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Gold is a unique financial asset. It is best thought of as a non interest bearing real asset. Its performance is primarily driven by two main drivers: 1) the long-term interest rate on money and 2) the value of paper money relative to real assets. Because of those drivers gold does well during periods where easy monetary policy creates rising inflation or during depressions. As a result, gold is best thought of as protection against extreme tail environments rather than incrementally diversifying during normal times
In dollar terms gold sold off in 2022, but not nearly as much as either nominal or real interest rates. The attribution of the return is pretty clear using the framework above - gold benefitted from the rising inflation but was weighted down as long-term interest rates rose substantially. Gold certainly held up well overall suggesting that the impact from rising inflation was supportive to its price (20%+).
Sources: Yahoo Finance and Unlimited Calculations.
For informational and educational purposes only and should not be construed as investment advice. Past performance not indicative of future results.
In many developed economies gold provided a substantial diversification benefit to declines in equities. In Japan, the UK, across Europe and Australia gold returns were positive in local FX terms in contrast to equity markets that declined. In these economies monetary policy and the shift on the long end was not as substantial relative to rising inflation. The US dynamic is the outlier across developed economies as the Fed pursued more aggressive monetary tightening than elsewhere.
This range of outcomes is critical for investors to think about when constructing a strategic portfolio. While it’s true in the US case the Fed took an aggressive tightening posture this time, it wasn’t a given nor should it be relied on to continue. If anything, it was the outlier in response to inflation relative to other developed country counterparts.
Sources: Yahoo Finance and Unlimited Calculations.
For informational and educational purposes only and should not be construed as investment advice. Past performance not indicative of future results.
While the rising inflation environment has supported gold prices in many local currencies, the real sweet spot for gold is in more tailed environments. The chart below shows the average annual return of gold in local currency terms during a range of different inflation rates across roughly 10,000 historical 12m periods in both emerging and developed economies (which are broken out below).
Gold typically starts to perform well as inflation emerges but does better than inflation itself starting at inflation of around 10% up until inflation approaches 40%. Above that both gold and inflation reflect the exchange rate moves one for one.
Gold also starts to outperform when deflation emerges - with clearly positive returns once inflation falls below zero. And in extreme depression environments gold typically rallies as paper money is devalued relative to productive real assets to arrest the deleveraging dynamic. The US depression is the classic case, but we also saw gold do well during the GFC deleveraging environment.
Sources: Yahoo Finance and Unlimited Calculations.
For informational and educational purposes only and should not be construed as investment advice. Past performance not indicative of future results.
So, what is the right allocation to gold? It is different for each investor given their risk tolerances. It comes down to how much an investor desires protection from the impacts of a tailed inflation outcome. Determining that is a function of the probability that an investor sees that outcome in their own currency and the impact on the rest of their portfolio.
Many emerging markets investors hold a substantial amount of gold because inflationary environments are relatively common. In the developed world those outcomes are less likely but happen with enough frequency that gold is a valuable portfolio diversifier.
For instance, in the last 100 years in the US we have had 2 instances of depression and several instances of rising inflation where gold would have been a very valuable asset in a strategic portfolio. In the floating exchange rate era alone in 11% of all 12m periods stocks were down and gold was a better diversifier than bonds.
Despite these tailed outcomes being reasonably common the vast majority of investors do not hold gold in their portfolio. Given the uncertainties about building inflationary pressures and central banks’ response, it could be worth considering.
For informational and educational purposes only and should not be construed as investment advice. It does not constitute an offer to sell or a solicitation of an offer to buy any security. Opinions expressed are our present opinions only. No Representation is being made that any investment will or is likely to achieve profits or losses similar to those shown herein. No investment strategy or risk management technique can guarantee return or eliminate risk in any market environment. The material is based upon information which we consider reliable, but we do not represent that such information is accurate or complete, and it should not be relied upon as such. The historical analysis should not be construed as an indicator of the future performance of any investment vehicle that Unlimited manages.
