries all around the developed world saw their yields battered as investors looked for shelter from risky assets.

Why gold underperforms when real rates are high

Most of the world’s central banks are trying to hold interest rates at or below the level of inflation. This strengthens the argument for buying gold because it means there is no opportunity cost for holding gold—in other words, investors aren’t going to be missing out because inflation is so low to begin with. Over the past two decades, this relationship between real interest rates and the return to gold has been exceptionally strong, explaining roughly 60% of the variation in the annual return to gold.

 

Gold and real interest rates move in opposite directions 2015-01-20

Gold underperforms when real rates are high

The above graph shows real interest rates and gold prices in the last ten years. The bank prime loan rate serves as a proxy for nominal interest rates. Real interest rate is nominal interest rate minus the inflation rate.

Gold (GLD)(IAU) prices have moved up when real interest rates remained low. On the other hand, gold underperforms when real rates rise. This decreases the attractiveness of gold since investors would rather invest in more attractive bank deposits.

Most major central banks in the world are keeping interest rates at record lows. Europe (EZU) and Japan (EWJ) are keeping interest rates low to support economic growth in their respective economies. Japan has also introduced a quantitative easing (or QE) program, much like the United States did. The ECB (European Central Bank) could also introduce a similar program soon. They’re doing this to pump money into the economies in order to boost consumption and investment.

Although the Fed wound up with QE in the United States, interest rates remain very low as the Fed seeks to boost the economy further. Although inflation rates could remain low, global interest rates also could remain low, which could support gold prices for a while. Low interest rates could also support equities (SPY).

Why gold and the dollar move in opposite directions

While the US dollar is strengthening, I still believe that investors should consider maintaining their allocation.

 

A stronger dollar is a negative for gold 2015-01-20

Gold and the dollar move in opposite directions

The above graph compares the dollar index (UUP) with gold (GLD)(IAU) prices for the last five years. It illustrates that gold and the dollar move in opposite directions.

There are many reasons why the value of the dollar affects commodity prices. The main reason is that most commodities are priced in dollars. When the US dollar strengthens, it will take fewer dollars to buy commodities. In other words, commodity prices fall. Exactly the opposite happens when the dollar weakens.

The S&P 500 (SPY)(IVV) has given splendid returns in the last three years or so. The markets perceived the Fed’s QE (quantitative easing) program to be positive for equities, which led to funds flowing from safe assets like gold toward equities. However, Treasury (TLT) prices rose due to aggressive buying by the Fed.

More recently, the end of QE and the fear of a rate hike has led to a further decrease in gold prices. As higher rates are positive for the dollar, the dollar index has soared. The fact that interest rates remain low elsewhere while those in the United States could rise soon is a positive for the dollar.

However, as long as the uncertainty regarding global growth lingers, gold could benefit. It could take a while before we see improvement.

Why you should own gold: The diversification angle

Investors should also consider gold as a diversifying asset. In an environment in which correlations are elevated, gold continues to march to its own drummer. Since 2010, gold’s correlation to the S&P 500 has been 0.06, a remarkably low correlation in an environment in which most assets, apart from Treasuries, tend to move together.

The bottom line is that I continue to advocate a strategic allocation to gold, in addition to investing in a broader commodity benchmark.

Gold is good from diversifaction point-of-view 2015-01-20

Gold adds diversification benefits to your portfolio

The above graph shows the correlation coefficient of gold (GLD)(IAU), the S&P 500 (SPY)(IVV), the iShares Emerging Markets Fund (EEM), and the iShares Barclays 20+ Year Treasury Bond ETF (TLT), considering monthly returns for ten years.

The correlation coefficient, which always lies between -1 and 1, is the extent to which two securities move with each other. A correlation coefficient of 1 means that the two securities move in absolute tandem with each other. A coefficient of -1 means the two securities are inversely related. A coefficient of 0 means the two move in random directions. It’s the most desirable coefficient as far as portfolios are concerned.

The correlation between gold and the S&P 500 is 0.1. Between gold and Treasuries, the correlation is also 0.1. Between gold and emerging markets, it’s slightly above 0.3. The correlation between gold and the S&P 500 is much lower than between the index and emerging markets. Surprisingly, the latter stands at 0.8. The correlation between the S&P 500 and Treasuries is -0.3. Gold, which has a correlation close to 0, is a better option in terms of diversification.

This means that gold adds diversification benefits to a portfolio containing the other three assets. So gold needs to be in your portfolio and you should own gold, at least in a small amount.

Disclosure: The content Market Realist publishes should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of Blackrock.

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